ECB highlights dangers of over-concentrated FX market

Market consolidation and a reliance on electronic trading in the foreign exchange markets could lead to an over-concentration of risk and liquidity among too few market participants, the European Central Bank has warned.

High-profile mergers such as between JP Morgan and Chase Manhattan and the Deutsche Bank/Bankers Trust marriage, have reduced the number of firms engaged in foreign exchange trading, while increasing the market share of the top tier, the ECB said in a review of the FX market published this month.

At present, the study said, liquidity is holding up well in the markets, with euro liquidity, for example, coming close to that of the now-defunct German mark. But ongoing concentration could lead to ‘liquidity gaps’ in the market. "Small gaps in liquidity [a sudden movement in price is often interpreted as a sign of reduced liquidity] seem to be occurring somewhat more frequently," the central bank’s report said.

But market participants said the risk of liquidity gaps in the market at present is small. "The liquidity that exists is more than adequate to support the level of dealing that’s going on today," said David Puth, global head of foreign exchange at JP Morgan Chase in New York. "While volumes have gone down to some extent, it hasn’t created liquidity pockets that central banks should be concerned about."

The ECB added that concentration in the market is likely to continue as demand for increased efficiency continues. "The trend towards increased concentration is likely to continue owing to the following factors: heated competition that has been intensified by growing transparency, and a sharp increase in costs related to development and operation of new systems in connection with the need to participate in the global market-place," the report said.

Market participants told RiskNews’ sister publication FX Week the main problem facing the industry following 10 years of development and change is reliance on electronic trading systems and the potential for that reliance to lead to liquidity shortages.

"If you go back 10 years there was a broader market-place, with more participants," Puth said. "Many of these participants were involved in the interbank market and had a strong obligation to support pricing both through the voice-broking market and via the interbank direct-dealing market. Those elements of the market do not exist in the same manner today. We are all now significantly more reliant on electronic dealing platforms to derive liquidity. It is quite possible that participants could step away from those platforms during times of increased volatility."

There is concern that in the event of a catastrophic incident, pricing on electronic systems could halt, leaving a large liquidity gap. “Around 10 years ago, there was a sense that people would support each other with pricing to some extent," said one senior foreign exchange manager at a US bank in New York.

The newly launched Continuous Linked Settlement (CLS) system for forex could also promote the acceleration of concentration risk, the ECB report found. As most banks will use the service as third parties of the top tier FX banks, more volume will be concentrated on those institutions.

The ECB’s report also said liquidity in the foreign exchange options market is deteriorating. Although this can be attributed to the declining number of market makers, a less dynamic approach to foreign exchange risk management is also to blame, the central bank said.

Despite the bank’s warnings on over-concentration, the study found some positive developments in the foreign exchange market: real-money funds have taken a more proactive approach to the management of forex positions in recent years, and lower returns in equity markets have led equity fund managers to focus more on FX returns, boosting the currency overlay market.

The ECB’s market study was carried out in conjunction with eurozone national central banks and put together through interviews with banks, foreign exchange managers, corporate treasurers, insurance companies, pension funds, hedge funds and currency overlay managers.