44 | july 2013 e-FOREX july 2013 e-FOREX | 45

Liquidity aggregation has become a staple feature of the FX market, and for some people it has developed almost to the point of commodity-status where it is difficult to think of new ways to differentiate one service from another. Yet for others FX liquidity aggregation remains a complex and technically challenging undertaking in an increasingly fragmented marketplace which continues to see a proliferation of trading venues.

“Liquidity aggregation was complex in the past and will continue to be complex in the future,” says Ralf Behnstedt, chief executive and managing partner of FXArchitects, a consultancy company specialized in design, development and implementation of Foreign Exchange related business models. The original appeal of liquidity aggregation was obvious, says Behnstedt. It gave banks the opportunity to broaden the spectrum of offered currency pairs, increase trading revenues and manage risk based on the best bid offer price. Furthermore, for the many banks that did not have electronic price feeds available in-house, aggregation was and still is one of the best ways to provide prices electronically.

However the aggregation business model has been faced with some challenges in recent years, says Behnstedt. “Liquidity providers have been faced with the issue that not all of their clients are using their liquidity in a good way. Rather than creating a stable and reliable stream of proper prices, they are identifying opportunities to leverage arbitrage opportunities. We always recommend that clients establish business models where aggregation will be used to work with the respective liquidity providers and not against them. Establishing a good long term relationship takes a lot of hard work and should not be jeopardised by any attempt to leverage short term revenue opportunities.”

Struggle to copeAnother issue is the number of liquidity providers and the update frequency have increased dramatically, says Behnstedt. Consequently, first generation aggregators built as sequential software programs without proper ‘queue & throttle’ management services are struggling to cope and will continue to struggle in the future. Instead FX banks and software providers should be moving to second generation aggregators built on complex event processing (CEP) engines in order to cope with the high number of updates. For the highly sophisticated clients, technology will go one step further says Behnstedt. “We will see aggregators based on field programmable gate arrays (FPGA) that provide ultra-low latency through the use of hardware.”

The liquidity aggregation business model will also face some challenges from regulatory changes – in particular the current discussions around high frequency trading, says Behnstedt. “Both liquidity providers and clients need to make sure that the model complies with respective regulatory requirements which are still to be defined and will change over time. It is a speculative process to guess what these requirements will be but communicating with the regulators and making them aware that the fundamental aggregation model is not about high frequency trading but about providing streamed and tradable prices is important.”

It is not just the access to liquidity that is important to a growing

number of FX participants but also the quality of the liquidity. “The best price feeds from the top liquidity providers are worth nothing if the aggregator cannot handle the update frequency. This leads to price delays and, ultimately, forces banks to reject trade requests because the prices are already invalid,” states Behnstedt.

If these rejections were to continue, it may lead to the worst possible scenario- that the user turns off the aggregator and reverts to manual workflows. “Ultimately pricing workflow quality matters more than pure pricing quality. It is not just about providing prices anymore, it is about the ability to push them through the business process chain with the lowest latency possible, without trade rejections and allowing both parties – the liquidity providers and the liquidity takers – to gain from a software environment that is robust and can cope with changes during a

FX Liquidity Aggregation An old concept witha new faceNicholas Pratt looks at the efforts of liquidity aggregation providers to develop innovative features and the importance of long term relationships between liquidity providers and takers.

LIQ

UID

ITY

MA

NA

GEM

EN

T

LIQUIDITY MANAGEMENT

Nicholas Pratt

Ralf Behnstedt

“The best price feeds from the top liquidity providers are worth nothing if the aggregator cannot handle the update frequency. This leads to price delays and, ultimately, forces banks to reject trade requests because the prices are already invalid,..”

46 | july 2013 e-FOREX

normal and abnormal business day. This reliability and trust can only be created by establishing a robust and sustainable environment and industrialising it. This will become even more important as new ideas and concepts are added to the liquidity aggregation model, like smart order routing and position hedging based on algorithms. We always advise clients to focus on getting a proper and robust framework first before going down the route of adding further requirements,” he says.

So far the majority of focus in the use of liquidity aggregation has centered on the FX Spot market and, to a lesser degree, the FX Swaps market. However in the future, Behnstedt anticipates more demand for OTC products that have yet to be added to aggregation platforms. “We think that FX Options will be one of the products added to liquidity aggregation services very soon.”

Behnstedt also believes that the continued improvement of hedging strategies employed by FX market participants and the introduction of more single algorithms will drive innovation among liquidity aggregation providers. “Users are expecting a clear step forward in functional enhancement. In our work with many clients we have experienced that improved position monitoring and management, enhanced order management, more flexibility in applying hedging styles, also based on depth of market/laddered pricing, more graphical support, flexible and individualised decision support mechanisms, online hit/rejection rate reporting are just a few things those banks wish to have to improve their use of liquidity aggregation.”

AggregAtion proliferAtionSuch is the proliferation of liquidity aggregation venues that liquidity providing banks have several factors

to consider when deciding which aggregation venues to offer their liquidity to. The essential issue for the liquidity providers, says Yaacov Heidingsfeld, chief executive and co-founder of TraderTools is how the aggregation technology engages with the liquidity providing bank and in what way the customer engages with that aggregation technology. “Is that customer predatory by

nature or does the aggregation technology enable the customer to engage in predatory behaviour? Or does the technology enabling the customer to access the best price in a way that is friendly to the liquidity providing banks?”

A further question is whether the liquidity bank has to pay for access to the customers through the

FX Liquidity Aggregation

LIQ

UID

ITY

MA

NA

GEM

EN

T

liquidity quality has also been important for some time now

48 | july 2013 e-FOREX

aggregator. For ECNs the answer is yes, for TraderTools it is no, while other venues are taking a discretionary approach. All of these issues are leading liquidity providing banks to choose certain aggregation venues over others.

The final question for liquidity providing banks is the identity of the ultimate customer and the nature of their trading behaviour, says Heidingsfeld. “Not all horses are for the same courses and there are certain aggregation platforms that are more suitable for certain trading types, be that predatory or not, dark or lit. The consolidation I see happening in the market is a result of trying to match the right venue with the right trading behaviour of the customer.”

intermingling liquidityThe danger of intermingling liquidity has been highlighted by the announcement in April from EBS that it intends to change the way it processes orders so as to

eliminate certain advantages for high frequency traders. “I don’t believe that the intention behind the EBS move was to curb high frequency trading order flow. I think it was an attempt to create a more level playing field. The Spot market, where most of the low-latency FX trading occurs, is not a homogenous market and participants have different motivations. The traditional EBS customer base was not speed-driven but position-driven so by batching and randomising orders on the platform, EBS is looking to regain some of its former customers.” says Heidingsfeld. Although sceptical that this move will be enough for EBS to recover its former status as the premium venue for FX spot trading, he thinks it is indicative of a new reality within the FX market and has implications for service providers. “Volumes are down and volatility is down, so high-cost, zero-latency trading is not the only option. What participants are looking for is innovation but they want to know how much the technology will cost to have on their desktops.”

“We don’t think there is a single solution in the market that will suit all participants, so you need to make the appropriate liquidity available for the appropriate traders. The arbitrage-seeking HFTs would be best suited to the dark pools, but the market-making, strategy-driven HFTs – that use CEP to analyse patterns in the market – could continue to use all kinds of venues because they are not predatory by nature. But if you intermingle liquidity in the aggregated prices, you run the risk of damaging credit

relationships and winding up with wider spreads as a result.”

The key to avoiding intermingled liquidity – and to ensuring an appropriate match between liquidity types and participants’ trading objectives – is transparency, says Heidingsfeld. “As far as TraderTools is concerned, it’s all about transparency. That does not mean that if the liquidity is not transparent, it is not available. Participants that do not want transparency can go to alternative venues or risk getting wider spreads by going directly to the banks. But if you are transparent about your identity and your trading patterns, you are going to get better-quality liquidity with better spreads.”

Fortunately it is becoming easier to profile the type of liquidity a participant requires. Alternative liquidity sources are clearly able to attract a certain type of business interested in a certain type of trading. In a multi-tenant model, the transparency can be achieved by identification and the process need not go so far as asking participants to declare their trading objectives to aggregation platforms, says Heidingsfeld.

The need for greater transparency will also have implications for FX aggregators seeking direct bank connectivity, says Heidingsfeld. “A credit line will no longer be enough to attract direct bank liquidity. The banks want to know more about your trading style, volume and patterns as well as how many venues you are streaming prices to.”

“The essence of our platform is to customise liquidity sources to the liquidity taker or redistributor. If we match the right liquidity providers to the right customer, we will continue to deliver better spreads to that customer. The streaming APIs from the banks manage risk based on the profitability of every customer

FX Liquidity Aggregation

LIQ

UID

ITY

MA

NA

GEM

EN

T

Yaacov Heidingsfeld

“A credit line will no longer be enough to attract direct bank liquidity. The banks want to know more about your trading style, volume and patterns as well as how many venues you are streaming prices to.”

50 | july 2013 e-FOREX

using that API. Not only can you can take that information and make it profitable for both the customer and the liquidity provider, it’s a business model that will win every time. This does not mean that our model is the best for all participants, especially the HFTs. But for a customer prepared to show who they are and willing to work with the liquidity providers to get the fill ratios where they want them, it’s a win-win scenario. It is cutting-edge liquidity aggregation with traditional values.”

BrokerAge perSpectiveSFor Olivier Virzi, chief operating officer at Olfa Trade, a Swiss-based provider of trading and brokerage software services, liquidity aggregation remains a complex process, particularly for the brokerage community. “It is more than just calculating a volume weighted average price (VWAP). The process involves other factors such as the individual agreements between brokers and liquidity providers and the business constraints of each party.”

Although all integration involves the same general processes, each liquidity provider has their own requirements and policies making each set-up a new one, says Virzi. “Further complications arise because liquidity providers do not want to be ‘hit’ several times on different prices while trying to respect mechanisms like limit orders that brokers place, which means to provide the best VWAP within the set limit.” In order to facilitate this, Olfa Trade offers its customers specific algorithms, such as its ‘knapsack’ algorithm.

An additional complexity arises from the fact that brokers usually want to avoid ‘sweeping the books’ whilst

still providing their clients with a VWAP composed of the best quotes,

says Virzi. “In order to maintain the confidence

of their liquidity providers, we aggregation specialists provide the necessary flexibility and tools needed by today’s firms to manage this complex brokering process.

Virzi is cognisant of the potential dangers of intermingling liquidity in the aggregation process and risking a widening of spreads or causing damage to the relationship with liquidity providers and takers. Much of this danger is borne out of the common misconception that the more liquidity you connect to, the better pricing you’ll have to trade with.

“While this can be true, what is vastly important is the relationship one maintains with their liquidity providers, certain practices have been known to stem the quality of liquidity received by brokers from their

FX Liquidity Aggregation

LIQ

UID

ITY

MA

NA

GEM

EN

T

The key to avoiding intermingled liquidity is transparency

52 | july 2013 e-FOREX

partners,” says Virzi. For example, if a broker systematically fractions its deals and consequently ends up ‘sweeping’ a unsuspecting and unprepared liquidity provider for, say, ten £500,000 trades for £5 million order, the relationship between both entities may deteriorate.

HonorABle BuSineSS prActiceS“Many FX market participants would assume that they can deal with their liquidity providers as they wish because of signed agreements but honorable business practices are key to maintaining solid and dependable liquidity over the long term,” maintains Virzi.

Another danger rises when brokers combine bankable and non-bankable prices feeds, says Virzi. “In this situation, it is a pre-requisite to ‘unsubscribe’ banks already included in the aggregated liquidity. Eventually it is up to the broker to decide if he wants to work with 15 or only 5 liquidity providers and also use aggregated or non-aggregated feeds. What is definite though is that whatever the combination is, when there is an agreement in place, the broker expects good prices while the liquidity provider expects good volumes.”

“Our aggregation service will give our clients the best pricing and execution available on the market today but it is up to them to ensure that their relationships with liquidity providers are cordial. This is key to maintaining competitive spreads, ensuring execution and avoiding price interruption in difficult or fast moving markets.”

Providing more effective bridges between execution venues and liquidity providers and delivering a new generation of customizable liquidity management solutions therefore lies at the heart of the development efforts of the leading FX service providers, says Virzi.

“Today liquidity management solutions have to address the tri-partite relationship between the FX providers, their client and the liquidity providers in a well-balanced manner. Nowadays banks are able to provide liquidity with various price bands depending on the clients’ expected volume and guarantee quality of execution. Therefore, FX providers have to pick the right feed in order to provide their clients with the best spreads available considering the volume they are trading and still satisfying the bank. Technically these requirements translate into the possibility to constitute the adequate pool of liquidity in regards to the clients’ needs so as to satisfy each party.”

level of innovAtionLiquidity aggregation has not become a commodity service, believes David Newns, COO at eExchange, State Street and this is best demonstrated by the level of innovation still evident. “Liquidity

aggregation is an extremely commonplace activity but there is a range of participants using it in different ways – from desk aggregators used for manual click and deal trading, to auto-hedging for eFX market price making platforms to alpha-seeking, rules-based trading engines. These activities all have different stipulations and different tolerances as to how the liquidity behaves. So it is complex and challenging if you want a satisfactory experience across these multiple scenarios. Alternatively you can opt for a plug and play approach but I have not seen any one ‘out-of-the-box’ solution that works for all participants.”

One of the main variables in the FX market is the behaviour of the different venues and the way they deliver market data both in terms of its precision and the frequency of the updates. “You have participants that do not have the infrastructure or application architecture to handle the volumes of market data generated by real-time market data delivery and precision pricing and participants that have problems building and maintaining their aggregated book correctly. There are aggregation solutions that cannot cope with market data loads or the speed at which fills are coming back from trading venues. If it was a commoditised service, those kinds of problems would be resolved by now.”

In order to cope with some of these issues, Currenex can employ depth of book controls and limits on the speed of updates according to clients’ preferences and to limit the market data load. “The

FX Liquidity Aggregation

LIQ

UID

ITY

MA

NA

GEM

EN

T

Olivier Virzi

“Many FX market participants would assume that they can deal with their liquidity providers as they wish because of signed agreements but honorable business practices are key to maintaining solid and dependable liquidity over the long term,”

fact that we are coming up with ways to help customers get around the deficiencies of some of the aggregation services out there shows that it is still a technologically challenging area and this again suggests it is not a commoditised service.”

The danger of intermingling liquidity is the danger of expectation from liquidity takers, says Newns. “If you approach execution across multiple venues with some degree of insight into how these different venues work, then you would be aware that you cannot take feeds from every second tier bank and then constantly sweep all those venues when executing and expect them all to keep up. If you have the idea that you can just buy the software and turn it on, you will not have your expectations met and this can make aggregation a less effective mechanism for price discovery and execution than taking liquidity form a non-aggregated source. There can also be errors in implementation logic and getting the views of your own liquidity wrong or being unable to maintain an updated aggregated book.”

Liquidity quality has been important for some time now, says Newns, as is evident in the development of smart order routing and the use of dynamic scorecards. “As people overcome some of the barriers associated

with aggregation implementation and have all of the liquidity venues on a level playing field, they begin to see where the real quality of liquidity is and can then ensure that their SOR algorithms can dynamically keep up with the performance and liquidity quality of those venues.”

impAct of regulAtory reformIn terms of the regulatory reforms in the FX market, and the potential introduction of Swaps Execution there are some interesting aspects in the implications for aggregation, says Newns. “Liquidity aggregation originated in markets, such as exchange-based futures and equities markets, that behaved in the ways that regulators are trying to introduce in the FX market – that is, more exchange-like behaviour rather than bi-lateral trades. “There is still uncertainty with regards to how the final rules will be interpreted but we suspect that SEFs will already have multiple execution options, for both order book and RFQ, and this will have some impact on the way liquidity can be consumed and therefore aggregated. But I suspect that it is more likely that when clearing and execution mandates are in place, they will create more connections for all participants and make FX more like the futures market. That would be an interesting trend given the pedigree of aggregation in the FX market.”

Liquidity Aggregation is complex

Sub ad