FX Voices: From the Floor

The TRADE caught up with a selection of senior buy-side traders and dealers to discuss their key themes, priorities, strategies and expectations for the future.  

Peter Welsby

PETER WELSBY, Senior Multi-Asset Trader, Manulife Investment Management 

At the start of 2021, the majority of NDF flow was on Primary markets, however, new entrants have been gaining traction, with mid-matching venues and secondaries growing their market share. 

Manulife’s main FX Trading objective for 2023 is to continue to improve the best-in-class execution that we achieve for our clients. Some key areas to focus on will be how market infrastructure and liquidity patterns are evolving and how capital requirements impact our liquidity providers. 

From a spot trading perspective, market infrastructure is starting to converge between developed markets (DM) and emerging markets (EM). For a while now DM volumes have been moving away from Primary ECNs and toward bank client matching pools, mid-matching venues and secondary ECNs. For deliverable EM and NDFs however, it has been a slower move away from Primary ECNs. At the start of 2021, the majority of NDF flow was on Primary markets, however, new entrants have been gaining traction, with mid-matching venues and secondaries growing their market share. We may be starting to reach critical mass in terms of liquidity pools in DM, but it doesn’t feel we have gotten there yet in EM. With signalling becoming particularly noticeable on lit ECNs for EM currencies, alternative liquidity sources can be helpful reduce market impact and improve slippage, especially in volatile markets with thin liquidity. 

One evolving liquidity pattern is related to off-SEF and on-SEF fragmentation. During Asian hours, most trading is done off-SEF whereas during US hours, most trading is on-SEF. Historically, many banks have either been set up to trade on-SEF or off-SEF. Whilst this is becoming less of a problem, as more banks can now do both, certainly not all have this ability yet. Those that don’t have had to find more innovative ways to deal with it. For example, access to onshore helps banks to hedge flow if off-SEF is a struggle. But once onshore is shut, it becomes harder. Equally, not all banks have access to onshore in each country. 

The time of the day also needs to be considered when optimising execution. It seems natural that Korean Won would trade more volume off-SEF during Asian hours than on-SEF during US hours. However once off-SEF starts to dry up at 10am, there is a dark period until the US starts trading after midday London hours. Equally, there are drops in liquidity over ‘lunch breaks’ for EM currencies. CEEMEA pairs see a far greater dip in liquidity between 11am and 1pm London hours than G7 pairs do and similarly CNH and HKD see a dip between 4am and 6am London time. Essentially, once outside the majors, it becomes difficult to maintain execution costs at a similar level around the clock. Improved liquidity in these dryer periods is something the market can work on going forward. 

An additional challenge that the market has experienced more recently is related to forwards liquidity and pricing. SA-CCR has been causing RWA challenges for some banks, with the consequence of balance sheet premium often being wider forward spreads from a select group of banks at the same time.    

All of this highlights the need for the buy-side to pick wisely which banks are on their panels. 

Damilola Otakoya

DAMILOLA OTAKOYA, multi-asset investment dealer, Aegon Asset Management 

Emphasis should also be placed not only on attracting diverse talent but promoting an inclusive/ diverse culture and environment.

A diverse range of skills will be required to navigate and thrive in tomorrow’s data and tech driven environment. Skills which we value today to analyse, interpret, and utilise data, technologies in order to provide best execution and solutions for our clients will remain very important. Skills which make use of machine learning and coding on platforms such as python will be indispensable. I feel most importantly that the soft skills which we place in high regard today such as communication, problems solving, attention to detail and relationship building which allow us to collaborate effectively with internal and external aspects of our business, share ideas and ultimately allow us to better service our clients and provide best execution will continue to be of paramount importance. 

The pandemic forced many of us to place greater emphasis on business continuity, infrastructure and investing in more robust technologies to optimize workflow and enhance productivity. Adaptability and flexibility are key to future proofing desks in this quickly evolving environment with greater focus now more than ever placed on automation, regulatory conduct and culture and I believe that those that stand still run the risk of being left behind. 

Diversity is also key to future proofing and attracting new talent. As part of a diverse team myself with colleagues from different backgrounds and cultures and with a broad range of ideas, I fully appreciate the way this allows us to evolve organically within a modern and collaborative working and trading environment while this diversity of thought and expertise will allow us to meet future challenges in many ways. Advertising on diverse platforms and networks, using inclusive language on job descriptions, having a diverse panel and taking part in many initiatives out there that cater for diverse talent is important. Student outreach is also very important starting early in schools and colleges to speak about the range of career paths on offer and encourage young students to consider a future career in the industry – something Aegon AM has been heavily involved in. Emphasis should also be placed not only on attracting diverse talent but promoting an inclusive/ diverse culture and environment which works to retain, nurture and promote diverse talent. 

I think it would have been difficult to predict the last five years without a crystal ball. We have had a pandemic, lockdowns, war in Eastern Europe, inflation, rising interest rates, real risk of recession and the rise of crypto. In the future I think we will continue to embrace technology and go down the path of further automation and electronification. Better machine learning and Algos across the full FX product range including NDFs. Better gathering and utilising quality data. Better pre trade analytics and post trade TCA. All of these factors combined will work to ultimately reduce human error, increase oversight and achieve best execution for our clients. 

Patrick Forde

PATRICK FORDE, head of trading, Fulcrum Asset Management 

UMR has increased the cost of holding OTC FX positions for the buy-side and prime brokers. This makes the traditional FX model (OTC and PB) more expensive. 

The recent growth in the FX futures market is driven from two sides. Firstly, the benefits of holding a centrally cleared product vs an OTC FX trade. Secondly, recent changes made by the CME (and other exchanges) to allow futures participants access wider OTC liquidity pools. Holding a future can have substantial benefits in terms of leverage/sum of notional calculations, margin requirements, counterparty risk, as well as operational efficiencies. Changes made to FX futures contracts in recent years have substantially reduced some of the liquidity barriers to trading FX futures, particularly in less liquid contracts outside G4 currencies. In the past, the only option was to trade on the exchanges Central Limit Order Book of the future directly, which limited sources of liquidity for larger trades. The CME have now introduced ‘EFRP’ (Exchange for Physical), so one can now agree an OTC FX trade and exchange that for a future once the OTC trade is done. This allows us to have the best of both worlds, in that one can access all available liquidity (across the CME Order book, and the OTC market), while holding a centrally cleared product. 

Many market makers/banks continue to look at FX futures as distinct products/separate risk to OTC FX. Historically, this made sense as these products were not fungible/interchangeable. Now that the CME allow exchange of an OTC FX trade into a future, market makers need to rethink this separation and come up with products that give buy-side participants flexibility to move between OTC and futures liquidity more easily. Most banks require a manual step to Block or EFRP to FX options and futures, this makes pricing slow and cumbersome. We need solutions that automate this process in order to make it scalable and operationally safe. 

UMR has increased the cost of holding OTC FX positions for the buy-side and prime brokers. This makes the traditional FX model (OTC and PB) more expensive. Prime Brokers are also finding their FX PB less profitable in this environment which ultimately makes it less attractive as a business for them. I expect this will lead to substantial changes in how the FX market is intermediated in the next 3 to 5 years. The two obvious alternatives to FX PB are FX futures or a Centrally Cleared OTC market like we have in Interest Rate Swaps and Credit. The Centrally Cleared OTC offering in FX is still very limited, mostly to Non-Deliverable Forwards and lacks scale due to lack of uptake. This lack of scale ultimately makes it less diversified and more expensive at present. This leaves FX futures as the most attractive option, for now, to gain FX exposure in a scalable, cleared market. 

Building a knowledge base on how the FX futures market works and different ways to access various pools of liquidity is a key starting point. For some currencies/trade sizes it might be optimal to trade on the Central Limit Order Book of the exchange, while trading FX futures in less liquid currencies in large size, it is essential to understand how one can gain access to OTC liquidity, using EFRPs and Blocks to translate this into a future. 

Sunil Patil

SUNIL PATIL, senior trader, APG Asset Management 

DLT can essentially take away settlement risk and thus enable a big institutional trader to transact with, say a retail investor, without worrying about the paperwork or needing a prime brokerage in between. 

DLT (Distributed Ledger Technology) in combination with central bank digital currencies (CBDC) can fundamentally change market infrastructure over the next decade. With the advent of digital currencies, big-tech involvement in payments, and rapid rise of digital transactions, traditional cash is quickly losing its charm and CBs are concerned about losing control over how money flows in the system, and now almost every major CB has plans to introduce CBDC. Inherent features of DLT like instant settlement, on-chain smart contracts and innovative usage of permissioned blockchain have unlimited potential in traditional finance, however, regulation, platform uniformity/standardization and robustness will eventually lead to broader acceptance of the technology. 

Traditionally, big asset managers are risk averse and will be skeptical to be first adopters of a new unproven technology. FX markets tend to follow the volume and without volume a new tech/venue/platform will not be successful, it’s the proverbial chicken and egg problem. So no, I don’t see FX markets to be traded via ledgers in next few years. That said, I believe the benefits and cost savings from DLT will eventually tip the market in its favor. We are still in early days and lots of innovation and development is still needed before it becomes safe and robust to trade huge volumes. When that happens, DLT can essentially take away settlement risk and thus enable a big institutional trader to transact with, say a retail investor, without worrying about the paperwork or needing a prime brokerage in between. A proper democratization of FX markets. 

Web3 as it is evolving will probably create several ecosystems where the ‘money’ circulates within, with limited overlap with FX markets. FX markets will eventually benefit from the pace of innovation in web3, CBDC being a great example, where the idea was really put on fast track after the announcement of Libra by Facebook (Meta). 

Defi apps or DApps have created a lot of buzz recently and have also made financial inclusion a reality, anyone who has a smartphone is able to access some of the most sophisticated products on market. Increased interest from retail investors in financial products and FX specifically can lead to higher trading volumes. Some of the DApps architechture can materially enhance traditional financial products (depo/repo, sec lending, swaps) in addition to opening up a world of new products, say auto-hedging a bond trade on smart contracts. A big feature of DeFi is instant trade settlement making the creditworthiness of counterparts a technicality rather than an obligation, which can reduce a significant amount of work for contract negotiations and risk teams, not to mention efficient usage of collaterals. 

How these features will eventually affect traditional finance and FX markets in particular, will depend a lot on what view regulators and market participants take in general.