Will Market Fragmentation Impair Liquidity?

By James Sinclair | Jul 5, 2012

Eva Szalay, writing in today’s Wall Street Journal (“FX Trading system Boom Fuels Liquidity Concern”), says that whereas the 2001 spate of new FX platforms stimulated trading and lowered costs “this time looks set to be different”.

I respectfully disagree.   The platforms will attract new participants and permit hedges that were not previously cost-effective; the resulting increased quote volume will outweigh any liquidity impairment due to fragmentation.  Eva also writes that “out of the dozens of platforms that popped up around the turn of the millennium, only a couple exist today”.

In fact, most major entrants survived and thrived in some form and so will most of the recent entrants.

Each time new platforms launched, including in 2001, we had similar liquidity fears.  They proved unfounded.  For example, when Dresdner, UBS and others launched the first single bank platforms, we feared they would take participants from the interdealer market.  In fact, they attracted new mid-tier banks to became active traders who also ordered EBS and Reuters Matching.  Single bank platforms did a great service in Japan, in particular, attracting regional banks to the inter-dealer market.  This trend accelerated with FXall and Currenex.

Similarly, the FX growth of Chicago-style proprietary trading funds, controversial though it is in some quarters, owes much to CME FX on Globex and to Hotspot which was arguably the first platform to sell successfully both to CME futures customers and Spot participants as equals.  State Street’s FX Connect platform enabled hedging by real money funds in ways not economic before and, in response, FXall provided them choice with competing services.  That new hedging flow circulates through the market.

Additionally, new platforms stimulate innovation.  FX Prime Brokerage is an example:  platforms were keen to reach new participants who could not attract credit from many existing participants.  Today, all major platforms now permit you to get your credit from one party and use it to trade with another.  This in turn enabled new opportunities, for example the massive global growth in retail FX, which has greatly exceeded most expectations.

Of the platforms that launched around the turn of the millennium, most were single bank platforms of which there are many more today.  Hotspot, Currenex, the revived CME FX and FXConnect exist today.  Lava was absorbed into FXall.  eSpeed FX’s initial model didn’t succeed, but BGC does now have a successful platform; only a couple actually closed.  In fact, it is more remarkable that there were so few casualties.

Today’s new platforms appear each to have a clear purpose.   There will be twists and turns as well as M&A activity but expect more, not fewer.

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