Apr 18, 2017

Electronification in the FX Exotic Derivatives Market: Risk, Liquidity and Market Making

Udi Sela, VP of Business Development at Numerix, is a former FX market maker and one of our resident FX experts at Numerix. He joins us for a two part discussion on FX Exotic Derivatives and Electronification. In this first part, he and CMO James Jockle discuss the impact of electronification on the FX market. They delve into drivers and trends from changes in market making, risk and liquidity. Part II can be viewed here.


Jim Jockle (Host): Hi, welcome to Numerix video blog, I'm your host Jim Jockle. Joining me today is FX expert, Udi Sela, Udi how are you sir?

Udi Sela (Guest): Very good, good morning Jim.

Jockle: So, thank you for joining us. Over the past few weeks we did a couple of series of blogs and webinars on the electronification of markets, specifically around elements of the exotic market and wanted to get some of your perspective of digitalization trends that you’re seeing, specific to FX. In terms of evolution and automation of the FX markets, where would you say we are today?

Sela: Basically, Jim, what we see is, at least in my experience, is that the FX market typically tends to be one phase behind the equity markets, so its kinds of the equity market setting the tone, so that’s the first observation I would like to make. The second one is that we see more and more trades are moving into electronic trading and having “robots” that make markets instead of marker makers. We also see that given rising capital charges, banks tend to move away from market-making and from housing a large risk, therefore this also moves to the buy-side. So, one of the interesting trends that we see in that respect is dark pools, where people are looking to build venues where basically the two buy-side firms meet and trade, if you like, at a price which suits both sides. So basically, the benefits of banks as market-makers are diminishing and the banks seem to be taking back more the role of managing credit and deposits rather than trading. I think this is the strong trend we see.

Jockle: So, lets focus in on that a little more in terms of the shift in market making. Obviously, liquidity is always an issue, you know, as a market maker, but also what about long term willingness? So, you know, obviously, we’ve seen some larger funds taking that role, but, you know. It’s a newer role, newer challenges, but you know, obviously, a lot of firms are thinking about alpha. Is it ok to take incremental values across the way? And what would that ultimately mean for the market longer term?

Sela: You make me think of things, like first if we need market fixings, how will we settle the fixings, right? If it doesn’t come from the banks, does it come from intermediaries? Will it be from fintech firms? That’s a possibility, right? In terms of thoughts, and we see that also the impact in fixed income market; as you know, liquidity is being hampered and people now tend to trade in lesser, underlying assets. So, probably in larger volumes in less underlying assets, which means that liquidity is hampered and then of course if you don’t have liquidity then you don’t open positions in illiquid underlying assets in the first place. So the commitment of large buy-side market makers to provide liquidity across the board is diminishing, that’s absolutely right.

Jockle: You know I want to digress a little bit and obviously, we’re talking about electronification of markets but you know one of the things we’ve always talked about in terms of increased capital on the banking side and things of that nature was an overall reduction of systemic risk to a broader economic market. Is this just from your perspective a transfer of risk at this point? And what are the broader consequences here?

Sela: I think you hit a great point. I don’t think that we reduce systemic risk because first, you know, when people would like to get out of the crowded room and would be running to the doors, not everyone will be able to get out because there will not be enough liquidity, that’s why. And now when you look at electronification, and you look at various ECN’s, think of a trader let’s say at the bank like Lloyds or bank of that nature. Do you see, and we speak of FX, how many different strains of different venue can one manage, you know? So, you have, I don’t want to mention names, but you have quite a few providers, let’s say in Europe, and it almost becomes impossible to manage your quotes across multiple trading venues and provide liquidity. So, I think, I think there is need in the market to aggregate all the different ECN’s into one provider because, as a trader, I don’t mind through which vendor do I trade, I’d like to provide prices just to one and then manage it and then I can also see because I’m being charged by the different providers. I’d like to see which provider provides me business? Where my hit ratio is the best? And maybe I’m paying fees to providers where I don’t need that because I don’t get business. Having like one aggregated ECN that sits on top of all the provider’s. Seems to me like something is just missing in the market.

Jockle: In many ways, this can become an inflection point in terms of electronification?

Sela: I fully agree with that because, and I think the regulators need to pay attention to that, to this risk of concentration, and the fact that liquidity is fading. In fact, in this respect we’re deserving our end clients so maybe the deregulation, which potentially will come out of the US, will swing the pendulum back because it seems like we went quite a long way.

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