Setting up FX Brokerage (Part I) - What you need to know about FX Liquidity?
What is FX liquidity?
Liquidity in the FX market refers to a currency pair’s ability to be bought and sold without causing a significant impact on its exchange rate.
According to the BIS Survey in 2019, the daily average volume of FX stood around $6.6 trillion making FX the largest financial market in the world. This explains the essential requirement of a liquid market, without which the FX market will not be able to function effectively and allow market participants to transact with each other at high speed.
The difference in time zones means that liquidity conditions can be broadly split into Asia, London and US sessions. London trading session offers the best liquidity condition for FX as it is strategically straddling between the 2 sessions whereas the Asia time zone offers the least liquid conditions.
Dangers of low liquidity
During a market with low liquidity, traders are exposed to volatile market movements and experience sharp price spikes.
Widening of spreads
When the market is highly liquid, there will be many market participants entering buy/sell orders creating market depth. With lower liquidity, the number of orders dissipates, causing a widening of the spread between bid and offers. This usually happens when the market is highly volatile in anticipation of news announcements such as non-farm payroll numbers or the first few minutes after the announcement.
Slippage refers to the price that is executed at a level different from the one that we anticipated. Low liquidity market conditions increase the chance of slippage due to the lack of market depth and can be exacerbated by market volatility.
When trading in a highly liquid market, you will get better market depth, a tighter spread, quicker fills and a lower probability of slippage.
What is Liquidity Provider?
A liquidity provider (LP) is an institution that acts as a price maker/taker of an asset. The existence of LP is to create liquidity in the market by generating buying and selling interests allowing market participants to enter/exit their positions resulting in a vibrant market.
Types of LPs
Tier 1 LPs
Tier 1 liquidity providers are large global banks such as JP Morgan, Citibank, UBS, Deutsche Bank and increasingly non-bank institutions such as XTX Markets, Citadel Securities and Jump Trading. Recently access to tier 1 technology at a manageable cost point has seen super-regional banks gain relevance when adding pricing power in local pairs. These institutions can be viewed as the wholesale market of FX where the rest of the world sources their FX from.
Tier 2 LPs
Tier 2 liquidity providers act as a broker (intermediary) between the Tier 1 LPs and end clients (smaller financial institutions, money managers, corporates, retail investors). These FX brokers usually make money either by applying a fee or markup on the spread sourced from Tier 1 LPs, internalize or match large volume of buy and sell order flows or warehouse risks and take a directional bet versus the client positions.
Why are LPs important for retail brokers?
Technically, retail forex traders do not have direct access to “Tier 1” liquidity but will do so via Tier 2 LPs instead. Tier 2 LPs establish bilateral relationships with multiple Tier 1 LPs, giving them access to more liquidity which in return allow them to offer competitive FX rates to retail brokers and their clients.
Retail brokers typically line up several Tier 2 LP relationships in order to give them aggregated liquidity from the interbank market. This is important as the more LPs a retail broker has, the tighter the spread they can offer to their retail clients and more room for the broker to apply markup to capture profit from each trade.
What are the types of retail brokers?
Non-dealing Desk/Market-maker Brokers
FX brokers can operate without a dealing desk where the orders they receive from the end clients are directly hedged with a liquidity provider.
These brokers operate as an agency model where they take no risk in the client trade and generate revenue from the margin they apply on the spread or transaction fees they charge on clients (eg: they source EURUSD price at 0.5pip and apply a 0.5pip mark-up to show 1.0pip spread to their clients). These are also known as STP (Straight-through-processing) or A-book brokers.
Another form of broker under this category is known as ECN (Electronic Communications Network). In this model, the ECN broker passes through your order into an ECN pool where orders are matched with banks, hedge funds or institutional brokers. The brokers charge a commission for every trade and do not apply any mark-up, unlike STP brokers.
Dealing Desk Brokers
Brokers with a dealing desk effectively act as a liquidity provider/market-maker. They are the counterparty to all trades by warehousing the risks of client trades, betting against their client’s positions and layoff excess risk to external liquidity providers when needed.
As an LP themself, they are able to offer much tighter spreads than A-book brokers by internalizing the bid and offers without paying a spread to external LPs for hedging the risks. When equipped with a sophisticated pricing and risk management engine and large client flows, they will be able to offset most of the risks or take a position based on the order book and market information. These types of brokers are also known as B-book brokers.
True liquidity providers are difficult to find
Increased regulations since the global financial crisis have hampered the market-making abilities of global banks with stringent capital requirements and limits on proprietary trading activities. Most banks now source liquidity from other banks rather than making their own bids/offers. This results in the “recycling” of liquidity where the waning influence of previously market-making banks forces them to widen spreads to factor in their lack of risk appetite and acting more like an agency by passing on the risk to other counterparties.
Over the years, we have seen the rise of non-bank liquidity providers such as XTX, Jump Trading and Citadel to fill the gaps left behind by the major bank LPs. Having said that, their reliance on bank’s credit via prime brokerage means the overall liquidity conditions of the FX market have not improved as some of the liquidity are essentially recycled from the prime broker’s liquidity pool.
Soren Klausen, Sales Director at AlpFin, noted that there is a trend towards asset managers supplying liquidity instead.
“We have now witnessed a unique phenomenon where more buy-side asset managers acting as market-makers providing liquidity in the FX market. Retail brokers have to appreciate that “recycled LPs” relationships are not sustainable and our role is to bridge the flows of the brokers and match that with the suitable LPs whether they are banks, non-banks or buy-side firms.”
Besides non-bank LPs, there is also a growing number of Tier 2 regional banks in Europe and Asia building their own pricing engine and market-making capabilities. This is made possible by lower barrier to technology enabling mid-sized banks to compete with Tier 1 LPs on specific currency pairs.
“What we witnessed in recent years is the increasing sophistication of regional banks stepping up to become LPs of their own currencies such as the Skandies and Asian pairs. They will be takers of major currencies from Tier 1 banks but market-maker of their own currencies given their dominant positions locally,” added by Klausen.
The increasing complexity of the market-making landscape means there is no one-size-fits-all solution for brokers when choosing their LPs. Part 2 of this blog series will address this conundrum and further examine the factors you need to consider when selecting LPs.
1) Would you like to find out how improved liquidity can drive more trading volume from your customers?
2) Would you like to know how you can improve your profitability by selecting the right LPs?
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