Providing tailored liquidity to individual clients was once seen as a business for banks only, but some banks are now asking more technologically savvy non-banks to do it for them. The bank continues quoting to its customers, but has the option to do so on an agency basis, using prices streamed direct to its desks by a non-bank risk-taker.
It's an arrangement that, in theory, meets needs for both sides: banks can limit their risk, while still serving their customers; non-banks get a ready-made distribution network and genuine customer relationships, rather than being one of many faceless price providers on a platform.
This phenomenon has started to gather steam in the US Treasury market, but has already been a feature of foreign exchange trading for some time, where XTX Markets has made direct streaming a pillar of its business. The firm currently streams prices to more than half the top 20 forex dealers.
"We provide liquidity to many of the larger players in the market, to either their principal desks or their agency desks," says Zar Amrolia, co-chief executive at XTX Markets.
It's also a potentially touchy subject. In Treasuries and other rates products, some banks are wary of taking white-labelled liquidity because they don't want to rely on another firm's willingness to make prices; others fear the non-banks ultimately plan to leapfrog incumbent dealers and stream direct to their clients.
In forex, some of those sensitivities have been overcome. XTX is already connected to a wide assortment of clients - including regional banks, retail aggregators, systematic hedge funds and some macro hedge funds, with more than 50 clients in total today. Other client types remain out of reach, though.
"Real-money investors typically use banks as a credit conduit and are increasingly executing through algorithms. We can't trade with them directly as they don't have prime brokerage relationships, but it's an ideal situation for banks with agency desks looking to provide best execution between an electronic liquidity provider - like us - and a counterparty," says Amrolia.
The key building block to a successful relationship, says Amrolia, is that both parties know what they are looking to get out of the partnership, which helps narrow down the liquidity requirements.
"There are many different factors to go through: how much volume do you do? What execution style do you want? Do you want EUR/USD liquidity in $1 million lots in London hours, or liquidity in $20 million lots on USD/ZAR in an Asian time zone? All these questions are important and help us tailor our liquidity provision accordingly," says Amrolia.
Amrolia says one of the key considerations revolves around ‘last look', which gives the liquidity provider the right to confirm the trade before it is officially executed, as well as rejecting it outright. XTX offers both firm, executable streams as well as ‘last look' streams.
"There's an education process, particularly around last look. If a counterparty agrees, how are we allowed to use the last-look information we get? What do you value in terms of market impact and rejection rates? These are the dialogues we establish, because liquidity is not just a function of the bid/offer; it's a function of market impact and the cost of rejects on given trades," he says.
One of the factors behind its success, clients say, is that XTX quotes in larger size than other non-banks, regularly offering prices in $50 million lots or more. Other positives include tight spreads and the ability to minimise market impact - XTX typically warehouses risk for more than 10 minutes in G-10 currency pairs and for as long as 20 minutes in emerging markets.
This requires a strict focus on risk management, as well as the ability to marry up the various flows the firm sees - increasing rates of internalisation generally help to minimise market impact because a market-maker is not seeking to lay off customer risk quickly via external trading platforms or pre-hedging positions as much.
"Internalising risk reduces the market impact of our trading, which further benefits counterparties. As we choose to hold risk, we're also able to use internalisation as a lower-cost alternative to market hedging," says a spokesperson for XTX.
A strong internalisation strategy combined with a strong focus on operational processes helps keep the algorithms that supply liquidity to XTX's counterparties in good working order too.
"We're continually prototyping the models to ensure that when we go live they behave as intended," says Andrew Brand, head of operational risk at XTX Markets. "The models are continually fine-tuned, back-tested and benchmarked against market data. Even if something didn't work as well as we wanted it to, we would know straight away as they are continually tested and checked."