A call to action on electronic pricing

The protracted explosion in bid/ask spreads and implosion in liquidity since mid-September is causing mounting frustration among algorithmic traders.

Some question the level of concern over credit quality and Herstatt risk, particularly given the role of CLS in the market. As one trader said, while there needs to be some caution, does it warrant cable spreads being blown out from two to four pips, to 15 to 25 pips?

He said even when crossing some of the majors against each other, such as AUD/CAD, AUD/NZD, GBP/AUD and EUR/CAD, which can be either quoted directly or synthetically, prices are unacceptably wide. "It's a complete breakdown in what sell-side market-makers are paid to do and it's very, very frustrating."

Sell-side traders say that, ultimately, pricing still reflects the underlying liquidity but admit, clearly, wider pricing means more forms of arbitrage are covered, making it difficult to arbitrage. A sell-side trader said, right now, market-makers equate being competitive with making sure they're not the last to narrow spreads and not the first to widen spreads. "If you want to be the first one to narrow spreads, then potentially you are taking on risk ahead of your peers. But you hope that pays dividends when the clients think, when all things are even, you were the first to tighten spreads, and so on a matching deal will stick with you."

"The key thing here is, if you still think you can buy EUR/USD through a one-tick spread and sell it 10 pips later, and that's your profitability, have I got news for you. Because you could be 30 points out of court before its gone two points in your favour."

There is also scepticism over the strength of the prime brokerage model in FX, which was brought to light last month when Currenex was forced to urgently replace AIG as its central counterparty. "People started thinking about their business model and thought, 'Do I want to be exposed to single counterparty risk?' Clearly, that drives anonymity. Those models have definitely been challenged," said the trader.

Although this paints a dim picture, the trader claims all is not lost, despite the move back to more relationship pricing. "How many times have we said foreign exchange is dead? It will bounce back. We all have to work out to what degree it will bounce back."

Saima Farooqi, Editor

Comments? please email saima.farooqi@incisivemedia.com