The bulge bracket banks are losing ground in foreign exchange market share, with causation for the rare phenomena being a decision made by the banks, not the customers. Nonetheless, the top FX dealers in a 2016 Greenwich Associates study continued to reflect the world’s dominant financial intermediaries – JPMorgan, Citi, UBS and Deutsche Bank finishing in fourth place. Tied for fifth were Bank of America Merrill Lynch, Barclays, HSBC, and Goldman Sachs. In part, causation for the loss of market share is market maker profitability, which can impact liquidity.

cocoparisienne / Pixabay

Bulge bracket bank market maker dominance dips slightly in FX, holds steady in other liquidity providing areas

Bulge bracket bank dominance in the FX markets is trending lower, down for a peak of 53% market share in 2013 to 44% in 2016, but they continue to be the dominant player in the market.

The reason for the drop isn’t so much competition nipping at their heels and taking business, the top FX dealers collectively decided that “prioritizing more profitable clients” was a path to their own revenue needs.

While FX trading exhibited a drop, government bond trading is on the rise, up from 39% in 2012 to stand at 43% today. Investment grade credit has seen a slight rise since 2014 and remains over the 50% level.

Bulge bracket banks: FX markets often involves the trading venue playing a role in market making and being the trade counterparty

The FX markets are often characterized by a trading venue, often with brokerage ties, being cast in the market maker rule, taking the opposite sides of trades. Depending on venue structure, liquidity is self-provided but also assisted by contract market makers. Often times bank-driven platforms use nonbank platforms to hedge their risk, and various strategies to keep a market making book close to delta and gamma neutral exist.

The operational internals typically don’t matter to the institutional clients of the top FX dealers as much as the end result, a tight bid-ask spread, which is also correlated to account profitability to various degrees.

Bulge bracket banks are important FX market makers and liquidity providers, particularly during crisis, a Greenwich report notes. “While these large, global banks continue to emphasize research offerings and market color among their larger suite of financial services—and investors appreciate those offerings—the primary driver of counterparty selection has and continues to be execution quality,” the Greenwich report stated. This is commonly defined by tight and unprofitable bid-ask spreads, low transaction fees as well as quick execution and privacy among a long list of considerations.

The top concern among customers, consistent since 2013, is the price, with the report pointing to “45% of the value customers said was provided by their FX dealers pricing.” Greenwich says pricing is “the largest driver of FX business by far.”

From another perspective, when concern in a sale is for the lowest price in a transaction, market maker profitability can be threatened. The banks don’t like to wade in shallow water.

Bulge bracket banks: What matters to sophisticated investors is how market maker liquidity is provided during crisis

There are several generally little-known issues when making a decision on an FX trading venue. One is centered on the market maker and their behavior during a very low percentage amount of time: during a crisis.

The issue of the trading venue also providing brokerage services has always been an issue – your broker isn’t a neutral third party, but a counterparty. But beyond the theoretical complexities raised, one of the top concerns comes when market volatility hits: Will smaller non-bank liquidity providers (NBLPs) deliver relatively tight bid-ask spreads when market volatility strikes?

Volatile markets have seen some NBLPs widen spreads and shrink trade sizes, a behavior that concerns some investors unfamiliar with the individual firms and their business models and trading strategies. We see this as simply prudent risk management, however. For those NBLPs who act as pure market makers, whether on a name-disclosed basis with customers or anonymously, market research increasingly shows those that stay in during volatile periods outweigh those that don’t.

The most sophisticated investors tend to model various scenarios during a crisis when making decisions to custody assets, trade securities, and futures contracts as well as picking an FX platform.

Ultimately these various industry participants have a different level of importance. One provides a suite of services and the other is an isolated provider:

We do not mean to imply that nonbank liquidity has no impact on institutional investors—that is far from the truth. But it is important to understand the different roles that principal trading firms and hedge funds with market-making strategies play as compared to global, money-center banks. While the former focus all of their energy, technology and capital on providing the most continuous, firm and low-cost liquidity, the latter strive to provide a full suite of products to meet their clients’ needs, including research, capital commitment, market color, and access to credit.

The bulge bracket banks might have lost a bit of market share, but they did it on their terms, not because customers are making a choice to switch.