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Dynamic Liquidity Management – towards a next generation solution
John Ashworth
john.ashworth@riskcare.com

Everyone is talking about Dynamic Liquidity Management. In this article, John Ashworth, Chairman of RiskCare, discusses: • How banks and other sell-side institutions are exposing their FX liquidity to an ever increasing range of FX market counterparties and the risks involved with doing this • Why many institutions no longer wish to allocate static limits to control exposure • How the latest technology and software solutions can assist in optimising capital allocation by dynamically managing liquidity.

In the good old days, the FX market was a neat pyramid. A small number of well endowed investment banks made markets at the top and the great unwashed like you and me would be changing our holiday money at the bottom. In the middle of the pyramid, there was a whole selection of global banks, regional banks, asset managers and corporations. A participant’s position in the pyramid governed not only with whom they could trade (typically the counterparty was a peer or at most one position above or below in the pyramid so that credit and relationship issues could be dealt with

more easily), but also the terms on which the trade was executed. Deals at the top were typically large, so and and executed trusted narrow between spreads. At the other end, you and I had our arms ripped off as we turned pounds into francs or dollars, giving up tens of thousands of basis points, a commission, and the possibility of a further fee or premium to ‘fix the rate’ just in case we came back from the Dordogne or Florida with any cash left over. credit-worthy

counterparties,

enjoying

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Dynamic Liquidity Management – towards a next generation solution “Indeed, the conventional distinction between market maker and market taker is increasingly blurred”
The good old days are over. Market forces within world trade and science are driving liquidity and technology ever onwards. The FX market welcomes newer participants who can connect more directly to a wider range of counterparties. Your position in the pyramid – assuming you can satisfy the counterpart that your credit is good – is less relevant in determining the width of the spread. Market takers can choose from a multiplicity of platforms or single bank portals. With the

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Market makers need smart price distribution systems, and in the spirit of ‘attack is the best form of defence’, a clear strategy to embrace algorithmic trading. Regulatory scrutiny. Regulatory scrutiny of electronic trading capability is increasing to reflect the proportion of risk that is derived from electronic channels. Regulators need to be assured that market risk systems and in particular credit risk systems are keeping up with the pace of change in electronic trading technology. If clients are trading through both traditional and electronic trading channels, it is questionable whether the liquidity providers’ credit systems capture risk by all these channels. introduction of

electronic trading channels a liquidity provider can no longer rely on a salesperson to be aware of all trades that are being dealt with a particular counterparty. If one user at a client is trading an outright forward at the same time that another user is selling an option to the liquidity provider over the phone, can the credit checking for each of these products capture the incremental exposure in ‘real time’? This raises many further

Indeed,

the

conventional

distinction between market maker and market taker is increasingly blurred. You no longer need a marquee name to just make a markets computer in and FX, a

balance sheet. Oh, and some technology and technologists.

There are three major forces concerning today’s FX market makers:

questions as to what real time really means. If all these channels are not integrated with respect to credit there is a significant risk of is credit lines being inadvertently broken. The reality of STP. The increased volumes being driven by systematic electronic trading channels is placing strain on downstream processes and systems. Electronic trading should deliver significant cost savings as less human involvement is required at the trading end. However, if electronic trading systems do not extend throughout the value chain then costs could be increased. Enabling clients to perform trade verification and trade confirmation electronically is the only way to ensure that the savings promised by electronic trading are captured.

Screen/Voice proportion transacted

Ratio. of

The

business

electronically

increasing. This is being driven by both early adopters increasing the proportion of business that they execute electronically and by new users of electronic channels. The biggest growth in volumes is coming from Hedge Funds and CTAs using systematic trading models. Some of these new entrants are specifically arbitraging the electronic trading ‘technology curve’, that is, they are arbitraging the relative strength of counterparty technology.

Those liquidity providers with technology that is not at the cutting edge risk being systematically picked off.

Correspondingly, in a buyers’ market, the pressure exerted by sales heads to provide liquidity to all clients (either directly or indirectly) can cause loss making relationships to persist much longer than is necessary, and at the expense of traders’ P&L.

“The proliferation of trading channels exposes liquidity providers to the risk of getting hit on their prices on multiple channels simultaneously.”

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Dynamic Liquidity Management – towards a next generation solution
The proliferation of trading channels (increasingly tailored to specific target client segments) exposes liquidity providers to the risk of getting hit on their prices on multiple channels simultaneously. This is a risk that is not present in the traditional dealing channels. If a spot trader is asked by several clients simultaneously on the phone, then the trader will typically quote them sequentially.

“Dynamic allocation of liquidity limits to specific currencies or currency pairs is the only way to ensure that multiple in-flight RFQs do not expose a liquidity provider to excessive risk.”
This is complicated further when the relationship of the liquidity provider to the clients is that of a Prime Broker. As the Holy Grail of prime brokerage, cross asset class margin and collateral management is demanded by hedge fund and CTA clients, liquidity providers have no choice but to invest in technology solutions that maintain competitiveness.

This natural latency allows the spot trader to adjust his price depending on the information he receives as each sequential quote is hit or passed. This process mitigates risk by enabling the trader to quote each sequential price based on the best available information at the time, including the effect that each trade has on his overall position.

In

the

electronic

trading

Similarly, market and liquidity risk issues are being

channels, several prices could be in flight at the same time and it is not possible on the Request For Quote (RFQ)

complicated by serving multiple electronic channels. Dynamic allocation of liquidity limits to specific currencies or currency pairs is the only way to ensure that multiple in-flight RFQs do not expose a liquidity provider to excessive risk.

systems to easily pull or adjust these prices as

in flight quotes are accepted by clients.

Also, the total amount of liquidity that is being made available to clients through electronic channels which are both streaming and RFQ could exceed sensible limits. The amount made needs of liquidity to being clients Intelligent liquidity limits that reflect the underlying liquidity available to a trader ensure that tradable rates (derived from interbank platforms such as EBS) reflect the liquidity

available to be

available on the same systems.

managed intelligently and the

The

systematic

capture

of

systematically,

information from all channels, subsequent processing of that

and dynamically. The systems to handle this are defined by the liquidity providers’ particular blend of products and target segments, and almost always require bespoke development or at least complex integration.

information to dynamically change prices, adjust liquidity limits and make trading decisions ensures that the amount of value captured from all flows is maximised.

There was never a more exciting time to be involved with Credit checking technology has been put under constant strain by the evolution of electronic channels. Whilst interbank trading of FX has been electronic through EBS and Reuters for many years, this does not provide a good model for the current market. Simply allocating ‘carve out’ limits has many drawbacks. These drawbacks are increased as the pressure to provide competitive credit lines competes with the need to manage credit risk across different FX products and across different asset classes. Here at RiskCare, we’ve been working on FX systems addressing sales, pricing, liquidity, trading and risk systems for a variety of institutions. Customers want a combination of technology and business expertise but above all the ability to plumb vendor technologies into their own internal systems. technology! Opportunities abound within financial institutions and the vendor community alike to embrace these challenges.

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