Understanding the quality of FX liquidity provision - why not all FX liquidity is created equal

Global FX markets are in transition, the catalysts include tougher regulation, higher capital costs and reductions in leverage ratios. As a result, we are seeing continued fragmentation of liquidity across primary venues, and reduction in risk appetite by banks who are scaling back on market making, leverage and appetite for risk warehousing (position taking).

Non-bank market makers: Against this backdrop, we have seen an inexorable rise of the non-bank market makers, with newer technology and less onerous regulatory costs, stepping in to fill the market making gap and grow their global share of FX volumes. Indeed according the latest EuroMoney 2016 FX survey, non-bank market maker XTX (whose Co-CEO, Zar Amrolia was until a year ago, co-head of FICC at the mighty Deutsche bank), now rank 9th in overall global FX market share, 4th in global FX Spot and 3rd in global Spot e-trading market share.

As a consequence of fragmented liquidity pools, banks and brokers are increasingly turning to electronic aggregation services, in order to access the available liquidity they require from across venues and liquidity providers (LPs), for use by traders and as input for Rate Engines, in order to effectively service their clients and risk manage the resulting flows.

However, aggregation on it's own is not the answer. As trading on the best aggregated price (best bid-ask at top of book), does not always deliver the best results. This is because, not all liquidity is created equal. Banks and brokers that aggregate multiple liquidity providers into a single stream need to understand the quality and characteristics of the liquidity they consume, as they may well find that simply combining all their LPs and then hitting what seems the best price, does not necessarily deliver the best results!

So, what determines the quality of LPs pricing, and how can banks and brokers separate the good from the not so good liquidity provision?

The power of Analytics: Analytics has now become a critical component in any eFX business. Only by leveraging real-time trading analytics can firms truly understand the quality of liquidity they aggregate, and then use those analytics to optimize LP selection to ensure they are consuming the best liquidity for their needs.

Here at TradAir, we use BigData analytics that enables clients to analyse flows, with a real-time suite of trading analytics that provides the deep insight needed to understand and optimize the LPs being aggregated. By comparing LP metrics by currency pair, one can understand the quality of LPs such as: Spread Ranking (by trade size/time day), % time top of book (how well do they price), refresh update rates, available liquidity (how much liquidity do they offer, and changes in that liquidity over time), last look latency (how long do they hold your order before confirming trade) etc, which all help to understand and rank LPs based on their ability to price.

LPs ability to internalize flows? More detailed analysis of LP pricing can show an LPs ability to absorb or internalize flows, with metrics such as fill ratios, reject rates, market impact and cost of rejection. Here what we are looking at is to measure how much of an order an LP fills, and what their pricing looks like post execution.

If the order is not completely filled, and the LP isn't able to internalize that flow, but begins to unwind the amount they did fill, then it's likely that their pricing will reflect that, and the cost of filling the residual of the original order will increase as the market impact of the partial execution increases with the ripple effect of LPs unwinding the flow - the LP is actually competing with the residual of the original order.

In some cases, firms with larger size trades to execute, may well find they get better overall fills by aggregating Full Sum streams from their LPs. These are streams where the LP is pricing for the full amount and will do all or nothing of the trade, thus removing the risk of partial execution and market impact of residual cover.

So, in summary, whilst not all liquidity is created equal, using a platform such as TradAir that offers powerful real-time trading analytics, can empower price taking banks and brokers to understand and optimize their liquidity providers in order to only aggregate the best LPs for each currency pair and for each volume size, improving their ability to competitively price and profitably and risk effectively manage resulting flow, and providing an outstanding trading experience for their clients.