Why has peer-to-peer buy-side liquidity become increasingly popular for market participants?
Managers that find new ways to reduce costs, streamline workflows and optimise their resources are the ones able to pass along efficiencies in the form of more cost-effective products to their investors. With FX swaps, pricing is often the lesser issue as many managers have a range of banks to trade with, but they work hard for that. Buy-side firms allocate talented trading resources who are spending time rolling passive hedges rather than generating alpha. These are not alpha-generating trades; these are alpha-preserving trades. It’s just trying to get from the 29th to the 1st with as little loss, impact and effort as possible.
In the FX markets, there are two essential elements of a trade. The first is pricing and the second is credit and settlement. In order to provide and accept a price, a credit relationship must exist between the firms. Under the FX HedgePool model, while liquidity is now directly accessible between peers, the sell-side remains central for the credit and settlement of the trade.
Balance sheet costs are relatively stable so banks can provide credit at a transparent and fair rate and matching fees are independent of market conditions. In March 2020, when the COVID-19 pandemic hit, we saw EURUSD spreads, arguably the tightest in the market, spike tenfold. For us, it was just another day.
Market impact is a major focus for the banks right now. Especially with the Global Foreign Exchange Code (GFXC) and the regulatory pressures that banks are feeling around pre-hedging. These large, predictable and passive swaps that everyone in the market knows are coming and in what size and direction they are happening are arguably the most susceptible to pre-hedging risk. If you wake up and your portfolio manager decides to buy European stocks and you go out and buy euros, nobody can plan for that. A bank can’t pre-hedge that. However, if a bank knows that their clients’ passive hedges are approaching roll date, then they might start pre-hedging to create an inventory so that they are able to provide a competitive price while managing their internal position risk. By then the damage is already done.
How do you expect FX swaps trading will develop?
Trade automation, e-trading and alternative liquidity in the spot market have surged over the past decade, however, forwards and swaps have largely remained unchanged. While there are a number of contributing factors, I’d argue that this lack of innovation in the swaps market is primarily due to the market structure of credit.
Forwards and swaps come with considerable credit exposure to both parties of the transaction and with that comes regulatory, capital, collateral and operational implications. As a result, under the current market structure only those willing and able to supply the credit are able to compete for the trade.
This has been long addressed by the prime brokerage market, where centralised credit allows for multiple access points to liquidity. However, in the FX swaps space where large institutional managers drive incredibly sizable volumes, largely on a passive basis, credit diversification is a central component of their best execution policies. As a result, few have embraced prime brokers and instead continue to rely on the bilateral trading model with a relatively narrow panel of banks.
Technology is enabling innovation that allows us to think differently about how the pieces fit and blur the line between how we define buy-side and sell-side. As client demand continues to grow, we could easily allow members to match outright forward, spot and NDFs and possibly even beyond FX.
Within the swaps realm, we have had growing interest from our members for expanding the product set to include more NDFs and emerging currencies where pricing, spreads, and market impact are most challenging. Workflow automation is a big trend in the market. Traders are recognising that a lot of their flow can be automated and they can shift to focusing on more strategically important trades.
We are now trading about $200 billion a month in match volume. That is $200 billion a month that the market never sees and is instead being done directly between the firms that are responsible for looking after our investments.
How and why has swaps trading become more automated?
Swaps continue to dominate the overall FX market in terms of volume and growth, in large part due to the incredible pace of growth of the passive investment space where FX hedging is a major driver. For trading desks to keep pace with the growing size of their trading requirements, they must either hire more people or automate the process. Necessity is the mother of invention and in this case, necessity is the need to remain efficient, lean and profitable.
In what other ways has FX electronic trading technology changed in the last year?
With remote working becoming the norm over the past 18 months, the necessity for change has never been greater. Screen real estate has become scarcer, the ability to rely on teams is more challenging and internal technology teams are stretched to the max. This environment invites innovation as people are forced to do things differently.