News & Analysis

Are the Tier 1 FX desks in the banks really at the mercy of the traders?

Andrew Saks, Friday, 16 April 2021

For over ten years, interbank FX dealing desks at Tier 1 financial institutions have pretty much had it all their own way.

The long-established, and in many cases legacy technology-based single dealer platforms have dominated the very top level of FX market making to the extent that so much revenues are derived from the efficiency of having one investment banking center in London's Canary Wharf executing trades across all global markets that just one office outperforms the entire retail branch banking divisions across entire continents for the same banks.

Thus, the move toward online banking and the subsequent closure of many retail branches was a boon for the banks. What they saved in real estate costs, staff salaries and operational logistics concerned with physical locations, they could be sure would result in far higher overall profits because of the effectiveness of Tier 1 FX dealing from just one London based location.

After all, London's Tier 1 FX dealers handle over 65% of global FX order flow.

Despite this absolute dominance, the need for bank based market making has been so high, and their relevance in the Prime Brokerage space had caused the banks to be able to pick and choose which OTC counterparties they work with.

FX trading becomes a priority for risk managers

It became so risk averse, with banks knowing that liquidity takers would have to come to them and had no alternative, that OTC counterparties spent most of the 2010s ensuring that their relationship with their liquidity provider was absolutely water tight, whilst risk managers ensured that a huge hurdle to overcome was the need for OTC FX counterparties to have to prove that they have over $50 million on their balance sheet.

Today, however, things are somewhat more democratic, and it is becoming clear that the markets themselves, and perhaps even more specifically the actual market participants, are now the ones to whom the banks are at mercy.

It is becoming apparent that bond and stock markets have become so dependent on ultra-loose monetary policy, so hyper-sensitive to any perceived possibility of a change in conditions, that there is little monetary authorities can now do to influence their movements.

The listed derivatives sector has been instrumental in driving this route to self-determination. Some analysts in London are drawing a conclusion that there has been a discourse which has come from growth into value and cyclical stocks, while the consensus within the market participants seems to be that any real inflationary signals will prompt a more general correction in equities.

One particular observer in London today stated that it is becoming apparent that having invested a huge amount of capital resources at achieving asset price stability, global monetary authorities just are unable to register a correction and certainly not one that they might have a chance of preventing.

The foibles of a stimulus-based economy

The Bank of England a number of years ago altered its stance with regard to ‘forward guidance’, and especially the nuanced question of normalization, which is a jargonistic way of saying when rates might be allowed to rise from their crisis-solving levels and QE might be paused or even unwound.

Now, thanks in part to more recent crises, we have had a normalisation - but not quite as was imagined then. The new normal is a world with lots of QE and rock-bottom interest rates.

Now, the banks are too nervous to cause any ripples in a totally stimulus-dependent global financial market when it does not pay to save, yet savers are being relied upon to bring back an era of proper interest rates.

Going back over 40 years, nobody thought it was worth holding cash because of the interest rates which were the benchmark rate minus inflation, and often these were in the negative figures thanks to oil price shocks and dysfunctions in the economy.

However, for the best part of three decades from 1980 to the financial crisis, savers enjoyed positive real interest rates, mostly between 2 and 6 per cent.

To those who’d spent their adult lives getting 4 per cent on top of inflation just for having money in the bank, crisis-era monetary policy has come as something of a shock.

Inflation is looking likely to stay at 2% whilst the banks keep their interest at 1%.

Who's in charge now? The currency trader, that's who!


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