Liquidity the achilles heel of eFX
Mark Galanta 20-year Wall Street veteran, is CEO and founder of GAIN Capital,
a Warren, NJbased provider of foreign exchange services, including
direct access trading and asset management. For more information
about GAIN Capital
While liquidity has decreased over the past few years, the uptake
of eFX is not the main culprit says Mark Galant, who traces the
impact of electronic trading in shifting liquidity amongst
different FX players.
After a tumultuous start, eFX is finally hitting its stride. Both
the major multi-dealer portals as well as several independent
platforms have all recently reported a significant rise in
transaction volumes. As success is never without controversy, some
market participants are now questioning the impact of electronic
trading on market liquidity and volatility. Truth be told, the
uptake of electronic trading has not had a material impact on FX
market liquidity to date. It is, however, drastically altering the
market landscape and affecting both buy and sell side market
participants in a variety of ways.
To begin, it is important to make the distinction between
dealer-to-dealer and client- to-dealer electronic trading. While
current estimates figure electronic trading on EBS and Reuters 3000
to account for more than 60% of all interbank volume, only 15-20%
of customer-to-dealer transactions are currently transacted online.
Notwithstanding the current usage, lets consider the impact of eFX
on each group.
For end users, the benefits of electronic trading are numerous:
greater efficiency, reduced costs and, of course, improved price
discovery and transparency. With the proliferation of eFX platforms
over the past few years, end users have their choice of liquidity
sources, including multi-bank and single dealer platforms from both
banks and well-established independent firms.
Moreover, the availability of real time streaming prices on many
platforms provides end users with instant liquidity.
Recent reports put the average trade size conducted via one of the
largest multi-dealer platform at roughly $3.5 million. While this
might seem low to some observers, the average trade size on EBS is
just $2.5 million. So while its probable that many end users are
reluctant to transact large deals (>$25mio) electronically, a
more likely scenario is that end users find the instant liquidity
an especially appealing aspect of eFX platforms, and the ease of
trading online facilitates more deals, albeit smaller ones.
Assuming the largest buy side clients (with the most aggressive
liquidity requirements) gravitate to the multi-dealer platforms,
its safe to assume there is more than enough liquidity on
electronic platforms to meet the needs of the vast majority of end
For the banks, with the benefits of eFX come a host of challenges.
Banks long dominated the FX market by restricting access to price
and other market information. Today, customers can easily gain
access to multiple real-time price sources via electronic
platforms, contracting bid/offer spreads and thus profits for many
The prospect of lower revenues, coupled with banking consolidation,
has left fewer banks willing to assume the risks associated with FX
market making. As a result, the lions share of FX liquidity is now
in the hands of a few large, global banks. The BIS reports that in
2001, 75% of FX transactions in the United Kingdom were conducted
by 17 banks compared to 24 banks in 1998; in the United States just
13 banks captured 75% of the turnover, down from 20 banks in 1998.
Worldwide, its estimated that only 20 banks now quote two-way
prices on a wide range of currency pairs.
This loss of the information advantage is felt most acutely by
local and regional banks. In the past, these banks were able to
profit from the decentralized market structure and the lack of
price discovery by acting as an intermediary between their clients
and the interbank market. A local bank would get a customer order
and offset the trade with a regional bank, who would then turn it
over to a market maker. In this common scenario, one economic
transaction would hit the market several times as it changed hands,
propping up volumes and creating the illusion of deeper liquidity.
The rise of electronic trading further shifts the balance of power
away from small- to mid-sized banks by enabling end users to trade
directly with a market maker. Firms like Cognotec and white
labeling services accelerate this trend by enabling banks to
completely outsource their FX business, route customer trades
directly to a market maker and, at the same time, more efficiently
service their customers.
Competition also plays a hand here; most banks now realize they
must offer their customers electronic trading capabilities and
purchasing or leasing off the shelf technology is the fastest means
to that end.
So while electronic trading has, to a large degree, shifted
liquidity into the hands of fewer market makers and almost
completely disintermediated the local and regional banks -- the
overall impact to FX liquidity is diminished because electronic
trading has made it possible for new liquidity sources to enter the
market. Independent firms like GAIN Capital and others have
captured a significant percentage of the market share once owned by
these mid-tier banks.
Willing to take a much higher degree of risk relative to their
balance sheets, these firms provide liquidity to smaller buy side
clients, as well as to a new class of market participant, the
retail day trader. In fact, volumes reported by the largest and
most established of these firms rival, if not exceed, that of many
small- to mid-sized banks.
And what about volatility? FX
volatility over the past several years has declined. At press time,
EUR/USD traded in a five big figure range for the six past months.
Why? The introduction of the Euro caused a systemic change in the
FX market, one that could very well dampen volatility long term. In
addition, volatility always trades in ranges and right now we are
in the midst of a low point. However, because volatility is mean
reverting, it will eventually snap back to its historic mean (minus
any long term impact from the Euro).
Liquidity will suffer further when volatility returns to the
market. Larger intraday moves create additional risk, which will
cause further attrition from the ranks of FX market makers. Within
the next few years, its likely that less than a dozen true FX
market makers will remain.
eFX Fuels Risk Issue So while
liquidity has indeed decreased over the past few years, the uptake
of eFX is not the main culprit. Rather, the root causes are 1) a
decrease in the number of banks due to consolidation, and 2) fewer
banks willing to take risk as an FX market maker.
However, eFX is exacerbating the latter issue. As the volume of
trades conducted online increases, FX volumes will further contract
as a result of disintermediation, and margins will contract due to
increased transparency, both of which will further reduce FX market
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