dynamic liquidity management-eforex

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]

>>>



“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 >>>



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.

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