Accessing liquidity for all order sizes
Despite narrowing top-of-book bid-ask spreads in FX, our volume-based analysis shows market liquidity has materially worsened. Increasingly fragmented markets, less risk-taking by dealers, rising volatility and falling volumes on major platforms have all reduced deep liquidity in the market limit order book. Additionally, markets are becoming more fragile as phantom liquidity creates the illusion of stability.
The FX market has become more fragmented since 2008
Source: BofA Merrill Lynch Global Research1
While pricing for smaller orders looks attractive, lack of liquidity depth for larger orders is having greater market impact and increasing liquidity premiums — the market impact of a given volume is already 60% greater than in 2014.2 To overcome these execution challenges, clients are seeking the best ways to access liquidity, including:
- Electronic FX (eFX) principal trading
- Voice trading
- Algorithmic execution
PRINCIPAL EXECUTION AND PRICING
Recent regulatory tailwinds have led to the growth of eFX over voice trading. Despite worsening liquidity, eFX principal trading remains an effective method of immediate risk transfer for clients. With tight top-of-book spreads, clients can execute small orders efficiently and cost-effectively. Moreover, multi-dealer platforms may enable clients to do this while achieving best price.
Structural changes in FX have not reduced the need for principal liquidity, but they are impacting the growth of algorithmic execution for larger orders. However, algos are no longer reserved for very large strategic flows — demand is coming from all client types and sizes as a result of their distinct characteristics:
- Access to multiple pools of liquidity: EBS market share of all FX spot has fallen from over 55% before 2008 to 22% in 2015.3 Multi-dealer platforms and ECN pools have spread liquidity around, requiring the important decision of where to route orders. Algo execution using smart order routing technology ensures that venue access is consolidated and intelligent.
Volumes fell 20% on primary markets in 2015
Source: BofA Merrill Lynch Global Research4
- Cost reduction: Appropriate algo use can result in significant spread cost reduction on individual executions compared to crossing the bid/offer spread for tickets in larger sizes and less liquid pairs.
- Market impact: As market fragmentation has increased, so has the difficulty of executing larger tickets while minimising market impact. Distributing an order over multiple venues in smaller sizes can help reduce its footprint and improve overall execution.
- Internal flows: BofAML’s client franchise can offer opportunities for internal matching of orders, potentially reducing the implicit execution costs associated with information leakage.
- Increased transparency: BofAML algos have a post-trade transaction cost analysis (TCA) component. This details overall performance against benchmarks, and gives a holistic view of execution and implementation quality.
- Hybrid solutions: These make use of both external and internal execution, giving access to multiple third-party pools while potentially lowering market impact and spread costs.
The future for FX execution
Providing a strong offering of multiple execution methods allows us to remain attuned to client demand and the changing FX landscape. We believe algorithmic execution will grow even further as clients seek to navigate challenging conditions and minimise their footprint. Ultimately, the balance between algorithmic execution and principal liquidity provision will be decided by clients’ risk preferences.
While post crisis regulation and a culture of tighter risk management has led to a general retrenchment in market-making by some sell-side liquidity providers, at BofAML we will work with counterparties and continue to provide principal pricing as a core business line.
2,3BofA Merrill Lynch Global Research