As discussed in an earlier blog post, convergence of equities and FX markets is spurring some institutions to merge their respective trading operations so as to enjoy economies and leverage successful activities across both asset classes. But for firms taking this route, there are significant challenges.
Despite the convergence of FX and equities markets, there remain important distinctions between them, and these need to be understood and appreciated before firms embark on attempting to merge their respective trading platforms. Fundamentally, the FX and equities markets reached their point of electronic trading convergence via two very different paths. Cash equities were the first asset class to take advantage of the introduction in the early 1990s of the FIX (Financial Information eXchange) standardized messaging protocol. This was pioneered by firms like Salomon Brothers and Fidelity, encouraged by regulators keen to streamline the delivery of order messages between market practitioners, and represents one of the most successful attempts at standardization within financial services. By contrast, flow FX shifted to electronic trading on a piecemeal basis, largely with no regulatory involvement.
As a result, FX venue operators developed a broad range of data exchange protocols, each best suited to cater to their clients’ needs while taking into account the venues’ specific matching methodologies. Furthermore, banks’ historic tendency to use proprietary FX trading models led to the adoption of point-to-point connections for access to trading venues for both flow and non-flow FX business. These point-to-point connections exist between liquidity providers and venues, between liquidity providers and some of their clients, and between dealer-to-dealer platforms and the dealers whose inventory and orders these platforms aggregate. Many of these point-to-point connections use proprietary APIs or are bespoke, direct connections between systems on either side. This diverges from the equities model based on FIX messaging to centralized, exchange-like trading venues.
Another aspect of variance between the two asset classes relates to price formation and client pricing. Equity derivatives pricing is based on a range of industry-standard models that are, by definition, client-agnostic. These range from binomial pricing, Monte Carlo pricing methods and the Black-Scholes partial differential equation for options. Conversely, non-flow FX instrument pricing in 2019 remains a highly customized process. FX pricing remains bespoke because it’s based on the overall currency position that a dealer holds at any one point in time. This incorporates the dealer’s currency positions and inventory, the skew, the spread, and the capability to internalize real-money flows passing through a variety of different order books. Unlike equity derivatives trades, most non-flow FX trades are uncleared. Hence FX pricing must incorporate client-specific risks relating to credit and settlement.
Exceptions exist – in particular, in cases where specific currency trades are settled via continuous linked settlement (CLS) or for those trades that are centrally cleared. But CLS and central clearing aren’t available everywhere and to everyone, being mostly confined to trades by the largest broker-dealers and across the main currency pairs. Price distribution also varies significantly between the two asset classes. Cash equities and equity derivatives trades are ‘universally priced’ – that is, priced identically regardless of the potential counterparty. They are also distributed universally so that all market participants see the same prices, and these prices are tradeable for all.
This is not the case in FX. The bespoke nature of the majority of non-flow FX instrument pricing follows the exact opposite trajectory: individual prices are streamed only to the client for whom they were made. Convergence – in the form of a common structure across both markets – holds the promise of real benefits for those firms that choose to take advantage. These include mapping performing systems and processes from one market to the other, and benefiting from the economies of a single technology platform for both. But logistical and technological barriers need to be understood and overcome before firms can reap rewards from following a convergence strategy. This necessarily requires careful analysis of the characteristics and nuances of a successful combined trading technology infrastructure.