Liquidity is a key factor in all markets. And it is often more elusive and fragile than it appears, as recent events in the commodity markets have emphasised.
“Obviously liquidity is a very relevant subject,” says Peter Billington, Head of FX Trading at Commerzbank. “We've had a timely reminder of the importance of liquidity in the markets, when you look at what happened to silver on the CME [Chicago Mercantile Exchange] after they changed the margin calls, and how quickly positions can be forced to be liquidated or squeezed. And certainly with some of that spill-over, we have seen the dollar impacted in the FX markets.”
The decision by the CME to raise margin requirements for silver futures four times in just a couple of weeks meant traders had to sell positions to raise cash for margin calls – the commodity price falls, and a cycle of further calls and price falls ensues, impacting the amount of available liquidity. However, it is not just silver: CME has raised the margin requirements on energy futures too.
Fortunately, when it comes to foreign exchange trading, the forex market is the most liquid in the world. Nevertheless, service providers such as Commerzbank are acutely aware of the importance of liquidity, and how changes in the foreign exchange markets can (and are) affecting its provision.
Gerald Dannhaeuser, Head of FX Sales at Commerzbank, aptly states how this translates for market participants: “You only feel liquidity, when its not there.”
A changing market
As well as the general market news, says Mr Billington, there are a lot of changes in the $4trn a day global foreign exchange market that potentially affect the amount of liquidity being provided, how it is provided, and how stable that liquidity is.
“It is going to be very interesting to see how the market develops over the next year or so,” he says. “There are a lot of people who seem to be providing liquidity to the markets in terms of high frequency trading and intermediary providers. It will be intriguing to see how much of this is real liquidity.
“When you're providing liquidity across a variety of platforms, single bank platforms, brokers, and so on, it's good to step back and think about how much liquidity you are providing to the market on any one price at any one time,” he says. “For example, when you have one liquidity provider providing liquidity across a whole host of platforms, in good times there is a sort of relaxed attitude in terms of how much liquidity is out there, but then when an event happens you begin to see how skinny the market can really be.”
A broad client base
Commerzbank provides FX services for a broad client base. “As an overview, the way we segment the clients at Commerzbank is that we have non-financial corporations and then the broad area of financial institutions,” says Mr Dannhaeuser.
“While there are some corporations that do act more like financial institutions, and vice versa, generally the corporate business is very much driven by cash flow hedging needs, certain and uncertain cash flows, as well as by more translation risk hedging needs and also special situations, such as mergers and acquisitions.”
With many non-financial corporations, where they are importing and exporting, for example, the transaction is naturally in one direction or the other – and arbitrage doesn't really play a big role.
“Generally speaking these clients can be very price sensitive,” says Mr Dannhaeuser. “Liquidity is, of course, important, but liquidity and price are not the only factors that play a role or that make a difference here. It's in addition to the advisory part, about structuring capabilities, and whether you have an existing lending relationship with these accounts.”
On the other hand, he notes, there are the financial institutions – banks and non-banks. “With banks, there is certainly the need for liquidity, and also commercial facilities,” he says. “Then there is the big segment of non-bank financial institution clients such as the asset managers, for example, and hedge funds. There it is probably a mixture between hedging needs and the search for alpha, i.e., through currency overlay programmes, but there might be as well high frequency traders looking purely for liquidity and liquidity arbitrage.”
So what advantages does the Commerzbank FX operation offer its clients? One advantage, says Mr Dannhaeuser, is that there is a very strong client focus. “It's the client that we centre our activities around,” he says. “We are not engaged in proprietary risk-taking. So our client is not competing with any other activity of the bank. We are there for our clients five days a week, 24 hours a day, with full attention to clients' positions.”
Mr Billington agrees. “Trading and sales work together, making sure that we're actually providing liquidity for a reason and for our customer base, and we make sure that we understand how we use it,” he says. “So the risk systems are on a 24 hours a day, five days a week basis. We're keen to understand the risk that we take on board and have flexible risk systems that can respond to any changes that happen in the market, so we can help ensure the customers are taking on the right amount of risk, at the right time.”
Another advantage is the bank's specialist knowledge of particular regions. “There is deep market knowhow with regard to special currency pairs in particular regions, for example Eastern Europe, and in facilitating global trade flow between Germany and Asia,” says Mr Billington. “Also, we can give the client the choice regarding which channel they need or want to access liquidity via – whether it is an ecommerce platform, voice sales coverage, or any kind of multi-bank platform that we service. So again we provide the flexibility the client requires and we can centre our offerings on the client's needs.”
Clients expect creativity and innovation, research, knowhow and market intelligence. And of course, adds Mr Dannhaeuser, it is important to be competitive. “But competitiveness does not only mean having the best price at a certain millisecond, but rather competitiveness means being a good, consistent, reliable partner as well in challenging markets and across timezones. It may not sound new and ground-breaking but these are the kinds of things that are easy to say but are more difficult to implement and to get right.”
“From a trading side the key technology is the e-platform offering which is all our own in-house technology. Meaning we don't have to go to outside vendors and we're very much in control of what we're doing, and how we're doing it. It's a definite advantage, for example when EBS changed the number of decimals on their currency pricing, we were able to react quickly to that, for our clients,” says Mr Billington.
“So the e-offering on that basis is something where we can be in control of what we offer our customers, and are able to expand the platform into what they need. In the e-space, it's very easy to spend a lot of money developing a lot of items, but unless they're what our customer will use it's not a very wise investment.”
There is also the multi-bank versus single bank platform debate, although Mr Dannhaeuser believes that there is room for both. “For some client segments, i.e. the ones that are required to do best execution, a multi-bank platform is attractive. We certainly see demand for our prices and liquidity on the multi-bank platforms.
“But clients in other jurisdictions may require more of a multi-product, research, support and advice kind of approach, and then the single bank platform still plays a major role. The market is so big that there is room for both types of channel. In a way you can compare it to when eplatforms were supposed to put an end to voice business – but they haven't.”
Messrs Billington and Dannhaeuser see a number of challenges ahead for the FX market.
“For a start, the FX community is looking to Asia with the diversification of reserves, and relaxation of some trading restrictions there, there's going to be a huge market,” says Mr Billington.
“Probably, with the further development of the Asian fixed income market, there will be greater demand for currency overlay, for more currency pairs, and a much higher liquidity. Plus there is also the decline in the importance of the dollar as a proxy as correlation to the US-Dollar becomes more volatile,” adds Mr Dannhaeuser. “And regulation will certainly have an impact on the FX market; firms will need to be agile and flexible in response to any rules and regulations that may or may not come in.”
Whatever the challenges, Commerzbank is well placed to deal with them. “I think we've got the right platform in terms of global setup and coverage,” says Mr Billington. “The globalisation of our clients' business is increasing, as is the demand for clients to have access across a whole host of currencies, not necessarily in their time zone, depending on world trade and acquisitions. Finding these trends and expanding upon them is going to be the key.”
“There is a lot of transparency and pricing in the market,” he continues. “We really have to differentiate ourselves in terms of the relationship and the service that we provide to the customer. The service we provide covers all aspects, so its sales, research, structuring and trading all working together; it all operates under the one umbrella at Commerzbank, and one client experience – characterised by reliable and robust liquidity.”
For more information: www.commerzbank.com