In the endless pursuit of flow, liquidity providers across all asset classes are engaged in a constant mission to drive down trading costs and make their pricing appear the most favourable to end users. While such innovation may be seen simply as a by-product of an efficient market, the harsh reality is that this remains a capital-intensive proposition and one that comes with inescapable third-party fees. The adage that there’s no such thing as a free lunch is widely known and this sector is no exception to that premise.
Q What has changed in the market recently and why is the race to zero suddenly high on the agenda?
A The race to zero has been evolving over the last few years, primarily driven by a re-evaluation of credit markets. The evolution has seen traditional liquidity suppliers scaling back their participation, in turn meaning that some counterparties are no longer to directly access the same quality of pricing they may have received historically. It could be said that those Tier One liquidity providers may have been too lenient in the past when it came to who they were willing to do business with, but regardless of that, the market has been forced to develop.
As a result, we have seen an explosion in the so-called prime of prime broker space. It’s a term which is arguably overused and often misapplied, but ultimately a range of non-bank entities have stepped in to fill the gap which has emerged. The challenge here, however, is in ensuring that brokers can provide such services in a sustainable manner and maintain a high quality, transparent service throughout. That’s where the prospect of a race to zero emerges. This is a high volume, low margin business, where the transaction cost per yard can be seen as all-encompassing, in turn driving some providers to low-ball on price, yet be left trying to make up their necessary profit margin elsewhere.
Even those market participants who are aware of such a trade-off and feel they can work with the constraints of such a scenario, should tread with a degree of caution. Liquidity providers who ultimately access prices from another ‘prime of prime’ liquidity supplier rather than via their own direct market access or through tier one liquidity relationships can be a classic example of this. Yes, it’s cheap to implement, but it comes with the potential to make the price less reliable, extend execution or order fill times and increase the rejection rate. The risk is that this skews the underlying price by moving the market against you before a trade has even been placed. Technology-light short cuts may make for a good business model on paper, but the reality of the service this will see being delivered isn’t always quite as appealing.
Q Could a race to the bottom negate the market benefit of there being a wide range of participants?
A While there are economies of scale to be had by those offering liquidity, simply serving up cheap headline prices is fraught with problems. That’s why it’s important that counterparties understand exactly what they’re paying for, what sort of depth they’re getting and how good the prices are. It’s also vital to understand how those prices are being derived in the first place as if risk is being disclosed as part of the process, then it’s a regressive step in terms of ensuring counterparties are getting the fairest price. This sector is reliant on high quality liquidity, but there are underlying costs that have to be met — if it is being served up too cheaply, the chances are that someone is cutting corners. That may not be apparent in the early stages of a relationship, but as with any aspect of business, remain diligent and continue to re-evaluate those spreads, execution and rejection rates. As an example, research conducted by a tier one liquidity provider in conjunction with CMC Markets highlighted that a quoted spread of 0.7 with a 15% rejection rate could actually equate to a spread of around 1.1. If the service quality isn’t being maintained, then again it’s a potential red flag that the model you were originally sold is simply unsustainable.
Q Why is it a problem to try and do this at minimal cost?
A In addition to there being a real cost in providing liquidity, risk regulation means that it’s a capital-intensive business, to boot. If shareholders aren’t seeing a sensible return on investment, will they continue to support the Straight Through Processing (STP) model, or will they demand that capital be deployed to obtain better returns elsewhere? A pure-play prime brokerage who is desperate to stay in this market may therefore be inclined to start running some risk in a bid to amplify internal returns, but that in itself poses a series of issues. After all, just how much volatility can their own balance sheet tolerate before abnormal market movements create problems of their own?
Asking questions like this of any liquidity provider — especially those suggesting that deep discounts on pricing can be delivered – is therefore critical. Take a look at their credit rating or recent annual accounts too, to better understand whether this actually adds up. But be mindful that not all LPs are alike, with some able to integrate or blend their internal flow with that which is available in the wider market. This can provide a powerful combination as any saving, be that through internal hedging costs or through other efficiency gains through third party connections, can be genuinely passed back to the counterparty through improved pricing.
Q What should you be asking liquidity providers, especially those doing this at knock down prices?
A There are a few key factors which need to be addressed here, but asking the following questions of a liquidity provider arguably makes for a good starting point:
- What is the price and depth that’s on offer – obviously, that’s useful when comparing across a number of providers, but again understand whether that’s going to be sustainable in the longer term.
- How do they derive their prices? So, do they have dedicated access into the market, or are they having to disclose the position before being able to deliver a quote back to the counterparty? Price action as a result of indicative interest will do little to improve your business profitability and whilst less sophisticated technology may be cheaper to run, this is likely to come with a cost for counterparties in the longer term.
- How reliable are those prices? By the time the quote has been compiled then the order executed, are you getting a price close to what was originally promised? Again, a lack of diligence here could mean switching to a lower cost liquidity provider will quickly prove to be nothing more than a false economy.
- How good are their market relationships? An established firm will likely have better lines into the traditional tier one providers, whilst a significant balance sheet will also carry more gravitas when it comes to cementing that link with the best source of liquidity.
Q What’s the solution?
A As we have already said, the market has moved on and traditional tier one liquidity providers will simply no longer work with the mass market. To suggest that it’s like the Wild West out there would be grossly unfair on the vast majority of market participants, but care still needs to be taken to ensure that you’re well aware of what’s driving the proposition on offer. A small balance sheet and the use of recycled liquidity will likely lead to an unhappy relationship not least as market depth is unlikely to be sustainable — especially during periods of heightened volatility. One solution is to seek out those well capitalised, high quality liquidity providers, especially those who can blend internal flow with that sourced from the genuine tier one providers. By all accounts, this post-trade aggregated flow could prove to be the Holy Grail when it comes to securing the best pricing options in today’s evolving liquidity market.
Ross Newell is a business development manager with CMC Institutional, the broker-to-broker division of CMC Markets. Newell works with institutional clients including hedge funds, family offices, smaller banks and FX brokerages to ensure they receive tailored liquidity solutions to meet their needs. With the company having invested more than $100m in its next-generation trading services platform, he also ensures that clients have a full understanding of the institutional-grade technology which is on offer.