Diversifying Liquidity

Q2 2016 Diversifying Liquidity Attaining Best Execution in FX Trading

CONTENTS 2 Executive Summary 4 The Changing Face of Liquidity 5 Use of Non-bank Liquidity Providers on the Rise 6 Gaining Access 7 Expanding the List of LPs 8 Science Trumping Art to Ensure Best Execution 9 Algo Demand vs. Algo Usage 10 TCA Has Room To Grow 11 Educated Consumers are Good Customers Kevin McPartland is the Head of Research for Market Structure and Technology at Greenwich Associates. FOR LIQUIDITY PROVIDERS, THE MORE TRANSPARENCY INVESTORS HAVE INTO THE QUALITY OF THEIR EXECUTIONS, THE BETTER Executive Summary 20 % OF FX TRADING VOLUME BY INVESTORS USING NON-BANK LPs WAS EXECUTED VIA THIS CHANNEL The electronic trading revolution hit the foreign-exchange market years ago, but the macroeconomic and regulatory-driven events of the past few years are spurring a new wave of change. Investors are increasingly focused on best execution, utilizing sophisticated analytics to direct counterparty selection and to ensure their clients are trading as efficiently as possible. At the same time, the dealers are adapting to the impact of new rules that change the economics of FX liquidity provision and finding themselves increasingly competing for flow with non-bank, high-tech liquidity providers. While the result is a more complex market in the short term, the long-term result is a more liquid, transparent and efficient market for all. METHODOLOGY Between September and November of 2015, Greenwich Associates conducted in-person interviews with 1,633 top-tier users of foreign exchange at large corporations and financial institutions in North America, Latin America, Europe, Asia, Australia, and Japan. RESEARCH PARTICIPANTS BY TYPE VOLUME WEIGHTED TRADING VOLUME BY INSTITUTION TYPE 8% 1% 2% 2% 2% 6% Government agencies 15% 11% Government agencies Insurance companies Corporates (including TC and FC) Hedge funds/ctas Fund managers/pension funds Banks Other financials (including retail aggregators) 19% 27% 28% 17% 21% 42% Insurance companies Other financials (including retail aggregators) Hedge funds/ctas Banks Fund managers/pension funds Corporates (including TC and FC) 2 GREENWICH ASSOCIATES

The global FX market is the most electronic institutional market in the world. Nearly 75% of investors trade over three-quarters of their volume on the screen, all without a single regulatory mandate. Investor behavior in this segment is purely demand-driven, with the efficiencies provided by point-and-click and automated trading keeping the phones of investors on the hook the vast majority of the time. BUY-SIDE ELECTRONIC TRADING OF GLOBAL FX 74% 75% 76% 71% 74% 73% 71% 61% 62% 62% 67% 55% 57% 53% 56% 57% 61% Proportion trading online 43% Proportion of total volume traded online 2007 2008 2009 2010 2011 2012 2013 2014 2015 Note: In 2012 and 2013 online volumes include short-dated swaps/rollovers. Based on 1,780 responses in 2007, 1,440 in 2008, 1,497 in 2009, 1,563 in 2010, 1,632 in 2011, 1,763 in 2012, 1,584 in 2013, 1,612 in 2014, and 1,633 in 2015. Source: Greenwich Associates 2015 Global Foreign Exchange Services Study This rosy view of technology adoption only tells part of the story, however. The FX market has seen its share of disruptions in the past year, with macroeconomic events and the price-fixing scandal putting strain on the underlying market structure. FX dealers have been forced to rethink the sales role in an effort to alleviate any perception of inappropriate information sharing. The appropriateness of the WMR Fix as a benchmark is continuously questioned and the extreme volatility catalyzed by the Swiss National Bank s removal of the currency cap left market participants unsure if their executed trades were priced properly. These and other changes have left investors scrambling to update their trading and investment approach. A renewed focus on execution quality has driven adoption of transaction cost analysis (TCA) in the FX markets. And with this deeper insight into the cost of trading, investors are also beginning to explore their counterparty options. In response, non-bank liquidity providers are stepping up their game, with the potential to upend the market. 3 GREENWICH ASSOCIATES

The Changing Face of Liquidity The largest FX dealers in the world continue to handle nearly half of global FX trading, and Greenwich Associates firmly believes that the world s largest money center banks will continue to play a huge role in facilitating the buy side s FX needs. However, the last two years have seen the top five dealers lose share. Collectively, they now control 48% of the market, matching the level seen just before the financial crisis. The top four FX dealers who have long dominated the space continue to cede share to dealers 5 8, a trend discussed in our 2015 report, Top FX Dealers Still Dominate but Cede Market Share to the Middle. A deep investment in technology by those middle dealers coupled with a business right-sizing by the top four have created a less concentrated top 10. Interestingly, despite this spreading out of flow across a longer list of bulge-bracket banks, investors continue to send nearly 70% of their trading through their top three counterparties. CONCENTRATION OF BUSINESS Third dealer 14% 34% Lead dealer Top 3 Allocation 69% Second dealer 21% Average number of dealers 8.1 31% Other dealers Note: Based on 1,633 responses from global top-tier users of foreign exchange. Source: Greenwich Associates 2015 Global Treasury Services Study These two data points tell us that while the buy side continues to keep flow concentrated to ensure they receive the non-execution-related services they need (e.g., research, capital commitment), they re slowly reshuffling which dealers make the top three. Furthermore, a heavier weighting of execution quality to the detriment of those non-executionrelated services is likely also having an impact. 4 GREENWICH ASSOCIATES

Use of Non-bank Liquidity Providers on the Rise Missed in these market share numbers is the impact of non-bank liquidity on client FX trading. FX markets are perfectly suited for non-bank liquidity providers, particularly principal trading firms; they are standard, liquid, electronic, and boast daily turnover in the trillions. Of the more than 1,600 global investors interviewed for this study, 5% have access to non-bank liquidity providers, up slightly from 4% last year. More intriguing is the 20% of volume that was executed by these investors via non-bank liquidity providers in 2015, up from 16% the year before. USE OF NON-BANK LIQUIDITY PROVIDERS Global FX investors Proportion of total volume traded with non-bank liquidity providers 16% Traded with non-bank LPs 20% Do not trade with non-bank liquidity providers 95% 5% Trade with non-bank liquidity providers 84% Traded with banks 80% 2014 2015 Note: Based on 1,682 responses from global top-tier users of foreign exchange in 2014 and 1,633 in 2015. Source: Greenwich Associates 2015 Global Treasury Services Study It is also important to note here that these numbers do not reflect trading done with non-bank liquidity on an anonymous basis, where most of the principal trading firms do the bulk of their business, as investors cannot know their counterparties in these venues. As such, while the numbers reported to us tell an interesting story of growth, we suspect true growth of this segment is in fact bigger. The more active the investor, the more likely they are to have access to non-bank liquidity. Thirteen percent of firms that trade overall $50 billion in FX annually trade with this segment, compared to 2 3 % of those trading less. These higher volume investors tend to trade in a more diverse set of currency pairs. As such, they often look to a longer list of liquidity providers, using those best suited for each given trade based on TCA and other related metrics (e.g., price improvement, market impact). 5 GREENWICH ASSOCIATES

Hedge funds are also heavier users of non-bank liquidity than traditional asset managers, trading 20% of their collective volume with these counterparties vs. only 2% for the asset managers. Their generally more quantitative approach to trading and investing coupled with a smaller need for the added services of the major dealers contributes to their higher volumes. We also see strong use of non-bank liquidity providers by retail aggregators. The 50% that have access execute one-quarter of their FX trading volume away from the major banks. On a regional basis, North American investors do the most trading with non-bank providers, with the U.K. coming in a close second. The gap here isn t large, however, leading us to conclude that the trends are generally global in nature with only small differences between regional markets. Gaining Access Most if not all of these behavior shifts have been made possible via the proliferation of innovative trading venues. The FX market is global by definition, and enables market participants from every corner of the world to interact seamlessly via the screen. Since 2008, flow handled by MDPs has jumped 32%, while phone-traded volume is down 50%. This electronic trading story isn t a new one, as evidenced by its growth over the past decade. The more recent proliferation of multi-dealer platforms (MDP) in lieu of point-and-click single-dealer platforms and the phone reflects the direction of FX market structure going forward. In 2008 as the financial crisis was starting to take hold, multi-dealer platforms handled only slightly more volume than the phone. Since then, flow handled by MDPs has jumped 32%, while phone-traded volume is down 50%. PROPORTION OF FX TRADING VOLUME, BY CHANNEL 38% 40% 43% 43% 45% 45% 49% 50% Multi-dealer platforms 34% 30% 28% 27% 22% 20% 15% 15% 15% 15% 13% 14% 8% 8% 10% 10% 10% 12% 10% 9% 7% 5% 4% 5% 18% 13% 10% 10% 17% 12% 12% 9% On the phone Single-dealer platforms Other Messaging systems on Bloomberg and Reuters 2008 2009 2010 2011 2012 2013 2014 2015 Note: Based on 814 in 2008, 906 in 2009, 963 in 2010, 1,013 in 2011, 1,094 in 2012, 1,127 in 2013, 1,211 in 2014, and 1,172 in 2015. Source: Greenwich Associates 2015 Global Foreign Exchange Research Study 6 GREENWICH ASSOCIATES

MULTI-DEALER PLATFORM INVESTOR USAGE GLOBAL FX 44% 29% Penetration Share 25% 25% 12% 4% 11% 10% 9% 9% 1% 7% 6% 5% 2% 7% 5% 5% 4% 4% FXall 360T Currenex Bloomberg FXGO Note: Based on responses from 1,597 global foreign exchange users. Source: Greenwich Associates 2015 Global Foreign Exchange Study FX Connect FXSpotStream Other Hotspot FX EBS Direct Thomson Reuters Dealing Large asset managers and corporate treasurers traditionally have looked to RFQ platforms such as Thompson Reuters FXall, Bloomberg s FXGO or Deutche Boerse s 360T to execute their large spot trades. Increasingly, however, trading via platforms that aggregate direct streams from liquidity providers (LPs), such as EBS Direct and Portware, and within anonymous, no last-look pools (e.g., Bats Hotspot) is increasing. This is especially true among more sophisticated and quantitative investment funds. Expanding the List of LPs These venues provide the liquidity taker with access to a broader range of LPs, many of which are not active in the RFQ or phone-based markets. Trading via direct stream allows the counterparties to keep their bilateral relationships intact, while still benefiting from a more always-on style of trading. The buy side gains access to non-bank liquidity providers via both of these methods. Anonymous order-book style trading is as close as the FX market gets to cash-equity style trading. While last look appears to be winding down its useful life, these pools can act as both a benchmark pricing source as well as a destination for trading with limited market impact. The direct stream and anonymous order book worlds overlap as well, with direct stream aggregators such as Portware allowing dealer streams and anonymous venue streams to be viewed and acted upon as if they were one continuous market. 7 GREENWICH ASSOCIATES

It is important to remember that non-bank market participants need access to credit to trade in the FX market. Prime brokers provide this for hedge funds, and more recently for some asset managers as well. Prime brokers give asset managers the ability to trade on anonymous platforms. Without this, trading was always done on a bilateral basis with a bank counterparty. FX TRADE ROUTES: ACCESSING CREDIT CREDIT INTERMEDIATION IN FX EXPLAINED Credit intermediation is not done on a centrally cleared basis like in equities, but rather cleared at each individual bank. Market makers Primary trading firm Credit intermediation Bank 1 Prime brokerage Direct credit Market takers Pension fund With few exceptions, all institutional FX market makers and market takers require intermediation services from creditissuing banks. Bank 2 ECN 1 Non-bank Bank 2 Prime brokerage Direct credit Bank 3 Prime brokerage Direct credit Bank 4 Prime brokerage Direct credit Hedge fund Bank 3 ECN 2 Historically, banks issued credit and then offered only principal liquidity for FX exposure. FX Prime Brokerage (PB) was introduced as a way for a bank to allow clients to trade with non-principal liquidity. Credit carve-outs allow Direct Credit clients the ability to trade with market makers that are PB clients of a bank. Bank 5 Bank 5 Prime brokerage Direct credit Corporate Non-bank LPs also utilize credit lines provided by the major banks. For instance, when an asset manager trades with a non-bank LP via a direct stream, they receive the price offered by that LP, but ultimately face the bank backing that LP. This severely limits counterparty concerns when trading with smaller counterparties, with the bank acting as an intermediary taking on much of the counterparty risk. Science Trumping Art to Ensure Best Execution Despite an increase in anonymous e-trading and non-bank liquidity, relationships still matter a great deal. In fact nearly two-thirds of client trading is allocated to dealers based on the service level they provide a statistic that has remained constant in our research since before 8 GREENWICH ASSOCIATES

the financial crisis in 2008. However, as best execution is increasingly scrutinized via more intelligent TCA and the buy side is more empowered to self-execute, the dynamic is starting to change. FX VOLUME ALLOCATION FACTORS Average FX volume allocated to dealer as a result of: FX service: value provided by dealers M&A/Corporate financing transactions 3% 3% 4% 6% 2% 2% 5 5 8 Breadth of FX product offerings Financing assistance** Prime brokerage relationships 16% 9 10 Online offering*** Back office/operations Fixed-income or equities trading relationships 17 Relationship management Custodial relationships Research Cash management and trade finance* 64% Day-to-day sales coverage Lending Relationships 45 Execution/Pricing FX Service Average Value Point allocation Total points = 100 Note: Based on responses from 1,682 global top-tier users of foreign exchange in 2014 and 1,633 in 2015. *Asked as treasury management in 2014. **Investing in your fund or deal, providing access to the bank s distribution network and capital introductions. ***Includes online research, execution and STP. Source: Greenwich Associates 2015 Global Treasury Services Study It is important to remember that the best price is not always the best execution. Market impact, execution latency, fill ratio, and the ability of the LP to execute inside the spread are all important factors to examine post-trade in an effort to make the right choices pre-trade. These factors and more are increasingly made available to investors by trading venues, liquidity aggregators and, most importantly, the liquidity providers themselves. The next step is for the buy side to proactively compare and contrast, incorporating the results of that ongoing analysis into the execution process. Algo Demand vs. Algo Usage The buy side is tackling this issue via execution tools and by pre- and post-trade analytics. Our research has found a slow but steady increase in execution algorithm usage on the buy side, with algos now handling one-third of their volume, up from just over a quarter last year. Hedge funds clearly pump the most flow through algos, but the asset management community is stepping up its usage at an impressive pace as well. 9 GREENWICH ASSOCIATES

The data also points to a desire to do more. For the last several years, 5 10% of non-algo-using investors tell us they plan to begin using them in the coming year. Actual results show that growth isn t quite that robust, signaling interest is dampened by difficulties changing the status quo. USE OF ALGORITHMIC MODEL TRADING Volume-weighted proportion executed using algo tools 2014 2015 61% 16% 21% 33% 27% 33% Fund managers/pension funds Hedge funds/ctas Total institutions Note: Based on responses from 1,660 foreign exchange users trading online in 2014 and 1,597 in 2015. Source: Greenwich Associates 2015 Global Foreign Exchange Study TCA Has Room to Grow When the only way to get a trade done was to call a pre-approved list of counterparties, finding and comparing liquidity was easy. But now, despite the positive impact the market structure changes will ultimately have, finding and comparing liquidity is as complex as the market itself. Buy-side TCA adoption is growing slowly, with 17% of global FX investors now utilizing it as a part of their investing process. High-volume funds, hedge funds and those based in the U.K. are using it even more. But conversations with market participants and providers tell us the technology still has a long way to go. Nearly every U.S. equity investor uses some form of TCA today. But even in that market arguably the most transparent in the world investors complain that TCA lacks standards. As a result, they must often use reports provided by their brokers, third-party platforms and those created in-house to triangulate the right answer. Even U.S. equity investors complain that TCA lacks standards. FX does not have the luxury of a consolidated tape, let alone a closing price based on actual trading data. This leaves TCA providers working hard to gather as much data as the market centers and market participants will provide, hoping that partial picture of the world can provide insight into the quality of a single trade executing at a certain point in time. Even currently accepted benchmarks are in question, with the WMR Fix under a microscope following the fixing scandals still being examined by global regulators. 10 GREENWICH ASSOCIATES

Educated Consumers are Good Customers For liquidity providers, the more transparency investors have into the quality of their executions, the better. This assumes that liquidity providers believe that the liquidity they provide is, in fact, better than that of their peers. As we ve seen in other markets, the tight spreads that made principal trading firms famous often drive the traditional bank liquidity providers to step up their game, ultimately benefiting the consumer. Investors should work to gain access to multiple liquidity streams and ways of interacting with that liquidity. Traditional RFQ trading will continue to have its place, particularly for derivative and large trades executed by corporates and asset managers. Anonymous order-book markets can be easily aggregating with direct streams from LPs creating a virtual, custom order book the best of both worlds. From a counterparty perspective, maintaining deep relationships with a few bulge-bracket brokers is prudent, given the wide range of services they provide. But supplementing that with non-bank liquidity streams is now an important part of ensuring best execution is achieved. 11 GREENWICH ASSOCIATES

Cover Photo: istockphoto/earleliason istockphoto/kmlmtz66 The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. 2016 2015 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. greenwich.com ContactUs@greenwich.com Ph +1 203.625.5038 Doc ID 16-2029