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8/14/2019 Dynamic Liquidity Management-EForex
http://slidepdf.com/reader/full/dynamic-liquidity-management-eforex 1/338 october 2005 e-FOREX
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 apeer 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, and executed
between credit-worthy and trusted
counterparties, so enjoying narrow
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.
Dynamic Liquidity
Management –towards a nextgeneration solution
John [email protected]
>>>
8/14/2019 Dynamic Liquidity Management-EForex
http://slidepdf.com/reader/full/dynamic-liquidity-management-eforex 2/340 october 2005 e-FOREX
“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.
Indeed, the conventional
distinction between market
maker and market taker is
increasingly blurred. You no
longer need a marquee name
to make markets in FX,
just a computer and a
balance sheet. Oh, and some
technology and technologists.
There are three major forces
concerning today’s FX market
makers:
Screen/Voice Ratio. The
proportion of business
transacted electronically is
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 bysales 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.
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.
With the 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
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
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.
“The proliferation of trading channels
exposes liquidity providers to the risk of getting hit on their prices on multiple
channels simultaneously.”
Dynamic Liquidity Management – towards a next generation solution >>>
8/14/2019 Dynamic Liquidity Management-EForex
http://slidepdf.com/reader/full/dynamic-liquidity-management-eforex 3/342 october 2005 e-FOREX
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.
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
channels, several prices could
be in flight at the same time
and it is not possible on the
Request For Quote (RFQ)
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 of liquidity being
made available to clients
needs to be managed
systematically, intelligently
and dynamically. The systems to handlethis are defined by the liquidity providers’
particular blend of products and target
segments, and almost always require bespoke
development or at least complex integration.
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.
“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.
Similarly, market and liquidity
risk issues are being
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.
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 on the same systems.
The systematic capture of
information from all channels,
and the subsequent processing of that
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
technology! Opportunities abound within financial institutions
and the vendor community alike to embrace these challenges.
Here at RiskCare, we’ve been working on FX systems addressing
sales, pricing, liquidity, trading and risk systems for a variety ofinstitutions. Customers want a combination of technology and
business expertise but above all the ability to plumb vendor
technologies into their own internal systems.