David Mercer, CEO at LMAX Exchange, the world’s only regulated multi-lateral trading facility (MTF) for FX, explains why recent market turbulence may prove to be a watershed for the currency market and why its future lies on an exchange.
The fallout from the Swiss National Bank’s (SNB) decision to remove the floor in the euro against the franc presents an opportunity for the currency market to put its house in order and restore client confidence,” says Mercer.
“It is certainly not a nail in the coffin, but it is the latest black mark against FX. We have had all these fines, all these investigations and now we have seen this huge move, with scare stories about FX participants going bust,” he says.
“It is time to say ‘enough’. We all need to stand up – the good guys – and tell the world we are regulated and we are fair. FX is one of the oldest markets in the world, and if restoring confidence means making the regulatory hurdle higher and pushing up collateral requirements, so be it.”
The SNB’s surprise decision on January 15 to abandon the Chf1.20 peg against the euro that it had maintained for three and a half years certainly caused havoc in the currency market. It is not without irony that the actions of one of the global institutions charged with maintaining the stability of financial markets managed to produce the biggest spike in prices for over 20 years. For 10 minutes after the announcement, liquidity vanished, leaving institutions and individuals with no way to hedge their currency exposure.
“Liquidity disappeared across the market, it seems as if it was shell shocked. I have never seen the market perform more poorly for ten minutes, but part of the reason is that it was the biggest move since 1992,” says Mercer.
“I don’t think you can blame any one particular party, I just think the market was heavily skewed one way. Everybody plans for price action, but nobody plans for a 25% drop.”
Indeed, he says “the fact that market makers were able to begin pricing again so quickly, reflects well on the resilience of the industry. ”
“We had one of the biggest shocks in 30 years and they were actively pricing within 10 minutes. In the whole scheme of things you could say that is brilliant: good job.”
No stopping the juggernaut
Nevertheless, the move produced pain for many market participants, with headlines focusing on bankruptcies at several retail brokers. Those were headlines that the FX market, still reeling from the fines levied on many of the largest market making banks in the wake of the investigation into the fixing scandal, could do without. That may raise concerns that volumes will fall, with participants increasingly wary of stepping into the FX fray.
But as Mercer points out, speculative retail activity – which has been attracting press attention and unwelcome comparisons with casinos – accounts, at its height, for just 10% to 15% of the FX market.
Indeed, he says, people can often get diverted from the truth of FX: it is a natural market that has emerged as a consequence of the fact that companies have become more global in nature, increasing the need to pay expenses in different currencies and repatriate income from abroad into their own currencies.
“FX is a five trillion dollar a day market without anybody speculating. It is a real market no matter what happens,” says Mercer. “People tend to focus on the speculative side of FX – the proprietary trading, but that only comes because of the core market that is underneath it. You can’t stop the FX juggernaut.”
He says it is up to the industry to give confidence back to the market and its customers: “That is key for the FX market; the industry, as a whole, has to stand up and say it is business as usual. FX is the biggest asset class in the world, there is huge liquidity and there is real money trading going on every day. We need to say: we are here, we are regulated, we are well capitalised – trade with us.”
A myth that surrounds the whole FX industry is that it is unregulated. However, it’s only Spot FX, as a product, that’s not regulated, but all market participants are regulated. One result of the recent events in the market could be closer scrutiny from the regulators, however.
“I think heavier regulation is a good thing if it’s to give more trust to the market place, but it must not be regulation for regulation’s sake. It can’t be politicians and regulators enforcing rules on a market that mean it can’t perform efficiently,” says Mercer.
“Politicians and regulators seem to jump to central clearing as the answer, which is fine, we could clear and report that way. But most important is the regulation of the participants. We need well capitalised market participants, with higher capital constraints. I am happy if you put a higher capital requirement on LMAX Exchange.”
A pioneer in FX
Mercer’s confidence in the resilience of LMAX Exchange is reflected in the phenomenal growth the firm has witnessed as it has pioneered exchange-style trading in FX.
In just three years, LMAX Exchange has seen average volumes grow from a very low base to $10 billion per day. In 2014, LMAX Exchange became UK’s fastest growing technology firm in the Sunday Times Tech Track 100 league table, with the remarkable growth of 307.8% in annual revenues.
The firm’s progress has been based on the conviction that liquid markets trade most efficiently on exchange , and the vision that the FX market will transition to exchange style execution. Similar to equities, Mercer envisages FX trading to become a level playing field, where institutions or individuals trade on the same terms regardless of status, size or activity levels. “Today LMAX Exchange is still unique; we are still the world’s only regulated MTF for FX,” says Mercer. “Three years ago, people said it can’t work, but we have built a good business.”
Of course, while Mercer believes that FX will eventually move to exchange-style trading, he recognises that it is still early days – LMAX Exchange transacts about 1% of the addressable market after all. Still he believes regulators will push the market towards exchange style execution. Within a decade he believes there will be central clearing in FX, although the complexity of the required infrastructure means it will not occur overnight.
Disrupting the market
“I think that there will be the long-term evolution of the FX market,” says Mercer. “We are at an early stage, and we are the disruptors in the market and hopefully we can lead that evolution.”
Of course, as Mercer notes, a firm cannot lead that evolution if there are no benefits to clients: “You can’t lead the evolution, if nobody believes in you. Our customers and our liquidity providers have to see a benefit, and they must be seeing a benefit because of our growth. That is pleasing and I think generally the whole market will come in this direction.”
The benefits boil down to the cost of trading: due to transparent price discovery and certainty of execution, inherent in the exchange execution model, the cost of trading will be lower on an exchange venue, such as LMAX Exchange.
“It doesn’t matter what asset class clients are trading, they are happy to pay to hedge risk, they just want to know they are paying the right price,” he says. “There is a cost to hedging like any insurance policy: they just need that cost to be clear and comparable.”
To that end, the practice of “last look”, where liquidity providers can reject or requote a client’s order does not exist on LMAX Exchange.
Just like an exchange, LMAX Exchange operates central open order book with firm liquidity. ’Last look’, Mercer says, is a practice that may be necessary on other slower venues, but one which is open to abuse if some market makers use it as a profit optimisation tool.
“We don’t believe there is a place for ‘last look’, it is not used in other asset classes,” says Mercer. “It was initially created as a business solution to a technology problem. The challenge for the industry is to enhance their own technology to enable liquidity providers to price efficiently and eliminate the need for ‘last look’.”
Mercer says that about half of the firm’s technology is dedicated to ensure accurate and fast pricing by market makers, giving them a better risk management tool than the ‘last look’.
“If I am a good market maker and have written the software the right way, I have all the information necessary to make the right price within 200 microseconds,” says Mercer. “So then I don’t need the optionality of rejecting or requoting a client’s order.”
Given the commitment to delivering low latency trading technology and perhaps unsurprisingly given its recent accolade as the UK’s fastest growing technology company, the firm focuses heavily on developing its proprietary technology as a whole. Half the firm’s 120 employees are technologists, according to Mercer, while 70% of LMAX Exchange’s spending goes on technology.
“If I worried too much about the bottom line, the obvious thing to stop is technology development, but that stops your growth. You have to be brave especially as a young company,” says Mercer.
“Normally you don’t see the success or failure of a company for seven years and we are midway through that process. We have to keep investing, to have the courage of our convictions, and not focus on the bottom line, but focus on the top line, and to do that we have to keep investing in technology.”
A global approach
Part of that investment has seen LMAX Exchange add a matching engine in Tokyo at the end of last year.
The development means better pricing and reduced latency for the firm’s clients in the Asia Pacific region, where LMAX Exchange has seen enthusiasm for the transparency and quality of execution, only possible on an exchange. The firm has recently signed an agreement to provide liquidity to Japan’s Z.com Trade, part of GMO CLICK Holdings Inc, the world’s largest retail broker.
“It is important for us if we want to be a global organisation that we have a matching engine in Tokyo,” says Mercer. “All our market makers have been very supportive, and are looking for a new source of price discovery in that region. So when we asked them whether they wanted to make markets in Tokyo, the answer was a resounding ‘yes’.”
As part of the firm’s global expansion, LMAX Exchange recently opened an operational and sales hub in Hong Kong to better service the 30% of its customer base that resides in the region. Mercer says Asia represents a huge opportunity for LMAX Exchange: “We have had some success in the region without being there. We have pushed the door open, and now we need to kick it down.”
A Hong Kong operation also makes strategic sense for LMAX Exchange, given its proximity to the vast potential opportunity on offer in China. “The Chinese market is closed to us, but we need to be close to monitor developments,” says Mercer. “We would love to partner with someone and be the first FX exchange in Shanghai or Beijing.”
While, LMAX Exchange has gone east first, the firm also plans to set up matching engines and operational hubs in New York and Chicago to establish a truly global operation. Growth in North America will focus on institutional and interbank client base, to sit alongside the already healthy roster of broker and fund clients.
Reaching for the top
Ultimately, Mercer says, the firm’s ambition is to become the world’s leading venue for FX trading. If that seems presumptuous, he points to the fact that modern technology means firms can access more customers than ever before – allowing firms to get bigger quicker.
Indeed, he says no company is too big to fail and no company is too small to succeed in the modern world, pointing to the demise of the likes of Kodak and Blockbusters, and the rise of companies such as eBay and Amazon. It is, says Mercer, that latter group of firms to which LMAX Exchange looks for inspiration, not the City of London or Manhattan.
“I look at those disruptors, and I believe the FX market can also be disrupted, using modern technology and modern techniques,” he says. “The biggest FX venues trade $100 billion a day, so why can’t we do that? It is a massive market place to win, and we believe in the unbelievable.”
If the FX market continues to warm to exchange style trading, it may not be an imposs ible dream.