Internalisation by Electronic FX Spot Dealers

Quantitative Finance (2017)

Posted: 28 Nov 2017 Last revised: 23 Sep 2018

See all articles by Maximilian Butz

Maximilian Butz

Deutsche Bank AG (London)

Roel C. A. Oomen

Deutsche Bank AG (London); London School of Economics & Political Science (LSE) - Department of Statistics

Date Written: November 1, 2017

Abstract

Dealers in over-the-counter financial markets provide liquidity to customers on a principal basis and manage the risk position that arises out of this activity in one of two ways. They may internalise a customer's trade by warehousing the risk in anticipation of future offsetting flow, or they can externalise the trade by hedging it out in the open market. It is often argued that internalisation underlies much of the liquidity provision in the currency markets, particularly in the electronic spot segment, and that it can deliver significant benefits in terms of depth and consistency of liquidity, reduced spreads, and a diminished market footprint. However, for many market participants the internalisation process can be somewhat opaque, data on it is scarcely available, and even the largest and most sophisticated customers in the market often do not appreciate or measure the impact that internalisation has on their execution costs and liquidity access. This paper formulates a simple model of internalisation and uses queuing theory to provide important insights into its mechanics and properties. We derive closed form expressions for the internalisation horizon and demonstrate - using data from the Bank of International Settlement's triennial FX survey - that a representative tier 1 dealer takes on average several minutes to complete the internalisation of a customer's trade in the most liquid currencies, increasing to tens of minutes for emerging markets. Next, we analyse the costs of internalisation and show that they are lower for dealers that are willing to hold more risk and for those that face more price sensitive traders. The key message is that a customer's transaction costs and liquidity access are determined both by their own trading decisions as well as the dealer's risk management approach. A customer should not only identify the externalisers but also distinguish between passive and aggressive internalisers, and select those that provide liquidity compatible with their execution objectives.

Suggested Citation

Butz, Maximilian and Oomen, Roel C.A., Internalisation by Electronic FX Spot Dealers (November 1, 2017). Quantitative Finance (2017). Available at SSRN: https://ssrn.com/abstract=3076575 or http://dx.doi.org/10.2139/ssrn.3076575

Maximilian Butz

Deutsche Bank AG (London) ( email )

Winchester House
1 Great Winchester Street
London, EC2N 2DB
United Kingdom

Roel C.A. Oomen (Contact Author)

Deutsche Bank AG (London) ( email )

Winchester House
1 Great Winchester Street
London, EC2N 2DB
United Kingdom

London School of Economics & Political Science (LSE) - Department of Statistics ( email )

Houghton Street
London, England WC2A 2AE
United Kingdom

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