The claims, which surfaced in March, stem from concerns about the impact of the ongoing migration away from the primary FX markets and declining volumes on these venues, which Donner explains is correct and is borne out of the data with no sign of a let up. But the reports go on to suggest that this can then lead to a problem for traditional banks if they are then forced back to these traditional sources of liquidity during volatile periods, only to find that it is not possible to trade there in the same sizes as before.
While Donner agrees that primary markets have dwindled, he encourages taking a step back to observe the true FX liquidity landscape as it stands today. “We can see that the secondary markets have stayed stable, or grown slightly, but have not plugged the gap that is left by the reduction in primary. So far, it does look as if there might be a problem,” he says. “But what is also happening is that the more sophisticated banks have responded by addressing this liquidity gap. Algo providers are creating bespoke pools of liquidity by selecting liquidity providers, thus ensuring good KYC and therefore a very good ability to offset risk. In our case we have chosen to use FXSpotStream as a home for this bespoke liquidity, but it can be done in a variety of different ways and there are now a number of venues that offer firm liquidity.”
Liquidity curation
The benefits of banks using these venues are that, contrary to the reported claims, it can actually make the market more stable, argues Donner. “The banks can be sure that we are not dealing with HFTs on the other side, or participants who are not signatories to the FX Global Code,” he adds. “We have chosen our counterparties ourselves. There are other benefits, such as being able to create bespoke liquidity pool for a particular currency pair. For example, we can partner with regional banks to specifically address any areas where we need additional liquidity. This adds strength to our offering rather than diminishes from it.” Donner notes however that this is definitely not the picture across the whole market and that only certain select banks currently offer this level of bespoke, curated liquidity. “This is because it requires significant investment in terms of resources to be able to set up and monitor the pool,” he says.
“In addition, the reports came out prior to Trump’s Liberation Day and the subsequent market volatility allowed us to put the theory to the test,” Donner adds. “We had extremely high volatility and very, very high volume days, with some of the largest daily volumes in the past 10 years recorded. Even during this period of very high volatility we were finding that FX liquidity was actually very robust. There was no flight back to the reduced primary markets. We can see that the additional volume that was needed on those very, very busy April days did not come from the primary markets, but in fact came from having better internalisation and curated liquidity on bespoke venues. That is where the additional volume happened.”
From an algo perspective, Donner believes that there are now far more robust systems in place than ever before. Signalling risk now occurs more when interacting with the more traditional markets, he explains, while newer FX venues offer reduced mark outs which have proven to be more robust in a time of crisis, resulting in overall better algo performance as well. “Markets were generally high volume but orderly in this period and everything was fine in terms of off-setting risk,” Donner says. “Then in terms of internalisation what worked well during April, but also has served us well this year in general, has been employing a franchise skew in order to help fill an algo, allowing the algo to trigger the skew in streaming prices from the bank in order to help fill the algo.”
Focus on performance
Looking ahead, Donner expects further volatility and reason to continue to expect high volumes beyond the March/April market crisis. “There is a lot happening in the world that is peaking volumes and we are seeing that higher activity in our algos as well,” he adds. “Although everything gets wider, so in absolute terms may be less good, there is also a general risk aversion, desks are pricing wider and so some of that premium can be captured through algos.”
At Goldman Sachs, Donner says that algo development is continuing on two fronts. “We offer highly exotic, cutting-edge functionality for algos. For example, we already have knock-ins on algos, and now we offer a double knock-in on an algo so it is possible to watch two different levels simultaneously, each with its own limit price,” he says. “The main focus however is 100% on our algo performance, that is our top priority. It is more likely to be measured pre-trade via various third-party TCA tools integrated into multi-dealer platforms and elsewhere, so we just need to be certain that we are over-performing.”
Donner adds that the desire for live-TCA is also important, but that many pre-trade tools have been largely historic in nature. “That is now a key focus for clients who want TCA that is immediately useful at the point of trade,” he says. “We also offer a risk-filled Stop Loss level, which takes away a lot of the hassle for our algo clients. They might be debating whether or not to use an algo in case they take their eyes off the algo and the market gets worse. By offering tools that allow an automatic Stop Loss in such an event, then we can take away that risk and our client can just fire and forget.”
A final area of interest is the trend towards smaller banks using algos. “ A smaller bank can trigger a skew in our franchise with an algo that could allow a much greater opportunity to get out of risk than by attempting to do something with their own franchise,” he adds.
