Brokers – Love Thinking about Finance, Market Microstructure and Money View

By Jack Krupinski
(This Money View piece is by my students, Jack Krupinski. Jack is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics.)

Financialization and electronification are long term economic trends and are here to stay. It’s essential to study how these trends will alter the world’s largest market—the foreign exchange (FX) market. In the past, electronification expanded access to the FX markets and diversified the demand side. Technological developments have recently started to change the FX market’s supply side, away from the traditional FX dealing banks towards principal trading firms (PTFs). Once the sole providers of liquidity in FX markets, dealers are facing increased competition from PTFs. These firms use algorithmic, high-frequency trading to leverage speed as a substitute for balance sheet capacity, which is traditionally used to determine FX dealers’ comparative advantage. Prime brokerage services were critical in allowing such non-banks to infiltrate the once impenetrable inter-dealer market. Paradoxically, traditional dealers were the very institutions that have offered prime brokerage services to PTFs, allowing them to use the dealers’ names and credit lines while accessing trading platforms. The rise of algorithmic market markers at the expense of small FX dealers is a potential threat to long-term stability in the FX market, as PTFs’ resilience to shocks is mostly untested. The PTFs presence in the market, and the resulting narrow spreads, could create an illusion of free liquidity during normal times. However, during a crisis, such an illusion will evaporate, and the lack of enough dealers in the market could increase the price of liquidity dramatically.

In normal times, PTFs’ presence could create an “illusion of free liquidity” in the FX market. The increasing presence of algorithmic market makers would increase the supply of immediacy services (a feature of market liquidity) in the FX market and compress liquidity premia. Because liquidity providers must directly compete for market share on electronic trading platforms, the liquidity price would be compressed to near zero. This phenomenon manifests in a narrower inside spread when the market is stable. The FX market’s electronification makes it artificially easier for buyers and sellers to search for the most attractive rates. Simultaneously, PFTs’ function makes market-making more competitive and reduces dealer profitability as liquidity providers. The inside spread represents the price that buyers and sellers of liquidity face, and it also serves as the dealers’ profit incentive to make markets. As a narrower inside spread makes every transaction less profitable for market makers, traditional dealers, especially the smaller ones, should either find new revenue sources or exit the market.

During a financial crisis, such as post-COVID-19 turmoil in the financial market, such developments can lead to extremely high and volatile prices. The increased role of PTFs in the FX market could push smaller dealers to exit the market. Reduced profitability forces traditional FX dealers to adopt a new business model, but small dealers are most likely unable to make the necessary changes to remain competitive. Because a narrower inside spread reduces dealers’ compensation for providing liquidity, their willingness to carry exchange rate risk has correspondingly declined. Additionally, the post-GFC regulatory reforms reduced the balance sheet capacity of dealers by requiring more capital buffers. Scarce balance sheet space has increased the opportunity cost of dealing.

Further, narrower inside spreads and the increased cost of dealing have encouraged FX dealers to offer prime brokerage services to leveraged institutional investors. The goal is to generate new revenue streams through fixed fees. PTFs have used prime brokerage to access the inter-dealer market and compete against small and medium dealers as liquidity providers. Order flow internalization is another strategy that large dealers have used to increase profitability. Rather than immediately hedge FX exposures in the inter-dealer market, dealers can wait for offsetting order flow from their client bases to balance their inventories—an efficient method to reduce fixed transaction costs. However, greater internalization reinforces the concentration of dealing with just a few large banks, as smaller dealers do not have the order flow volume to internalize a comparable percentage of trades.

Algorithmic traders could also intensify the riskiness of the market for FX derivatives. Compared to the small FX dealers they are replacing, algorithmic market makers face greater risk from hedging markets and exposure to volatile currencies. According to Mehrling’s FX dealer model, matched book dealers primarily use the forward market to hedge their positions in spot or swap markets and mitigate exchange rate risk. On the other hand, PTFs concentrate more on market-making activity in forward markets and use a diverse array of asset classes to hedge these exposures. Hedging across asset classes introduces more correlation risk—the likelihood of loss from a disparity between the estimated and actual correlation between two assets—than a traditional forward contract hedge. Since the provision of market liquidity relies on dealers’ ability to hedge their currency risk exposures, greater correlation risk in hedging markets is a systemic threat to the FX market’s smooth functioning. Additionally, PTFs supply more liquidity in EME currency markets, which have traditionally been illiquid and volatile compared to the major currencies. In combination with greater risk from hedging across asset classes, exposure to volatile currencies increases the probability of an adverse shock disrupting FX markets.

While correlation risk and exposure to volatile currencies has increased, new FX market makers lack the safety buffers that help traditional FX dealers mitigate shocks. Because the PTF market-making model utilizes high transaction speed to replace balance sheet capacity, there is a little buffer to absorb losses in an adverse exchange rate movement. Hence, algorithmic market makers are even more inclined than traditional dealers to pursue a balanced inventory. Since market liquidity, particularly during times of significant imbalances in supply and demand, hinges on market-makers’ willingness and ability to take inventory risks, a lack of risk tolerance among PTFs harms market robustness. Moreover, the algorithms that govern PTF market-making tend to withdraw from markets altogether after aggressively offloading their positions in the face of uncertainty. This destabilizing feature of algorithmic trading catalyzed the 2010 Flash Crash in the stock market. Although the Flash Crash only lasted for 30 minutes, flighty algorithms’ tendency to prematurely withdraw liquidity has the potential to spur more enduring market dislocations.

The weakening inter-dealer market will compound any dislocations that may occur as a result of liquidity withdrawal by PTFs. When changing fundamentals drive one-sided order flow, dealers will not internalize trades, and they will have to mitigate their exposure in the inter-dealer FX market. Increased dealer concentration may reduce market-making capacity during these periods of stress, as inventory risks become more challenging to redistribute in a sparser inter-dealer market. During crisis times, the absence of small and medium dealers will disrupt the price discovery process. If dealers cannot appropriately price and transfer risks amongst themselves, then impaired market liquidity will persist and affect deficit agents’ ability to meet their FX liabilities.

For many years, the FX market’s foundation has been built upon a competitive and deep inter-dealer market. The current phase of electronification and financialization is pressuring this long-standing system. The inter-dealer market is declining in volume due to dealer consolidation and competition from non-bank liquidity providers. Because the new market makers lack the balance sheet capacity and regulatory constraints of traditional FX dealers, their behavior in crisis times is less predictable. Moreover, the rise of non-bank market makers like PTFs has come at the expense of small and medium-sized FX dealers. Such a development undermines the economics of dealers’ function and reduces dealers’ ability to normalize the market should algorithmic traders withdraw liquidity. As the FX market is further financialized and trading shifts to more volatile EME currencies, risks must be appropriately priced and transferred. The new market makers must be up to the task.

Link to economic questions website

Jack Krupinski is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics. He pursues an actuarial associateship and has passed the first two actuarial exams (Probability and Financial Mathematics). Jack is working to develop a statistical understanding of risk, which can be applied in an actuarial and research role. Jack’s economic research interests involve using “Money View” and empirical methods to analyze international finance and monetary policy.

Jack is currently working as a research assistant for Professor Roger Farmer in the economics department at UCLA and serves as a TA for the rerun of Prof. Mehrling’s Money and Banking Course on the IVY2.0 platform. In the past, he has co-authored blog posts about central bank digital currency and FX derivatives markets with Professor Saeidinezhad. Jack hopes to attend graduate school after receiving his UCLA degree in Spring 2021. Jack is a member of the club tennis team at UCLA, and he worked as a tennis instructor for four years before assuming his current role as a research assistant. His other hobbies include hiking, kayaking, basketball, reading, and baking.

“A broker is foolish if he offers a price when there is nothing on the offer side good to the guy on the phone who wants to buy. We may have an offering, but we say none.” Marcy Stigum

By Elham Saeidinezhad

Before the slow but eventual repeal of Glass-Steagall in 1999, U.S. commercial banks were institutions whose mission was to accept deposits, make loans, and choose trade-exempt securities. In other words, banks were Cecchetti’s “Financial intermediaries.” The repeal of Glass-Steagall allowed banks to enter the arena so long as they become financial holding companies. More precisely, the Act permitted banks, securities firms, and insurance companies to affiliate with investment bankers. Investment banks, also called non-bank dealers, were allowed to use their balance sheets to trade and underwrite both exempt and non-exempt securities and make the market in both the capital market and the money market instruments. Becoming a dealer brought significant changes to the industry. Unlike traditional banks, investment banks, or merchant banks, as the British call it, can cover activities that require considerably less capital. Second, the profit comes from quoting different bid-ask prices and underwriting new securities, rather than earning fees.

However, the post-COVID-19 crisis has accelerated an existing trend in the banking industry. Recent transactions highlight a shift in power balance away from the investment banking arm and market-making operations. In the primary markets, banks are expanding their brokerage role to earn fees. In the secondary market, banks have started to transform their businesses and diversify away from market-making activities into fee-based brokerages such as cash management, credit cards, and retail savings accounts. Two of the underlying reasons behind this shift are “balance sheet constraints” and declining credit costs that reduced banks’ profit as dealers and improved their fee-based businesses. From the “Money View” perspective, this shift in the bank’s activities away from market-making towards brokerage has repercussions. First, it adversely affects the state of “liquidity.” Second, it creates a less democratic financial market as it excludes smaller agents from benefiting from the financial market. Finally, it disrupts payment flows, given the credit character of the payments system.

When a banker acts as a broker, its income depends on fee-based businesses such as monthly account fees and fees for late credit card payments, unauthorized overdrafts, mergers, and issuing IPOs. These fees are independent of the level of the interest rate. A broker puts together potential buyers and sellers from his sheet, much in the way that real estate brokers do with their listing sheets and client listings. Brokers keep lists of the prices bid by potential buyers and offered by potential sellers, and they look for matches. Goldman, Merrill, and Lehman, all big dealers in commercial paper, wear their agent hat almost all the time when they sell commercial paper. Dealers, by contrast, take positions themselves by expanding their balance sheets. They earn the spread between bid-ask prices (or interest rates). When a bank puts on its hat as a dealer (principal), that means the dealer is buying for and selling using its position. Put another way, in a trade; the dealer is the customer’s counterparty, not its agent.

Moving towards brokerage activity has adverse effects on liquidity. Banks are maintaining their dealer role in the primary market while abandoning the secondary market. In the primary market, part of the banks’ role as market makers involves underwriting new issues. In this market, dealers act as a one-sided dealer. As the bank only sells the newly issued securities, she does not provide liquidity. In the secondary market, however, banks act as two-sided dealers and supply liquidity. Dealer banks supply funding liquidity in the short-term money market and the market liquidity in the long-term capital market. The mission is to earn spreads by always quoting bids and offers at which they are willing to buy and sell. Some of these quotes are to other dealers. In many sectors of the money market, there is an inside market among dealers.

As opposed to the bond market, the money market is a wholesale market for high-quality, short-term debt instruments, or IOUs. In the money market, dealing banks make markets in many money market instruments. Money market instruments are credit elements that lend elasticity to the payment system. Deficit agents, who do not have adequate cash at the moment, have to borrow from the money market to make the payment. Money market dealers expand the elasticity daily and enable the deficit agents to make payments to surplus agents. Given the credit element in the payment, it is not stretching the truth to say that these short-term credit instruments, not the reserves, are the actual ultimate means of payment. Money market dealers resolve the “payments management” problem by enabling deficit agents to make payments before they receive payments.

Further, when dealers trade, they usually do not even know who their counterparty is. However, if banks become brokers, they need to “fine-tune” quotes because it matters who is selling and buying. Brokers prefer to trade with big investors and reduce their ties with smaller businesses. This is what Stigum called “line problems.” She explains a scenario where the Citi London offered to sell 6-month money at the bid rate quoted by a broker, and then, the bidding bank told the broker she changed her mind but had forgotten to call. In this situation, which is a typical one in the Eurodollar market, the broker would be committed to completing her bid by finding Citi a buyer at that price. Otherwise, the broker would sell Citi’s money at a lower rate and pay a difference equal to Citi’s dollar amount and would lose by selling at that rate. Since brokers operate on thin margins, a broker wouldn’t be around long if she often got “stuffed.” Good brokers take care to avoid errors by choosing their counterparties carefully.

After the COVID-19 pandemic, falling interest rates, the lower overall demand for credit, and regulatory requirements that limit the use of balance sheets have reduced banks’ profits as dealers. In the meantime, the banks’ fee-based businesses that include credit cards late-fees, public offerings, and mergers have become more attractive. The point to emphasize here is that the brokerage business does not involve providing liquidity and making the market while supplying liquidity in the money and capital market is the source of dealer banks’ revenue. Further, brokers tend to only trade with large corporations, while dealers’ supply of liquidity usually does not depend on who their counterparty is. Finally, as the payment system is much closer to a credit system than a money system, its well-functioning relies on money market instruments’ liquidity. Modern banks may wear one of two hats, agent (broker) or principal (dealers), in dealing with financial market instruments. The problem is that only one of these hats allows banks to make the market, facilitate the payment system, and democratize access to the credit market.