I Got The Adverse-Selectin’ Internalisin’ Spread-Compressin’ Blues

Since it was published on Tuesday, Vincent Cignarella’s article for WSJ MarketBeat – The Foreign Exchange Traders’ Lament, and kudos to the WSJ’s subs for the correctly placed apostrophe – has done the rounds of every spot FX desk on the street, and “cable is 1.60” has already become a catchphrase on a par with “don’t fight the Fed”. 

There’s a good reason for that: Cignarella’s piece nails the current sentiment in FX markets. 

Part of the problem is the (relatively) low levels of volatility we’ve seen over the last few months. Traders in any asset class make more money when the markets are more volatile (except credit, am I right?); after four years of record-breaking volatility, FX vol is pretty much back to where it was in 2002-2004, so there’s less money to be made. 

But the other, bigger part of the problem is that the structure of the FX market is changing in ways that can’t be reversed.

The rise of competing electronic bank platforms and five-figure pricing mean that spreads are collapsing: sub-1-pip spreads in EURUSD are now the norm. Volumes are increasing by 10-20% a year, but margins are being compressed even faster; the net result is lower trading income (as Deutsche reported yesterday). This isn’t limited to spot FX, either – spreads in forwards and options have collapsed as well.

And the job of liquidity provision itself has been spread thin. The launch of EBS Prime a few years ago gave hedge funds and algo shops access to Icap’s EBS platform – the world’s biggest interbank FX market, sorry Reuters – and allowed them to become liquidity providers instead of liquidity takers. Meanwhile, banks are cutting back on risk-taking; your average bailed-out Volcker-ruled bank no longer has as much appetite to warehouse its customers’ risk or take outright prop risk, which gives bank traders less opportunity to make money.

So there’s less spread to go around; what spread there is is being distributed between more price-makers; and the rangebound markets have made directional trades less lucrative. 

All of which means that Vincent’s piece has pretty much hit the nail on the head. Welcome to the brave new world of FX. 

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