A study on the state of FX liquidity across foreign exchange markets published last week by the Bank of International Settlements is providing new insight into the foreign exchange market. The market, increasingly competitive thanks to years of technological progress, is facing technological, legal and regulatory challenges going forward, is the simple message.
The in-depth look into the latest developments in the market highlights algo market-making risks. Increasing worries related to black swan events are also a big challenge for the industry going forward. There is a pair of main drivers for the state of FX liquidity going forward, as identified by market participants.
The first component is technology and infrastructure. According to market participants the recent progress on this front facilitated the internalization of client flows at large dealer banks.
Better and faster technology also helped reduce the costs of setting up FX trading venues. The resulting market fragmentation has been offset by faster and easier communication between different trading venues.
The second major aspect that market participants highlight relates to regulatory and legal challenges. After the eruption of the FX fixing scandal, major banks appear to have materially reduced their risk appetites.
Algorithmic Market Makers and Flash Events
The Bank of International Settlements also states that algorithmic FX market-makers are frequently responding to periods of volatility in the market by dramatically impacting liquidity. During stress, the companies that are suing algorithms to price their clients are becoming more cautious and widen prices or even stop quoting them altogether.
Self-reinforcing of illiquidity leads to flash events, such as the rapid decline of the British pound to below 1.20 on the day of the GBP/USD flash crash. The BIS explains that when certain thresholds are breached, withdrawal of liquidity potentially becomes self-reinforcing.
The GBP/USD flash crash back in October 2016 was a direct reaction to an increased demand for selling sterling. Market participants went in to hedge options positions, while the execution of stop-loss orders and forced closure of positions exacerbated the event.
The BIS highlights “a mechanical cessation of trading on the futures exchange and the exhaustion of the limited liquidity on the primary spot FX trading platform.”
According to the publication, the main concern with flash events is that market-makers could demand additional compensation for liquidity provision. Market liquidity will therefore be impaired via wider bid-ask spreads and/or higher margin requirements.
FX Liqudity in the Future
According to the BIS, changes in the market have led to a decline in the relevance of conventional FX liquidity metrics. Market participants and central banks should resort to a combination of different data in order to asses FX market liquidity.
The reaction to recent major risk events has shown that the ability of FX markets to respond to market shocks has not been fully tested. While the impact of flash events was widely felt across the market, they have not been long term shocks that materially disrupted market access.
While technological innovation lowered transaction costs and enabled new players to access the market, it has also contributed to market fragmentation. Large banks have been internalizing client flows easier, while non-banks have been facilitated to participate in FX markets.
Algorithmic and HFT (high-frequency trading) trading strategies have changed liquidity dynamics. Normal market conditions are increasingly stable, while stressed market conditions lead to an increase in risks of illiquidity.
Post-crisis regulatory changes have been at the forefront of the industry with the impact on bank behaviour by new regulations so far being uncertain.
“Some market participants indicate that other types of recent regulatory development, such as fines and requirements for participants to closely monitor trader behavior, have reduced incentives for dealers to engage in discretionary risk trading.” the BIS report states.
The resulting internalization of flows is worth additional assessment by regulators. Clients that have previously been given access to the interbank market are netted internally to reduce trade costs and liquidity risks on part of the big financial institutions.
read more： http://www.financemagnates.com