CONNECTIVITY IN CRISIS.

Getting cut off in volatile markets can be disastrous; traders are focussing on their connectivity with services and data requiring trusted partners to support their trading ecosystem. Ganesh Iyer, Global Product Marketing Director for Financial Markets Network at IPC spoke to Best Execution’s Dan Barnes.

The FX market saw some enormously disruptive events in 2015; what are the operational lessons we can learn from the sudden price moves and changing counterparties last year?

From the impact it had, the uncapping of the Swiss franc was a black swan event. That exposed firms who had limited market access to greater risk than those firms who were well connected. There were also unexpected events around the euro and the yuan where markets moved quickly.

On each occasion what we saw was that having access to a diverse marketplace and connectivity to all of the operational aspects of the trade lifecycle can potentially minimise the impact of these events. That level of access is not standard for every trader. Many firms have – or used to have – bilateral trading relationships. Multilateral marketplaces are relatively new. Therefore one cannot assume that traders have the diverse connectivity to a wide range of counterparties necessary to manage risk when these type of events arise.

How does the FX market structure affect the demand and capacity for managed network services?

The over-the-counter nature of the market removes the support from infrastructure providers such as exchanges or trading venues that can offer liquidity and risk management in exchange-traded markets. Because there is no central marketplace in FX, connectivity becomes vital to sourcing liquidity, mitigating risk and harvesting alpha. Additionally, traders can experience considerable slippage because FX liquidity providers can give orders a ‘last look’. As an ecosystem provider, IPC can bridge that gap by offering a ready-made marketplace of liquidity venues, broker-dealers, trade lifecycle services, risk management and portfolio management systems, and market data to minimise slippage and increase execution speed.

How do the characteristics of FX instruments affect the services needed?

The FX market is complicated by the fact that it doesn’t just include the spot market or involve trading in the top currency pairs. There are a whole range of instruments such as currency swaps, forwards, options, indices, outrights and structured products along with many less liquid currency pairs. Non-deliverable forwards are big in the Asia-Pacific region. The conventional view of the FX market as highly liquid is not necessarily the case. Consequently, it is important to have a whole range of communications strategies for trading, with latency-sensitive connectivity for the most liquid parts of the market and voice capabilities for other parts of the market.

What role does connectivity play in turbulent markets?

Even heavily traded currencies such as the Swiss franc can be impacted by black swan events. In turbulent markets when liquidity becomes difficult to source, traders need to have access to a ready-made ecosystem of execution venues, counterparties, market data providers and trade lifecycle services. A counterparty could be shutting their doors if they have been sunk by an event. Having connectivity to a diverse community of market participants is critical for mitigating the impact of unanticipated events.

This doesn’t apply only to the trader. At a typical asset management firm, the portfolio managers and risk managers also need to be connected to various trade lifecycle services particularly to get an independent view of positions and prices. As transparency requirements increase both from a regulatory and stakeholder standpoint, the right type of connectivity becomes more and more important as firms need to demonstrate the robustness of their business models, investment practices, operational procedures and risk management processes.

How can network providers enable investment firms to source liquidity and mitigate risk in times of crisis?

The concept of ‘network orchestration’ and the power of the network effect – an ecosystem in which connected market participants interact and share in value creation – has become central to successfully executing trades and mitigating risk in the global financial markets across all asset classes. During times of stress, the search for liquidity becomes challenging as investors are simultaneously ‘de-levering’ and ‘de-risking’. Market makers also widen bid-ask spreads and charge more for providing liquidity. In this situation, being connected to a ready-made ecosystem of diverse market participants can enable sellers to find natural buyers and limit liquidity risk. Managed networks also play a major role in risk management, particularly for reducing tail risk. Strategies to mitigate tail risk include using collars or put spreads, buying put options or volatility futures, adopting a basket hedging approach, investing in high-quality bonds and allocating to certain hedge fund strategies. Successfully implementing tail risk strategies is largely dependent on having access to a diverse community of market participants trading multiple asset classes.

Are rising rates in the US likely to trigger another black swan?

Unexpected events can always arise. When a low interest rate currency is used for borrowing to invest in high-yielding assets or currencies as a carry trade, unwinding that trade when values suddenly shift can become a big issue – we saw that with the yen carry-trade during the global financial crisis. Prior to the crisis, firms were buying high-yielding assets such as mortgage-backed securities, asset-backed securities and the Australian dollar. When asset prices came crashing down and the markets were in turmoil, the yen carry trade had to be unwound resulting in significant losses for many firms.

We can’t predict the next black swan event but the carry trade from US dollars invested in high yielding emerging market assets can potentially unwind at any point as rates rise in the US and the prices of emerging market assets decline.

From an IPC perspective, we are seeing market participants seeking solutions that look to minimise the impact of these types of events. That means connectivity throughout the trade lifecycle from order creation to order placement to trade execution, clearing and settlement, with support and market data delivery. Market participants are looking for a diverse marketplace of buyside firms, sellside firms, liquidity venues and trade lifecycle services across asset classes.

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