The Gateway to Algorithmic and Automated Trading

Un-squeezing the middle

Published in Automated Trader Magazine Issue 29 Q2 2013

Given its size, it seems improbable that any trader might struggle to find an optimal way to access the FX market. Yet many mid-sized participants find themselves in exactly this situation, as they fall into a gap between full prime brokerage and direct liquidity relationships. Whether it's the complexity of the legal paperwork or costly and complicated connectivity, the end result is the same - additional expense and delays. But as Alex Knight, Head of Citi's FX Margin Trading business explains, there is now a better option.

Alex Knight

Alex Knight

"If a mid-sized firm wants to access aggregated liquidity from multiple sources, then there are further hurdles to clear. One possible approach is to employ an aggregator as a single point of access. While this has the upfront benefit of simplicity, it adds a further layer of cost. The aggregator will charge fees, in some cases to both the customer and the liquidity provider. "

F or a larger fund or trading group looking to trade FX in large volumes using a variety of instruments, the classic prime brokerage model works very well. But take a step down the size ladder from there and everything changes for the worse. A mid-sized firm looking to trade spot FX as a hedge/overlay for other asset classes or to add FX to its portfolio mix typically won't have the volume, balance sheet or track record to obtain a competitive prime brokerage relationship.

Even assuming such a firm can find a prime broker willing to take it on, there's still the very considerable overhead associated with setting up a prime brokerage relationship. Much of this relates to the copious legal documentation, (generally including ISDA agreements) covering every obscure eventuality relating to esoteric instruments that the firm has no intention of trading anyway. As a result, it's not uncommon for a year to elapse before a new prime brokerage relationship is fully up and running. For a large scale operation intending to trade multiple types of FX instrument in size this effort may be well justified, but not for a mid-sized trading firm that only wants to trade spot.

And this only covers the credit element. If a mid-sized firm wants to access aggregated liquidity from multiple sources, then there are further hurdles to clear. One possible approach is to employ an aggregator as a single point of access. While this has the upfront benefit of simplicity, it adds a further layer of cost. The aggregator will charge fees, in some cases to both the customer and the liquidity provider. Liquidity providers making prices on channels of aggregation will almost certainly look to recover their own costs for price making through wider pricing, while the mid-sized firm's own prime broker will also be charging them for trading away. Additionally, there are SWIFT and CLS costs between the two prime brokers or the executing broker and the client's prime broker to cover. In aggregate, these various layers can easily load up the total transaction cost cycle by as much as USD12 per million. Factor in the additional vagaries of not necessarily knowing the type and source of the liquidity on offer, and the total hit on potential P&L can easily make the whole enterprise non-viable.

The alternatives aren't a great deal more palatable either. Another possibility from the opposite end of the spectrum is to manage multiple peer-to-peer credit and liquidity provider relationships directly in-house. This may be a perfectly sensible option for a large specialised FX trading operation that has all the necessary legal and technological resources on hand, plus the credibility and scale to appeal to prospective liquidity providers. But none of this applies to a mid-sized firm, which can quickly find P&L being swallowed by set-up, maintenance and transaction costs - even if it can convince enough liquidity providers to sign up as counterparties in the first place.

The bottom line is that mid-sized firms looking to trade spot find themselves in limbo. The standard alternatives for large FX trading operations simply do not scale efficiently for their needs. Which, until now, has only left the option of using non-bank providers.

Whilst non-bank providers certainly score well for simplicity of set-up, there will always be lingering doubts about credit risk. Also, it should be remembered that these non-bank providers are generally incurring many of the PB and technology costs outlined above.

A better way: balancing flow

Fortunately, there is a happy alternative to this gloomy scenario for mid-sized firms. If a major prime broker already has established relationships with a critical mass of major providers and consumers of FX spot liquidity, then some significant efficiency opportunities arise. Nevertheless, much depends upon how intelligently such a broker manages the interactions among the various parties. Some liquidity providers will have objectives and appetites that conflict with certain liquidity consumers, but will be well-aligned with others - and vice versa.

For instance, some liquidity providers will be averse to retail broker flow because of surges in demand caused by retail investors trading en masse in the same direction on certain events or price moves. They will, instead, prefer to provide liquidity to professional traders from mid-sized firms who can exhibit more measured and uncorrelated trading activity. However, other liquidity providers may be perfectly willing to match retail broker flow as long as it is segregated from other business.

Therefore, matching broad categories of liquidity providers and consumers appropriately can add substantial value for all parties involved.

This is one of the fundamental principles of CitiFX TradeStream, which maintains several liquidity pools in order to optimise the matching of trade sizes and the underlying characteristics of the flow. Nevertheless, within each pool there is still a sufficiently diverse mix of participants to ensure homogenous aggregated pricing, sufficient depth and efficient price discovery.

Needless to say, this isn't a static situation, so there is a constant need to maintain equilibrium between supply and demand. This requires adding and maintaining a range of liquidity providers, such as banks and high frequency firms, that balance incoming flow. It is definitely not just a case of adding the maximum numbers of providers regardless of individual characteristics. Adding the wrong liquidity provider can damage the value of the flow to existing providers, driving them to widen their spreads and reducing the value of the market to liquidity takers.

A better way: simplicity

While active participant management can deliver better and more relevant liquidity than a generic aggregated feed, it still has to be readily accessible to be of value. Therefore, to maximise simplicity and implementation speed, CitiFX TradeStream can be accessed via a CitiFX Margin Trading account, or via existing prime broker relationships. The documentation for opening a CitiFX Margin Trading account is stripped back to just the bare essentials needed for TradeStream access. As a result, opening an account typically takes a few weeks at most (as little as a week if the customer doesn't require any technology integration) - as opposed to the months usually required for a conventional prime brokerage relationship. In a related initiative to shorten the set-up process, Citi has entered into a collaboration with Deltix Inc with an Equinix hosted deployment of the Deltix Product Suite already integrated with TradeStream liquidity.

Figure 1: Options to Access Aggregated Liquidity

Figure 1: Options to Access Aggregated Liquidity

The need for simplicity and ease of access applies to technology as well as any credit relationship. For this reason, TradeStream is accessible via FIX API, the CitiFX Velocity GUI, MetaTrader, cTrader, FXOne and Deltix, in addition to other trading applications. This means that any mid-sized trading firm looking for high quality spot liquidity can potentially be up and trading within two weeks using a combination of TradeStream liquidity and a CitiFX Margin Trading account. Contrast this with the rigmarole of opening a conventional prime brokerage account and/or connecting directly with individual liquidity providers directly or via a generic aggregator (see Figure 1).

A better way: numbers

Balancing the natural interests of the right mix of providers and flow pays off economically. In the case of TradeStream, the quality of the pricing is immediately apparent in the tighter spreads and available depth. For a mid-sized firm accustomed to the cost burden of multiple intermediaries stretching price spreads, this is an immediate benefit to the bottom line.

Citi, as a major prime broker, already has prime relationships in place with major makers and takers of liquidity, which reduces frictional costs for all participants. A single set of relationship and connectivity costs is effectively amortised over far greater turnover, and no additional third party costs are involved. Collectively, this results in a highly cost-efficient trading venue with characteristics that exactly match the needs of mid-sized firms.


Instead of enduring the costs and inconveniences associated with conventional credit and connectivity alternatives, mid-sized firms now have a far better option. No more making a career out of documentation, no more deciphering individual counterparties' proprietary connectivity, no more paying for other parties' multiple cost layers. Rather than remaining the forgotten segment, these firms can now access finely priced spot liquidity simply, swiftly and inexpensively. Just what they need, just how they want.