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Trading Viewpoints: A Little Skew Goes a Long Way

Our embedded traders work alongside portfolio managers and analysts to constantly assess market structures, liquidity and execution. These functions seek to help enable operational alpha by reducing risks, minimizing transaction costs and taking advantage of price differentials. To support our analysis, we gather and evaluate uniquely curated datasets. Below is the outcome of one such analysis:

The rise of electronic trading in liquid foreign exchange markets has brought significant benefits to asset managers, including enhanced price discovery, faster trading execution, and improved trade processing efficiency. However, one often overlooked advantage is the benefit of skewed prices offered by liquidity providers. We aimed to quantify the value of this skew and assess its impact on emerging market currencies. 

WHAT IS ‘SKEW’?

‘Skew’ is defined as the size of a liquidity provider’s price adjustment away from the previous midpoint, all else equal. In foreign exchange markets, liquidity providers uniquely adjust their prices to incentivize clients to trade in a direction that reduces the liquidity provider’s own risk positioning. For instance, if a liquidity provider is long EUR, they will likely adjust their euro offer closer to the previous midpoint to incentivize a buyer and reduce the provider’s overall risk exposure. At the same time, they might push their euro bid farther from the midpoint to discourage additional euro purchases that would increase their exposure. The result is a small range of prices that fluctuate independently based on each provider’s differing risk profiles rather than a single midpoint in which all bid/offer spreads are built around — constituting skew.

MEASURING SKEW

Isolating the effects of skew can be challenging as other factors may come into play when the dealer is building a quote, such as a client’s trading history and the probability of information leakage. One key consideration in analyzing skew is the method used to request foreign exchange liquidity data. There are two primary methods: request-for-quote and request-for-stream. While neither offers a perfect measure of skew, the request-for-stream method provides significantly better conditions to measure skew and generates a more comprehensive dataset.

In the request-for-quote method, the client requests a price from the dealer (or multiple dealers). This immediately signals to all involved dealers that the client is ready to trade, resulting in significant information leakage. Dealers may still use skew in this protocol to help determine their price, but they will likely also use other factors such as a client’s trading history and the probability of the information leakage moving the market against them, making it hard to isolate the effect of skew using this protocol.

In request-for-stream method, dealers provide a client with a continuous stream of executable quotes, with no advanced notice of when a client may trade or if a trade happened. As a result, clients can put dealers in competition without any information leakage or fear of trading history being used against the client. The result is an environment that can be easier to calculate skew.

DATA COLLECTION

Each day, our team continuously collects and stores over 300 million uniquely curated streaming executable prices across all currency pairs, tenors, and sizes from a geographically diverse network of major banks and non-bank providers. This extensive dataset can serve as a powerful tool for calculating the impact of skew.

METHODOLOGY

Using our dataset, we analyzed the impact of skew on a sample day for streaming quotes up to $1 million equivalents.

The analysis focused on the hours between 5 AM and 12 PM Eastern, the key overlap period between the London and New York markets. We examined both individual liquidity providers’ bid/offer spreads and the spread between the best available bid and offer among the ten liquidity providers in our curated pool. The difference between the best bid, the best offer, and the individual providers’ bid/offer spreads represents the measurable benefit of skew.

RESULTS

For developed market G10 currencies, such as the euro and Japanese yen, the effects of skew present interesting opportunities for analysis. As expected, each of the ten liquidity providers streams a normal bid/offer spread, effectively charging a markup from their perceived midpoint. However, the spread between the best bid and best offer across all liquidity providers is inverted, or negative. This inversion allows investors to buy and sell the same amount of euros or yen and potentially generate a profit. The inverted bid/offer is the aggregation of each liquidity provider’s skew. An inverted spread would otherwise be economically irrational!

IMPACT ON EMERGING MARKETS CURRENCY PAIRS

Unsurprisingly, the value of the skew is greater for currencies that have wider bid/offer spreads — specifically those in emerging markets — as that provides liquidity providers with greater flexibility to apply skew. As part of our analysis, we reviewed data for the Mexican peso and South African rand—two high-beta EM currency pairs. The skew results are similar to those for the euro and the yen, where the spread between the best bid and best offer is tighter than any individual liquidity provider’s bid/offer spread across both pairs. However, unlike G10 currencies, many emerging markets currencies do not have inverted prices because of their inherently wider spreads. Nonetheless, the advantage of skew is more meaningful in emerging markets. Our analysis reveals a skew range of 0.12bp to 2.8bp for the Mexican peso and 0.6bp to 4bp for the South African rand.

There is an even more compelling impact when shifting focus to lower beta currency pairs such as the Euro / Polish Zloty cross (EURPLN) and Euro / Hungarian forint (EURHUF) cross. On the day the data was collected, the bid/offer spreads for the Mexican peso (0.004%) and the South African rand (0.008%) were narrower than those for EURPLN (0.018%) and EURHUF (0.044%). As a result, the skew for the lower beta currency pairs was more meaningful than for the higher beta currency pairs; ranging from 0.4bp to 12bp for EURPLN and from 0.8bp to 9.3bp for EURHUF.

CONCLUSION

The price skew offered by liquidity providers is a key advantage of electronic trading, one that was unavailable during the era of primarily voice-based trading. Our findings indicate that the most significant advantages are observed in currencies with the widest bid/offer spreads, particularly in emerging markets. For instance, the benefits in currencies like EURPLN and EURHUF can reach as much as 9bp-12bp per trade.

 

 

Disclosure:

The information contained herein represents a simplified presentation of a complex process. Our investment process is subject to change and may differ materially from what is stated herein.