lmaxpiece

By HAMISH RISK
Published: 09 November2012
PRINT I EMAIL I COMMENT I ORDER REPRINTS/PDFs
Tweet Share

Finding an edge in the crowded space of multi-dealer FX platforms is a difficult
proposition these days. So far in 2012, a dozen new platforms have entered the
market looking to cater to institutional clients. Not all of those will stand the test
of time.

However, one new trading venue, Betfair’s LMAX Exchange, has set itself apart with a
unique business model that could give it that needed edge combined with a well-
established pedigree for innovation and a canny ability for market positioning.

Betfair revolutionized the sports betting industry in the early 2000s. It took horse racing
from being a market dominated by on-course bookies — with their leather money satchels,
hung off metal sheets that registered the odds — and created an electronic exchange with
hundreds of thousands of members.

It was not long before in-race betting was introduced, and sports gambling came of age. It
then started to resemble a real market, with depth and liquidity.

Betfair then turned its attention to the retail foreign exchange
market, and created a new electronic exchange, called LMAX
Exchange, only to stumble at the early hurdles. What it quickly
realized about retail FX was that without a massive sales and
marketing network, it could not gain critical mass in trading
volumes to create a profitable business.

The firm needed to focus on its strengths. One of those was its
state-of-the-art trading technology, which at its core contained a
component called the disruptor. In its early days, LMAX
Exchange had harnessed open-source collaboration to
enhance the idea that lay behind disruptor.

Disruptor was a low-level component that increased the speed
and therefore the number of operations that the system could process per second. With
that, LMAX Exchange wanted to create considerably more capacity on the exchange,
which it hoped would enable it to accommodate a five-to-six-figure number of trading
accounts.

LMAX Exchange sought to redirect its business strategy, and it realized it could apply
such a high-performance piece of technology to the institutional end of the FX markets by
creating an order-driven exchange.

However, rather than give up on retail FX altogether, LMAX Exchange refocused its
attention on the retail aggregators, as well as targeting hedge funds, money managers
and other investors looking for quick order-driven execution, while also positioning itself as
the only FX exchange in the OTC markets, outside the interdealer space.

LMAX Exchange now operates an open order book, where orders are matched to
streamed limit orders, as is similar on exchanges such as the CME and the LSE.

To further set itself apart in the liquidity provider-to-buy-side market place, the exchange
did not offer last look to liquidity providers, unlike many of the ECN marketplaces.

David Mercer, the chief executive of LMAX Exchange, says this gives the business an
advantage over multi-dealer platform competitors, such as State Street’s Currenex and
Knight Capital Group’s Hotspot FX — although Hotspot FX does offer a no-last-look service
to clients on request — because it allows for consistency of trade execution.

“On LMAX Exchange, the price you see is the price you get.” says Mercer. “You don’t
sometimes get filled in three milliseconds and sometimes in 100 milliseconds. You
always get filled in three milliseconds.”

He also adds that because the order is resting in the exchange, if a customer matches
that order they are immediately filled, meaning there is no need for messages to go back
to the trade server to ask if the price quote is still good.

Mercer joined LMAX as CEO in April 2011, having held senior roles at IFX Markets and
Saxo Bank, in London, Geneva and Sydney.

No last look

While the no last look might be favoured by the buy-side clients, market makers are likely
to compensate for that loss of flexibility by streaming wider bid offer spreads to the
exchange.

Mercer concedes this could be true, but he maintains that LMAX
Exchange has enough liquidity providers — it has eight and it says it
will have 11 by the end of the year — so that the spread will be “as
tight as, or tighter than, every other venue that is price and not order
driven”.

Indeed, Mercer says, in October, LMAX Exchange quoted a choice
price on EURUSD for over 30 minutes a day.

For Mercer, the proof is in the pudding that the exchange model works.

“Yes they may have given away some control [with no last look], but every single bank,
every market maker makes more quotes, streams more orders today than they did six
months ago,” he says. "Nobody has left us and everyone streams more orders and
captures more flow.”

With no last look, the exchange is, in theory, open to predatory pricing behaviour too,
which LMAX Exchange says it seeks to eliminate by vetting clients and their trading
strategy before they join. To date, LMAX Exchange says it has had no complaints from
general members on the type of flow they see on the exchange.

JPMorgan, Goldman Sachs and Dutch proprietary trading firm Optiver are the three
publicly disclosed LMAX Exchange market makers. There are two more banks and three
proprietary trading firms. with another two banks and prop firm expected to join by year
end.

“LMAX Exchange brings a fresh perspective.” says Tim Carrington, global head of FX at
Royal Bank of Scotland. "With the Betfair background, and the flow that they will bring to
the table, it has the chance to differentiate itself from ECNs that have evolved from within
the FX industry.”

Target market

The flow that LMAX Exchange will bring to the table will depend on the success it has in
attracting the institutional marketplace to trade on the exchange. It is clear that, given the
speed of its operations, LMAX Exchange is well suited to systematic traders who connect
into their API, but Mercer says its core market is broker dealers.

He refers to what he calls second-tier, third-tier and fourth-tier brokers who have not got
their own relationship with a prime broker and therefore struggle to find liquidity directly
from banks. LMAX has stepped into this space, creating a clear difference with
conventional ECNs.

“LMAX Exchange is two-in-one — it is a deposit-taking institution and an exchange, which
is what makes them interesting to us.” says Paul Belogour, a director at Boston Merchant
Financial (BMFN), a Boston-based retail broker dealer.

For firms such as BMFN, which make markets for retail FX traders, the traditional ECN
model does not allow a client to on-board business in the same way.

Belogour adds: “The typical ECN will say, ‘Look you have to get a prime broker
relationship with somebody else, and then use our technology to deal with the prime
broker.’ LMAX Exchange does all this for you.”

Volumes have risen strongly this year, although that is from a low base. In fiscal year
2011, LMAX Exchange saw no volume.

Since then, at its height, the company has seen more than $3 billion in daily volumes and
now daily average volumes (ADV) typically idle around $2 billion, says Mercer.

“Our monthly compounded growth rate has been over 20% since the relaunch in
September 2011,” says Mercer. “What drives volumes is client funds because they trade
on margin. Our funds are the highest ever and they point toward ADVs of $4 billion to $5
billion per day within the next three to four months.”

Mercer adds that LMAX Exchange ADVs grew rapidly this year between January and May,
as the company added three of its 11 current market makers. This was followed by a flat
period between July and September, as volatility slipped out of the market across the
board.

The company is now looking for a strong period of trading activity on its platform through
to the end of November and a healthy first quarter 2013, says Mercer.

Quote fill ratios

There are relative pros and cons between the anonymous no-last-look exchange model
versus those platforms that operate via full name disclosure and last look for liquidity
providers.

The argument in favour of liquidity providers having last look is that it is easier for them to
identify the flow that is predatory from the flow that is not.

One head of e-commerce at a large global FX bank explains: "The reason why we can
provide great service to some customers is because we reject others who are trying to
pick us off, and last look is a great help in managing that process.”

This then should translate in much more efficient quote-fill ratios than can be achieved on
many of the multi-dealer platforms, where it is harder to monitor. For instance, the same
e-commerce head says that a bank might have a quote-fill ratio of 99% on its own
platform, whereas on some MDPs the ratio could be as low as 30%.

On EBS, the interdealer platform, whose trading model most closely resembles that of
LMAX Exchange, leading liquidity providers say their quote-fill ratio ranges between 70%
to 75%, where the platform requires a minimum quote life of 250 milliseconds.

LMAX Exchange says it does not impose any minimum-order quote life, since 95% of
orders submitted by the buy-side on the exchange are at market, so by definition the fill
ratio on those orders is 100%.

Optiver’s European managing director Hans Pieterse says the elimination of last look for
order trade posted to the platform is not disadvantageous for his company as a market
maker.

"With last look it means that one party has the upper hand in trading,” he says. "That is
not beneficial for the investor. If prices are posted and people want to take them in time,
then they should have the assurance that they are able to trade those prices.”

Ultimately, adds Pieterse, it will boost investor confidence in the LMAX Exchange platform
to know that the prices they see are the ones they can trade on.

Positioning for possible shifts in market structure

LMAX is the first Financial Services Authority-regulated multi-lateral trading facility (MTF)
for trading spot FX. Essentially, an MTF focuses on exchange execution, but not clearing.
Just as on an exchange orders are matched in price/time priority, but trading is still bi-
lateral, with FX trades cleared through prime brokers.

There is a possibility LMAX Exchanges market positioning might prove to be a canny
move for the company, if not prescient when one considers the gradual shift in market
structure that is occurring at a regulatory level.

According to some regulatory experts, the concept of last look could potentially be phased
out, as regulators seek to push more trading down the exchange and swap execution
facility (SEF) route, where the last-look principle is not seen as acceptable.

Some market participants, largely banks, are sceptical that such a move would be
beneficial for the FX markets. They will argue if there is no last look and therefore no
control over the client then, inevitably, spreads will on average probably widen.

"My feeling is that the regulators don't really care and they would rather go for clarity rather
than some benefiting [non-predatory] and some not benefiting [predatory],” says the head
of regulation at a leading global investment bank.

For LMAX Exchange, by showing the market that it can host a competitive open and
transparent marketplace, this regulatory shift could place it in an advantageous position.
What the key will be is its ability to police and vet the exchange participants. If it does that,
then it has a real future.

We would welcome any regulation change to create fairness in the marketplace for all
participants.” Mercer says. “We don’t feel there’s a need for this concept in an efficient
[FX] market — and it doesn’t exist in other major exchange-led asset class.”