Hedge Funds Face More Scrutiny as They Expand FX Market Making

  • KCG sees growth for nontraditional foreign-exchange players
  • Most firms already deal indirectly with nonbanks: Eaton Vance

Be careful what you wish for -- that’s the advice from State Street Corp. to the newest market makers in the $5.3-trillion-a-day foreign-exchange market.

As hedge funds and automated-trading firms ramp up their currencies businesses, they’ll probably attract more interest from regulators, said Chip Lowry, senior managing director at State Street Global Markets in Boston, in a conference call Tuesday hosted by Greenwich Associates. 

Algorithmic trading firm and brokerage KCG Holdings Inc. said it’s accustomed to dealing in highly regulated asset classes such as equities and favors a more comprehensive approach to foreign-exchange regulation to give investors better information about pricing, execution and order handling.

“As nonbank liquidity providers become a more important part of the market, they will undoubtedly draw attention of regulatory authorities,” said Lowry, who’s also the chairman of the Foreign Exchange Professionals Association, a Washington-based industry group. “This is going to be a bigger part of the market infrastructure going forward -- be careful what you wish for, because with that comes some interesting potential scrutiny.”

Hedge funds and automated trading firms are providing more liquidity in foreign-exchange markets as traditional dealer banks step back from market making in response to stricter regulation, according to a survey by Greenwich Associates, a financial-services consulting firm in Stamford, Connecticut, published in May. Citigroup Inc., JPMorgan Chase & Co. and UBS Group AG are the world’s biggest currency traders, according to Euromoney magazine.

“Firms like KCG do not hold retail or other client deposits -- firms like KCG are not too big to fail,” said Michael Cahill, head of relationship management for the company’s foreign-exchange market-making business. “We let our execution speak for itself, we know it has to. There are very few clients that will deal with me just because they like me.”

KCG had a record day after the U.K.’s Brexit decision, Cahill said, declining to specify on what basis. Citadel Securities LLC, the market-making arm of money manager and securities firm Citadel LLC, said its foreign-exchange volume on June 24 surged to more than four-and-a-half times the firm’s daily average this year.

Many investment firms are already interacting with nontraditional market makers, even if they don’t realize it, via algorithms or working orders through banks, said Michael O’Brien, director of global trading at Boston-based mutual-fund company Eaton Vance Corp. Still, most investors don’t trade directly with nonbanks because of credit arrangements, he said.

About 5 percent of global foreign-exchange market participants surveyed last year had access to nontraditional market makers, with whom they traded 20 percent of currency volumes, Greenwich said in the May report. That’s up from 4 percent of investors who transacted with nonbanks for 16 percent of volumes in 2014.

“Anyone trading foreign exchange on the buy side should be up to speed on these relatively recent developments, and the emergence of the nonbank liquidity providers,” O’Brien said.