The collapse of the Internet bubble highlighted the fact that more is required than just launching a product over the Internet to become successful. Products have to be reengineered to take advantage of the inherent functionality of the Internet to improve the price efficiency of the product offered to the customer. Today, there is a vast array of E-Forex products. By and large, these products have confined themselves to an electronic delivery of foreign exchange prices and are a revamped version of the original foreign exchange product. They fail to harness the power of the Internet.

The Internet has so much more to offer than mere electronic delivery of prices. The offering of financial products is embedded in a complex system of market conventions, which were developed at a time, when transactions were confirmed by courier services or later by telex (who remembers, how a telex machine looked). These conventions were perfectly adequate at the time. Today, they are outdated. We have to have the courage to change the market conventions to tap the potential of the Internet.

Instantaneous settlement

In foreign exchange trading, transactions are not settled instantaneously. They are traded with value dates, i.e. delivery is in two business days (as we all know the detailed conventions are much more complex, the rules differ between currencies and account for the different business holidays). In the computer age, the two days delivery convention adds complexity. It is far simpler for computers to exchange messages, settle the deal instantaneously and then do the next transaction. For example, OANDA FXTrade, a retail currency trading platform, settles trade at the very time, when the customer executes the trade. Customers trade spot-spot, i.e. at the very second they buy a currency, they sell the other currency. This system is far simpler than the traditional system, where the customer has to trade a particular forward date, swap his positions, etc. When trading spot-spot, the customer does not have to deal with the complexity of forwards. This is a particular advantage to the new comers to currency trading. They have never learnt the complex market conventions. The system of spot-spot trading makes currency trading easy and caters to the demands of the masses.

It will take a long-time until the market at large shifts to spot-spot currency trading. As experienced with the CLS initiative, which has taken 10 years to get off the ground, it is extremely hard to reengineer the financial market top down. The existing players have made huge investments in infrastructure and find it extremely costly to convert their foreign exchange settlement systems to instantaneous transactions. There is, however, no reason, why foreign exchange brokers, who trade directly with the sell side, should not introduce spot-spot trading with their customers.

Continuous interest rate payments

Interest rate payments in foreign exchange are made at 24 hours intervals. Whenever a customer opens and closes a position within the same day, he trades the same value date and does not have to pay or receive interest. This convention was developed at a time, when transactions were recorded manually. Today, when transactions are executed electronically, there is no reason, why interest rate payments should not be charged on a second by the second basis. This would have the advantage that customers could earn the intra-day carry. This may not seem a big deal in todays markets, where most of the interest rate differentials have narrowed substantially. This is, however, an advantage for anyone trading exotic currencies. He can thus earn the interest rate carry for keeping a position open for only a few minutes, one, two or three hours. As with electricity, which is charged by the meter, the electronic delivery of foreign exchange prices makes it possible to charge interest second by the second. Such a system is more equitable the customer does not receive a free intra day credit for shorting a weak currency, nor does he have to forgo the interest income for buying a weak currency intra-day. On OANDA FXTrade interest rate payments are made on a second by second basis. Customers buying the South African Rand for example, earn the interest rate carry for the time in seconds, minutes and hours that they have the position open. On the other hand, they have to pay interest, when shorting the Rand.

The regulators and central banks have a vested interest in moving away from the system of discrete interest rate payments. Especially during periods of exchange rate crisis, when central banks have to protect their currency by hiking interest rates, the system of daily interest rate payments has the effect that interest rate increases have to be far larger than in a system of continuous interest rate payments. Only 5 to 10 percent of the overall foreign exchange transaction volume are inter-day. Over 90 percent are intra-day. In a regime of daily interest rate payments, 90 percent of the transaction volume is not impacted by changes in the level of interest only the inter-day traders, who maintain their positions over night, are affected by any increases in interest rates. In a regime of continuous interest rates, everyone whatever the duration of his trade would be affected by the change of interest rate level. Any increases in interest rates would thus have a far more immediate market impact. Especially during periods of crisis, central banks could reverse the market trend with much more moderate interest rate hikes. In Turkey, interest rates had to be increased to 8000 percent to protect the currency leading to the collapse of 10 or more banks, 1 Millon unemployed, etc. In a regime of continuous interest rates, far more moderate interest rate increases would have been sufficient to protect the currency.

In a normal market environment it could take a long time for the system of continuous interest rate payments to become generally accepted market convention. The existing system infrastructure within banks cannot handle such a change easily. It might be possible that market participants will force about the change. It has been observed that customers use the OANDA FXTrade platform to conduct arbitrage with the existing market place. Some customers maintain two accounts, one account with a regular foreign exchange provider and another with OANDA. Whenever, the customer wants to go short a weak currency, he does so with the existing provider. Whenever he wants to buy a weak currency, he does so on the OANDA FXTrade platform thus doing interest rate arbitrage between the two interest rate payment systems

Advanced risk analysis, 24x7 support, improved trading system functionality

Customers have other demands as well that can be easily met with an Internet trading platform. Customers want to have tick by tick risk analysis for their positions based on continuous VAR. They want to be able to trade, not only during regular business hours, but literally round the clock, including Saturday and Sunday. Equally, electronic linking are taken for granted.

Conclusion

With the electronic delivery of prices, currency trading has entered a new phase of development. In the coming years, dramatic changes will take place. We definitely expect that the changes will include instantaneous settlement and continuous interest rate payments as well as other standard tools, such as continuous risk analysis, 24x7 trading and complete integrated electronic access.