Non-banks charge ahead, but HFTs see warning signs

New risk-warehousing models are outpacing non-bank players that rely on latency advantages

Tough equation: the cost of keeping up latency advantages has become almost prohibitive

The non-bank market-maker pack is splitting into two camps, with a handful of shops choosing to become risk-warehousing entities, acting as platforms for banks, while the remainder stick to traditional, high-frequency trading (HFT) techniques.

The emergence of the new business model for firms such as XTX Markets, Citadel and KCG is a departure from the latency arbitrage space, where returns and margins have been under extreme pressure for several years.

"XTX is a research-driven software house. A lot of alternative liquidity providers are latency-driven hardware houses and they have to replace technology every few years, because it becomes obsolete and slow. These companies are increasingly realising the benefits of going from milliseconds to microseconds, and from microseconds to nanoseconds are far from enormous, while the associated costs are," says Zar Amrolia, co-chief executive of XTX Markets.

At the same time, over the course of 2015, banks' appetite for volume and risk warehousing dropped off dramatically, leaving an increasingly larger gap in the liquidity provision space. This so-called liquidity unbundling, where large players effectively outsource some of their processes to specialist and relatively small players, has allowed a number of non-bank liquidity providers to stake a claim.

‘'We see ourselves as helping to make the existing ecosystem more efficient, rather than replacing it, and are partnering with banks/platforms to make this happen," adds Amrolia.

The tremendous growth momentum in HFT seems to have reached its limit… The increasing cost of infrastructure and relentless competition… are probably the first to blame
Deutsche Bank paper

According to research by Deutsche Bank, High-frequency trading – reaching the limits, HFT firms in the US achieved as much as $7.2 billion in revenues in 2009, but overall takings slumped to just $1.3 billion by 2014.

"The tremendous growth momentum in HFT seems to have reached its limit in recent years. The increasing cost of infrastructure and relentless competition within the industry are probably the first to blame," says Deutsche Bank in its paper, before going on to warn of the risk of an overhang of HFT capacity building up.

"In addition, HFT firms are hardly participating in those dark pools where large block transactions are executed. Both trends are challenging their business model and trading strategies as HFTs have seen their revenues and profits erode. Furthermore, forthcoming tighter prudential regulatory oversight may lead to an overhang of capacity in the HFT industry," the bank adds.

These findings are already being borne out. Firms relying on latency arbitrage strategies seem to be dropping behind their peers, whose business models now focus on holding times measured in minutes and minimising market impact. At the same time, credit arrangements in the FX markets make it difficult for non-bank shops to reach new sources of flows.

"Yes, credit is an issue, but even if that was solved tomorrow, we still wouldn't be able to trade with asset managers or pension funds, because they want to trade in $25 million-$50 million chunks, not $1 million or $2 million clips," says a senior employee at a non-bank market-maker relying on latency advantages for its trades.

For HFT shops, which typically have negligible balance sheets and no overnight positions, this avenue is closed. But, for those positioning themselves as risk-warehousing entities, the opportunity to tap into new streams of customer flows is there in the form of bank partnerships and touching segments via agency desks or algorithmic execution.

"In the last couple of years, things have been quite difficult on the FX side, and I just can't see it getting better," the senior employee says.

In contrast, those who have the balance sheet and set-up to warehouse risk are charging ahead and leaving some of the traditional players of FX – banks – behind. In only a matter of a few years, the relationship between banks and non-banks has changed from one of acrimonious co-existence to one of collaboration.

"Natural partnership opportunity"

"There is a natural partnership opportunity that we've already found with many global and regional banks whose broad franchises can benefit from supplemental liquidity. Most of our bank partners are also focused on limiting the market impact of their external trades, which positions Citadel Securities very well, given our performance on this dimension," says Kevin Kimmel, chief operating officer at Citadel Execution Services.

One driver of this trend is the increasing market impact in even the most liquid currencies, as overall risk-warehousing capacity has shrunk. While banks still have to service their vast client franchises, they have neither the appetite nor the ability to sit on trades. Yet, if they try to offload risk into the market, price moves become exaggerated and damage execution quality for both the bank and its clients.

"Some liquidity providers engage in latency arbitrage and back-to-back hedging, which means counterparties will see a huge market impact. It's only possible to reduce market impact if you can hold risk and internalise," notes Amrolia.

Or trades can be offloaded by partnering a non-bank provider and using its liquidity to match-off outstanding positions without fear of having a severe impact on the market. Banks are increasingly keen to utilise alternative providers such as hedging venues, according to one employee at a global trading firm.

Banks are also seeking new partners in the growing agency space, including liquidity for client algos, from which flows are not internalised within the bank.

"We work in partnership with banks and fill in gaps where we are needed. Regional banks, for example, [are] usually very strong in their home currency, but they don't really have the same expertise in others. Banks that provide clients with algos can treat us [as] a separate destination for liquidity to differentiate their offering. We are basically another venue for banks," says the global trading firm employee.

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