The importance of minimising market impact
Market impact is a nuanced subject – one industry veterans are well aware of. But, with fundamental changes over the past decade shifting how FX markets function, a swath of new service, technology and liquidity providers has emerged. David Fineberg, deputy chief executive at CMC Markets, explores where the problems lie and what must be considered to maintain good etiquette for those looking to fill the emerging gaps in the market
How widely understood are the consequences of market impact?
David Fineberg, CMC Markets
David Fineberg: It’s fair to say there are differing views here, some of which could be seen as rather naive in their approach. For those of us with many years of experience, however, it’s clear this market isn’t always uber-efficient with infinite depth – and we are working every day with clients that are demanding meaningful-sized lots. The problems seem to come from those with a background in trading comparatively small order sizes and/or those that are blissfully unaware of the limitations of working over the counter.
Too many appear to believe this market can scale on a linear basis but, as we know, that’s simply not the case, and the behaviour of institutional counterparties will always reflect this. How these disruptors interact with the wider market needs to be the focus of attention in this area.
How can technology help minimise market impact?
David Fineberg: Used correctly, technology can essentially model the availability of underlying liquidity without repeatedly disclosing orders to the market. That translates into an immediate benefit when reducing market impact – although it’s important to remember that the efficacy of this scenario will be dramatically improved if a liquidity provider has access to a greater number of liquidity pools.
Has the reduction in availability of prime brokers resulted in market impact becoming more pronounced?
David Fineberg: That’s a fair assessment. Easy access for many to decent-sized pools of prime liquidity meant that, historically, there was simply little need for new entrants to be as disruptive. Yes, there were always side deals between brokers, but these were typically accounting for big lot sizes when they were looking to hedge the exposure they had accrued on their own books. However, with around a dozen prime brokers running the situation, there was meaningful competition, reasonable access for all but the smallest of players and pricing could be achieved routinely without having to disclose the request to the wider market.
The gap we saw being created as the prime broker cohort contracted resulted in a degree of innovation, and this laid bare the rather unsubtle approach taken by some of the new entrants. This was especially evident with the proliferation of prime of prime brokerages – which perhaps should have been the realm of the very well-capitalised non-bank participants, but was instead co-opted by those who decided they could achieve the same result by recycling liquidity and padding the spread. Unfortunately, the fact these providers cannot effectively offer an actionable price without going to the market first has rendered this a rather imperfect solution, the failings of which are now being seen.
Does the liquidity provider model mitigate some of these negative effects compared with straight-through processing (STP)?
David Fineberg: Without a doubt – it’s worth bearing in mind the driving factors behind the popularity of the STP model to start with. Namely, that there was a degree of cynicism where some counterparties were unhappy that, somewhere upstream, a desk was looking at an order before quoting a price against it. Obviously this is now the situation we have with prime of prime so, even if a broker claims to offer STP, someone still has to decide to take the other side of that trade. The liquidity provider model therefore not only offers a superior choice as the broker offering such an arrangement is a price-maker, but also ensures a significantly lower negative market impact.
Does blending retail flow into an order book help reduce market impact?
David Fineberg: Rather than using the term ‘blending’, I see this as being more about best use of the internal order book. Internalisation of flow among the largest banks has become yet more commonplace in recent years as they use technology better in a bid to keep part of the book out of the wider market, in turn boosting the bottom line.
Companies such as CMC Markets are able to use a similar approach, because we can make liquidity available not only from our direct retail clients, but also from the banks, brokers and funds we work with. On top of that, we’re able to leverage our own balance sheet and liquidity relationships to connect with a number of prime brokers, electronic communications networks and other non-bank liquidity providers.
However, that means liquidity providers such as CMC Markets are in a position to construct a price that is comparable with the underlying wholesale market, but it comes with minimal risk of rejection and can potentially be augmented with superior market depth, while limiting any impact on the available price.
What existing technologies are making inroads to reducing market impact?
David Fineberg: How CMC Markets Institutional has structured its white-label offering is worthy of note. In addition to a market-leading platform known for giving other brokers an unrivalled degree of functionality, it comes with what can best be described as a range of associated financial technologies. That includes functionality for managing individual accounts, position keeping and comprehensive reporting tools, but also utilities such as block trading tools.
Again, it comes back to providing a one-stop shop to meet clients’ needs – whether that’s simply the raw liquidity and execution or a product that goes right down to a comprehensive ‘broker in a box’.
Where are the next-generation financial technology firms – fintechs – heading next in this area?
David Fineberg: That’s a difficult question to answer as the way this market evolves, there’s never a single direction of travel when it comes to innovation. However, one area in which there is certainly room for further development is advances towards ultra-low latency trading. That’s a realm currently dominated by a select few institutions, such as a few of the legacy tier‑one prime brokers or those targeting high-frequency trading houses. Critically, the ability to execute orders in a matter of microseconds can play a vital role in reducing market impact, and that’s something CMC Markets is certainly working towards. Not only does this give the counterparty added confidence that an order can be filled at the quoted price, but also supports that underlying concept of being a price-maker, rather than price-taker.
Beyond that, the fintechs need to be focused on the value-add consultative services, so counterparties ought to be asking questions about what sort of quant analysis they can expect to benefit from, what other financial technologies will be made available, and so on. Again, this can all serve to mitigate market impact and is a key component of our own development path, all designed to reassure clients that consistent delivery of a high-quality service always sits at the very core of what we do.
It seems clear that facilitating good etiquette – and, in turn, maintaining a market’s integrity – comes down to a collaborative effort by all participants. Technology alone cannot mitigate the consequences of market impact, but combine that with a high-quality liquidity source and you’re getting close to the seamless, ultra-low latency solution.