David Mercer, CEO of LMAX Exchange, talks to Profit & Loss about his views on the future of FX liquidity and the responsibility that trading venues have to monitor the trading activity taking place on their platforms.
Profit & Loss: One big talking point in the FX industry right now is the forthcoming code of conduct from the BIS FX Working Group. Are you optimistic about the impact that this code of conduct will have?
David Mercer: I’m optimistic that it will say the right things and I’m optimistic that people should adopt it and that if they do, we’ll have a more transparent market place.
But right now I can’t be optimistic that it will be enforceable, that’s one of the biggest challenges facing the FSB. The code of conduct could be an out-of-the-box solution to ensure fairness in dealing with clients and in executing orders, but when it comes to compliance and risk management, I think that the code will be more difficult to actually enforce.
The only way that it will become enforceable is if a number of the major banks adopt it completely, endorse it and publicly acknowledge it as part of their compliance requirements within the bank.
P&L: What about the non-bank liquidity providers?
DM: This is the other complication. When you look at the amount of liquidity being provided by non-banks in the FX market today, you have to ask what happens if they don’t adopt the global code of conduct?
If either the non-bank or the banks don’t adopt the code, then suddenly you end up with an uneven and unfair market place.
Overall the industry needs to think, not just about the code, but about how customers want their business to be executed going forward.
There’s been a lot of emphasis in the past couple of years on splitting risk taking from customer flow. But customer flow doesn’t pay very well; so the way that banks made it pay historically was by running some risk and making markets. I’m not sure how well this model works going forward, because it relies on internalisation, a practice that may become forbidden by the code of conduct.
Meanwhile, we read a lot about non-banks filling the liquidity gap left by banks, but I think that it remains to be seen if this is going to be the case. Banks have traditionally been the main liquidity providers in the FX market because they have customer flow, they have real customer business, and I’m not sure that you can replace that.
Ultimately, I think that the world needs an efficient FX market and at the moment, this market has ground to a bit of a halt.
P&L: If banks are forced to reduce internalisation rates, then that’s good news for multibank platforms such as yourselves, right?
DM: Yes, it benefits firms like ours, because then more trading has to be done on multidealer venues, but it may not be that everything gets done on a public limit-order book.
Disclosed trading could be a bigger thing this year, and it sits in this grey area between dark pools and fully public limit order books, which is probably a step too far for the FX market right now.
P&L: Do you think that more FX flows could go into dark pools?
DM: I actually don’t think that dark pools will exist in five years’ time. If counterparties are just exchanging risk in dark pools – that’s one thing, but if customer flows end up in there, then execution venues will run into trouble in terms of whether they define it as agency or principal business. So personally, I just don’t think that they will be allowed to exist in the long-term.
P&L: What about the argument that they allow firms to transact in size without impacting the market?
DM: Maybe it can work for block trades in FX, but if you look at the biggest dark pool right now, there are not many participants in it, so how much flow can actually get done there?
And the reality is that ticket sizes are coming down in FX; if you go and ask the banks, they’ll tell you that the average ticket size is a buck now.
P&L: Do you expect trade size to keep getting smaller?
DM: That’s what I see, but I don’t know how small they will get. However, if I plugged in an HFT shop from Chicago alongside my retail brokers, you wouldn’t notice the difference between the two by size. Similarly, if I plugged in an algo execution desk from a bank next to one of them, you wouldn’t be able to tell the difference by size and maybe not even by frequency.
P&L: What does this mean for principal liquidity?
DM: Honestly, I think that right now we’re all learning what tomorrow looks like. But what we’re seeing right now is that there are not many firms in the market wanting to hang themselves out in large size, certainly not anonymously. Bilaterally I think that will continue to exist, as long as it’s fully disclosed and the customers are happy with the rules of engagement.
P&L: Talking about the rules of engagement, you’ve been an outspoken critic of ‘last look’. Do you feel that, provided that there is full disclosure about how and when ‘last look’ is applied, it is an acceptable market practice?
DM: If firms used ‘last look’ for the purpose that it was designed for – to protect market makers from toxic clients – then it would probably be ok. But even with disclosures, this is a practice that is open to abuse, and if it’s open to abuse, then someone will abuse it. If you’re a liquidity provider, how do you compete with someone else that is either abusing ‘last look’ or at the least exploiting grey areas and you’re whiter than white? If you get rid of ‘last look’, it will level the playing field for everyone.
And frankly right now, I think that some liquidity providers probably feel like they want to avoid ‘last look’ all together and avoid the regulatory risk that’s associated with it.
P&L: Do you feel like the trading venues themselves have a responsibility to monitor and control the trading that takes place on their platforms?
DM: Yes, I think that they have a responsibility and they need to have a public rulebook that’s available to everyone.
In this regard, some of the venues are going to get themselves into a pickle, because they have non-enforceable guidelines around ‘last look’. For example, you see guidelines around imposing an 85% fill-rate requirement. But what do you do with someone what provides an 84.9% fill rate and how do you reward someone that provides a 99.9% fill rate?
If I was on a venue providing a 99.9% fill rate and my number one competitor was offering 84.9%, I wouldn’t be too happy about that. So how are the venues going to respond to that?
Going forward, it will become more important that the venues and exchanges have clear rulebooks, because we’re going to have markets which are more skittish. Hopefully we won’t have another SNB-type event, but we’re going to have more skittish, gapping volatility.
So yes, we need to have more granular rules, while also understanding that there will always be some interpretation of these rules. But greater disclosure will lead to greater transparency and that’s a good thing for the market.