Market impact is a nuanced subject and one that many industry veterans are well aware of. But with fundamental change over the last decade having shifted the structure of how forex markets actually function, the result has been a swathe of new service, technology and liquidity providers arriving on the scene. Having been founded in 1989, CMC Markets is far from being a newcomer to the industry, but we spoke to David Fineberg the company’s Deputy CEO, to understand more about where these problems lie and what those looking to fill the emerging gaps in the market need to be considering if good etiquette is to be maintained.
Q: How widely understood are the consequences of market impact?
A: It’s fair to say there are differing views here, some of which could be seen as being rather naïve in their approach. For those of us with many years of experience however, it’s clear that this market isn’t some uber-efficient nadir with infinite depth - and we are working every day with clients who are demanding meaningful-sized lots. The problems seem to come from those with a background of trading comparatively small order sizes and/or those who are blissfully unaware of the limitations of working ‘Over-the-Counter’. Too many appear to believe that this market can scale on a linear basis but as we know that’s simply not the case and the behaviour of institutional counterparties will always reflect this. It’s how these disruptors interact with the wider market that needs to be the focus of attention here.
Q: How can technology help in the minimisation of market impact?
A: Used correctly, technology can essentially model the availability of underlying liquidity, without repeatedly disclosing orders to the market. That translates into an immediate benefit when it comes to reducing market impact – although it’s important to remember that the efficacy of this scenario will be dramatically improved if a liquidity provider has access to a greater number of liquidity pools.
Q: Has the reduction in availability of Prime Brokers resulted in market impact becoming more pronounced?
A: I would say that’s a fair assessment. Easy access for many to decent sized pools of prime liquidity meant that historically there was simply little need for new entrants to be as ‘disruptive’. Yes, there were always the side deals between brokers, but these were typically accounting for big lot sizes when they were looking to hedge the exposure they had accrued on their own book. However, with around a dozen PBs running the situation, there was meaningful competition, reasonable access for all but the smallest of players and routinely, pricing could be achieved without having to disclose the request to the wider market. The gap we saw created as the Prime Broker cohort contracted resulted inevitably in a degree of innovation and this laid bare the rather unsubtle approach taken by some of the new entrants. This was especially evident with the proliferation of Prime-of-Prime brokerages - something that should have perhaps been the realm of the very well capitalised non-bank participants but was instead co-opted by those who decided they could achieve the same result by recycling liquidity and padding the spread. Unfortunately, the fact these providers cannot effectively offer an actionable price without going to the market first has left this as being a rather imperfect solution, the failings of which are now being seen.
Q: Does the LP model help mitigate some of these negative effects when compared to STP?
A: That’s without a doubt. It’s probably worth bearing in mind the driving factors behind the popularity of the STP model to start with. Namely, that there
that was a degree of cynicism where some counterparties were unhappy that somewhere upstream a desk was looking at an order before quoting a price against it. Obviously this is now the situation we have with Prime-of-Prime, so even if a broker claims to offer STP, someone somewhere still has to decide to take the other side of that trade. The liquidity provider model therefore not only offers a superior choice as the broker offering such an arrangement is a “price maker”, but it also ensures there’s a significantly lower negative market impact, too.
Q: Does blending retail flow into an order book help reduce market impact?
A: Rather than using the term ‘blending’, I see this as being more about best use of the internal order book. Internalisation of flow amongst the largest banks has become yet more commonplace in recent years as they better use technology in a bid to keep part of the book out of the wider market, in turn boosting the bottom line. Companies like CMC Markets are able to use a similar approach, because not only can we make liquidity available from our direct retail clients, but also from the banks, brokers and funds we work with. Then, on top of that we’re able to leverage our own balance sheet and liquidity relationships to connect with a number of Prime Brokers, ECNs and other non-bank liquidity providers. What that means however is liquidity providers such as ourselves are in a position where we are constructing a price that’s comparable with the underlying wholesale market but it comes with minimal risk of rejection and can potentially be augmented with superior market depth, whilst limiting any impact on the available price.
Q: Are there any existing technologies which you feel are making significant inroads to reducing market impact?
A: Absolutely, and the way CMC Markets Institutional has structured its white label offering is perhaps worthy of note. So in addition to a market-leading platform that is known for giving other brokers an unrivalled degree of functionality, it also comes with what can best be described as a range of associated financial technologies. So that includes functionality for managing individual accounts, position keeping and comprehensive reporting tools, but also includes utilities such as block trading tools. Again, it comes back to providing a one stop shop to meet the client needs, whether that’s simply the raw liquidity and execution, or a product that goes right down to a comprehensive “broker in a box”.
Q: Where are the next generation FinTechs heading in this area next?
That’s a difficult question to answer as the way this market evolves, there’s never just a single direction of travel when it comes to innovation. However one area where there’s certainly room for further development is in terms of advances towards ultra-low latency trading. That’s a realm which is currently dominated by a select few institutions such as a few of the legacy tier one Prime Brokers, or those targeting the High Frequency Trading houses. Critically, the ability to execute orders in a matter of micro-seconds can play a vital role in reducing market impact and that’s certainly something we are now working towards. Not only does this give the counterparty added confidence that an order can be filled at the quoted price, but it also supports that underlying concept of being a price maker, rather than price taker.
Beyond that, the FinTechs need to be focused on the value-add consultative services, so counterparties ought to be asking questions as to what sort of quant analysis can they expect to benefit from, what other financial technologies will be made available and so on. Again this can all serve to mitigate market impact and is a key component of our own development path, all designed to reassure clients that consistent delivery of a high quality service always sits at the very core of what we do. At the outset we mentioned etiquette, but it seems clear that facilitating this – and in turn maintaining a market’s integrity – comes down to a collaborative effort by all participants. Technology alone cannot mitigate the consequences of market impact, but combine that with a high quality liquidity source and you’re getting close to the seamless, ultra-low latency solution.