LMAX FX report: Restoring trust in global FX markets (well worth reading)

Just finished reading a new report and survey from exchange operator LMAX, called “Restoring trust in global FX markets – Striking a balance between transparency and efficiency”.

It’s detailed, with lots of charts and tables and expert opinions, and covers much ground, including topics explored in recent posts around transparency, the FEMR report, and the issue of last look and more.

David Mercer, CEO of LMAX starts by stating:

Liquidity providers (LPs) and market makers need to be rewarded for the risks they take, and in order to enjoy the benefits of transparent price discovery and firm liquidity, customers must meet the costs of the service provided. Fair execution must come at a fair price, and transparency cannot come at the cost of destroying liquidity provision.

Customers have benefited from new technology, with spread compression and lower commissions. However, traditional LPs have had to invest heavily in technology to support globally distributed client base, whilst facing ever more sophisticated buy-side customers and smaller, more naturally agile competitors in the realm of liquidity provision (ie: non-bank market makers).

Mercer, adds that there is much that LPs can learn from these new entrants, including:

elements of exchange-style trading that create a fairer trading environment.

Proposals currently being considered to enhance transparency in the FX market risk disadvantaging LPs further, and could impact market liquidity. All participants would certainly benefit from firm liquidity, priced accordingly, with customers assured of fair execution. Customers need to accept that wider spreads, or increased commission fees, is the price that must be paid for firm liquidity and transparent price discovery.

Transparency for transparency’s sake is not a sustainable path, and the very real concerns of market makers regarding liquidity in a more open market deserve both to be recognised and addressed.

Having stated that LPs need to be rewarded, the report then goes on to show how the explosive growth of non-banks in the market, and the rapid advance of new technology, have created pressure on the traditional OTC market structure and legacy trading practices that can no longer be ignored. The only question is how far and how fast the industry is prepared to go.

The report asks three key questions:

  1. Will the over-the-counter (OTC) trading model continue to dominate an industry which is increasingly subject to demands for greater accountability and certainty of execution?
  2. Can the modern technology introduced by recently emerged FX venues enhance transparency in the FX market?
  3. To what extent can regulation and standardisation of FX market practices improve fairness?

The report then builds the case that fairness and transparency can best be provided by an exchange model…..

There is also a nice quote from my friend David Holcombe, Head of FX Product, Nasdaq

“On an exchange model you get firm prices, and that’s something the regulators like and understand. I think as the regulators turn over more stones in the FX industry they will say ‘wow, I didn’t know it worked like that’

Emergence of Exchange trading practices in FX

The market certainly support both OTC and exchange based FX liquidity, and each will have it’s

There will certainly be advantages for large buyside firms to trading on an exchange model. Transparent central limit order book (CLOB), firm liquidity with no last look, no counterparty credit risk, and be required to post collateral and subject to variation margins, although they would be as they will be trading with the exchange as counterparty, but will gain from the margin against other exchange traded products.

Although, many corporate clients would probably prefer relationship based trading with their banks, using credit lines rather than having to post collateral and be subject to variation margin.

However, under new regulatory rules, the capital charges – such as credit value adjustments (CVA), for non-cleared OTC products will become more expensive. OTC client clearing, would mitigate much of the increased capital charge, whilst enabling banks to retain the bilateral trading relationships whilst mitigating counterparty risk by novating trades to the CCP on execution, which we explained in earlier post around  client clearing and this study by Deloitte on incentives for central clearing).

The full report is certainly worth reading, and is available here

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