On a day when the UK’s historic vote to leave the European Union had sent the value of sterling plummeting to its lowest level in decades, with widespread predictions of chaos in financial markets, forex markets remained resilient.
Amid warnings that liquidity had deteriorated, banks had retrenched and the market might not be able to withstand such a big shock to a major currency, business continued to be done largely as normal. Aside from peak volumes on some trading platforms and temporary widening of spreads as traders repositioned themselves, it was an orderly day in the market.
Contrast that with January 15, 2015, when the shock decision of the Swiss National Bank to abandon its policy of holding the Swiss franc down against the euro sent trading between the two currencies into freefall and forced some large banks to step back from pricing the currency pair, while many participants incurred heavy losses.
There are clear differences between the SNB and Brexit scenarios – not least that traders had been able to plan ahead for the UK referendum, whereas the SNB decision came out of the blue – but what happened on June 24 also highlights deeper changes in liquidity provision and the growing importance of non-banks.
Zar Amrolia, co-chief executive of XTX Markets, said: “The market remained far more orderly during Brexit than over SNB as it was a known event and did not have the discontinuity which the SNB decision did. We were there for our clients throughout both events and were pleased to see that liquidity provision remained solid across the market generally this time around.”
XTX is one of a new breed of non-bank market-makers that have stepped up their activities in the FX market in recent years as banks have faced a maelstrom of challenges – from capital regulations to the damaging benchmark scandal – that have led some to retrench. Other growing non-bank players include Citadel Securities, Virtu Financial and Jump Trading.
Kevin Kimmel, chief operating officer at Citadel Execution Services FX, said: “There was a misperception among some in the marketplace that non-bank liquidity providers would not support the market during times of stress, but the pricing on Brexit day made it clear that this was a myth.”
Non-banks were once associated with disruptive high-frequency trading practices that used ultra-fast technology to snap up trades, compromising genuine market activity. But there is now a more widely accepted distinction between HFTs and non-banks that play an increasingly important role in providing two-way pricing alongside banks.
Tim Cartledge, chief strategy officer at EBS BrokerTec and formerly a pioneer of Barclays’ electronic FX business, said: “Non-banks have become valuable providers of liquidity in FX spot and some are clearly committed to providing liquidity to the market in all conditions rather than just profiting from running high-frequency strategies that only trade opportunistically when it suits them.”
The SNB drama of 2015, Cartledge believes, was a “wake-up call” that showed how reliant the industry had become on large banks to provide liquidity in all market conditions. “Given the cost and regulatory pressures facing banks, they may not have the capital to support another dislocation of that magnitude,” he said.
Banks are naturally quick to defend their turf. JP Morgan, for example, revealed that it processed more than 1,000 tickets per second after the UK referendum, trading more than $ 60 billion – at least four times more than normal – on its FX platform in Asia as the results came in.
But there is no escaping the impact regulation is having on banks’ ability to hold risk on their balance sheets. While FX spot may be less heavily affected than longer-dated, riskier products, banks acknowledge that their pricing of swaps and forwards has been impacted by regulation.
Stephen Jefferies, head of currencies and emerging markets trading in Europe, the Middle East and Africa at JP Morgan, said: “The ability for banks to price forwards and swaps, particularly longer-dated corporate trades, is more constrained by regulatory requirements on balance sheet than in spot trading, but the market has already adapted and priced that in accordingly.”
It is mostly in the spot market, however, that non-banks have really stepped up to provide liquidity.
Recent events have shown that, while some had warned HFTs would retreat at times of crisis, non-banks have demonstrated equal if not greater commitment than banks when currencies have been volatile in recent times.
While banks appear to have steered through the Brexit volatility in better shape than they did the SNB shock, trading platforms were warned in advance that banks may have to widen pricing or temporarily step back, depending on market conditions. With less capital available to support risky positions, banks appear to have little choice but to scale back and widen spreads, as they are reported to have done to varying degrees after the Brexit vote.
Bill Goodbody, senior vice-president for foreign exchange at Bats, which operates the Hotspot currencies platform, said: “We had a lot of dialogue with bank and non-bank liquidity providers prior to the vote and some confirmed that they would be dialing back on platforms and pricing in general until they had a sense of what was going on.”
The benchmark scandal has also played its part in the changes to liquidity provision, as it led to a string of trader suspensions and dismissals, while many experienced senior traders chose to leave the sell side voluntarily. The result is that some banks now lack the deep industry expertise they once boasted to get them through major shocks.
Cartledge said: “Liquidity provision in normal market conditions is still very good, but increasingly there is a decline in liquidity during market dislocations and end users have to accept that they may not be able to trade in continuous markets in any size during those events.”
That is clearly a challenge for the corporates, pension funds and asset managers with FX exposure to hedge. While it may be only during major market dislocations that liquidity issues are laid bare, some buyside firms report that their ability to trade large orders in normal market conditions has already been impaired.
Stephen Grady, global head of trading at Legal & General Investment Management, said: “It is certainly harder to trade in large size than it used to be as liquidity has diminished, so investment managers are now employing a variety of techniques to compensate for this development.”
He added: “Many are seeking to address the information leakage that took place in the past, and at LGIM we also seek to more actively manage the process of unwinding risk as opposed to passively outsourcing it.”
In the long term, the growth of non-bank liquidity provision could turn out to be the lifeline the FX market needs at a time when banks are retrenching. Few would dispute that banks will continue to play a key role in the market ecology, but their business models may have to be less ambitious and they will need to share the field with entities that look and feel very different.
JP Morgan’s Jefferies said: “The bulk of our business is in direct relationships with clients, while non-banks predominantly make markets on anonymous channels, and we feel there is a place for both models. Banks will continue to make up the bulk of dealer-to-client volume.”