FX forwards dealers face added challenges in P&L analysis

To be a successful market-maker, two attributes are required: you need to be responsive to price requests, and you need to make money. For foreign exchange swaps and forwards trading desks, the latter is harder than you might think.

The FX swaps and forwards business is often thought of as a loss leader, there to take on the predictable, month-end swap hedging rolls from asset managers at compressed margins in the hope that clients will remember you when they have more profitable trades to do – like FX options, for example. It also boosts volume rankings with clients.

The emphasis on profitability has prompted more dealers to start using so-called mark-out tools.

A mark-out analysis tracks the change in the market’s mid-price in the minutes and hours following the execution of a trade, relative to the price at which the trade was executed.

This kind of analysis, also known as alpha or client profiling, has been in use for years in electronic trading of spot FX. It allows banks to identify “toxic flow” – customers with a trading style that typically results in a dealer losing money – and then adjust pricing, have a stern word with the client, or delay and sometimes reject the trade.

Dealers expect mark-out analysis to become a key tool when making decisions about individual client relationships

One classic cause of toxicity is a client’s decision to broadcast a quote request to as many dealers as possible. 

It has two effects for the winning dealer: one, if the liquidity pool is competitive, it creates a “winner’s curse” syndrome as they potentially misprice the trade and subsequently fail to derive an economic profit; and two, it transmits information to the rest of the market about a big trade that is coming, allowing other players to position themselves in advance.

In FX forwards, dealers say toxic client behaviour and information leakage has a much larger impact on the profitability of a trade than in the spot world.

The (slow) electronification of the FX and forwards swaps market has meant that some of the more advanced banks have been able to deploy these tools to analyse flow data.

With a greater focus on profitability and cost of capital in times of low volatility, dealers of all sizes are now turning their attention to these tools. Once deployed, the bank can weigh the costs of trading with an unhelpful client against its overall relationship with that client. They then have a choice of sharing the analysis with the customer, in the hope that it prompts them to change their execution style.

But applying mark-out tools to FX forwards is not straightforward. One concern is that there is not enough transparency on the correct mid-price for all dates on the forwards curve, making it difficult to work out what the point of comparison should be – particularly for smaller banks.

There also remains a lot of manual pricing for longer-dated tenors, and only the most advanced banks can auto-price trades up to five years or more. For everyone else, market data is distributed across a number of different channels, so it can be challenging to combine it into a pricing model that doesn’t lag the market and accurately tracks it post-trade.

And finally, data from mark-out tools often tells part of the story for a bank that is trying to work out how profitable its trades are. Funding, balance sheet and credit costs have become a big factor in recent years, resulting in a more complex pricing methodology. For example, some dealers offer better pricing for clients that voluntarily collateralise their trades.

Still, dealers expect mark-out analysis to become a key tool when making decisions about individual client relationships. It could also play a wider role in helping dealers run the business in a competitive – but profitable – fashion as spreads compress. Whether it changes anything depends on how willing clients are to adjust their behaviours. 

Editing by Duncan Wood