The buyside is transforming the way it trades foreign exchange due to changes in liquidity provision in a forerunner for other asset classes, especially rates, according to consultancy Celent.
Celent, a division of consultancy Oliver Wyman, said in a new report Buyside Cross Asset Trading Technology: Putting the Pieces Together that market structure changes and regulation are driving asset managers to become more self-sufficient in their trading as liquidity fragments across venues and asset classes.
Brad Bailey, research director, securities and Investments group at Celent, said in an email: “The buyside is looking to automate the easy flow in equities, exchange-traded funds, options, futures, foreign exchange, and fixed income so they can focus on the challenging trades that require human guidance and expertise.”
In addition to transforming the front office, buyside firms also need to change workflows so there is more efficient integration with the middle and back offices. Oliver Wyman has estimated that buyside firms will face a profit drag of between 5% and 10% in order to react to regulation and shifting market structure.
“In certain markets, the concentration of liquidity in fewer hands is increasing the demand to source directly from other buysides and non-traditional dealers and leverage new network-based technology.,” added Bailey.” As markets become more electronic they produce more leveragable data.”
As a result an increasing number of asset classes are seeing fragmentation of liquidity and venue, as happened in US equities. For example, in foreign exchange multi-dealer platforms, 80% of liquidity was found in five global venues in 2011 but that has shrunk to 20% of the spot liquidity according to the report.
“Foreign exchange is going through a major transition for the buyside, creating challenges for legacy technology that cannot react to the rapid changes in liquidity provision,” said Bailey. “The investment bank’s single-dealer portal is dead in FX and has been resurrected as a streaming engine for firms to aggregate. “
A recent Celent survey of over 100 FX traders at buyside institutions found that only 3% were relying solely on a single counterparty for FX trading. In addition asset managers are looking internally before going outside of their own firm driving closer connections among trading, treasury, and risk systems. The proactive buyside firms are building robust desks and hiring FX execution expertise.
Bailey said: “We are at a time, not dissimilar, from US equites about a decade ago. More importantly, the FX transition is in many ways is a forerunner for other asset classes, especially rates.”
Chris Salmon, executive director, markets at the Bank of England, said in a speech this week that regulators need to understand changes in foreign exchange market structure to determine whether they have made markets more fragile.
Salmon said: “Benefits of the broader trend towards greater speed and electronification, common across a range of markets, include a reduced cost of transacting – and hence better value for end-users – but these structural changes as a whole have also led some to question whether markets are now less resilient in periods of stress.”
He gave the example of the so-called flash crash in the early (UK) hours of 7 October last year when the pound depreciated by around 9% against the US dollar in a matter of seconds, before quickly recovering.
A report by the Bank for International Settlements said the crash was the result of a number of factors, including the time of day, significant demand to sell sterling to hedge options positions, the execution of stop-loss orders and the withdrawal of liquidity by both human and automated traders in the face of unexpected volatility.
Salmon said: “Whilst it is true that this event was over in less time than it would have taken me to buy my regular morning latte, and as the BIS report noted, no systemic financial institutions appear to have incurred material losses, the reality is that our ability to describe how the flash unfolded doesn’t mean we can explain why it happened on 7 October.”
He continued that more flash crashes are likely to occur in core markets which increases the need for some form of public policy response.
