e-Forex Magazine | Foreword | Evolution and diversification in FX over the past 3 years
Foreword : Evolution and diversification in FX over the past 3 years
First Published in e-Forex Magazine April 2007
Godfried De Vidts,
Godfried De Vidts, President, ACIGodfried De Vidts looks back over the last 3 years since he took up the chair of the ACI.
A truly global market
Open 24 hours a day, seven days a week, turnover in this fascinating market has rocketed in recent years. The latest triennial survey by the Bank for International Settlements in April 2004 estimated daily volumes on the FX market were $1,900bn (£968bn, ?1,437bn) and analysts expect that figure to have reached $3,000bn by the time the BIS releases its survey in April.
Research from TowerGroup predicts that by 2007, global FX daily average volumes will exceed US$3 trillion, with more than 44% of this volume executed electronically. This represents a significant increase from US$1.77 trillion in 2004.
Yet the global picture is shifting. According to the Federal Reserve Bank of New York's Foreign Exchange Committee , average daily volume in over-the-counter FX instruments in October 2006 totaled $534 billion, 7.5% down on April 2006.
It has also been quite a first quarter in 2007. The last week of February saw the FX markets going into overdrive as equity markets wobbled in Asia, leading both Europe and the US to sneeze - and the FX market surged.
Reported volumes were the highest on record, particularly on 1 March which goes down as the volume record in market history, with much of the activity was carried out in yen and Swiss franc currency pairs.
Increasing diversity and liquidity
While electronic FX trading is still dominated by the large dealing banks, the market has also absorbed hundreds of new participants from both emerging and developed markets and non-banks all seeing great opportunity in FX.
This is, broadly speaking, excellent news for liquidity, as the more volume and diversity of participants, the more trading opportunities for all, as organisations can get the price in the currency pair at the time they need to play. It is clear that global foreign exchange remains the world's most liquid and widely traded financial market. If there has been a single trend over the past three years, it has been one of evolution and diversification. Many more counterparties have joined the core and downstream markets, using both the traditional interbank markets and the downstream retail offerings.
In part it has been the increasing participation by hedge funds treating foreign exchange as an asset class in its own right which have contributed to driving this explosion in volumes. But often overlooked is the growth in overall counterparty numbers from across so-called 'emerging markets'. Banks and non-banks which may have previously not had access to the market have been enabled by technology and are adding unique liquidity and diversity to the benefit of all.
The prime brokerage evolution
Much of the surge in interest in foreign exchange trading has in part been facilitated by the rise of FX prime brokerage, which allows clients to source liquidity from a variety of executing dealers while maintaining a credit relationship with a single entity: the prime broker.
This has allowed hedge funds, despite their own limited credit history or high risk profile, to use the prime broker's higher credit rating to gain access to new counterparties. The system is also popular since, with typically low head counts, hedge funds prefer to outsource or centralise as much trade processing as possible. In 1997, fewer than ten organisations in the global marketplace used a foreign exchange prime broker, and the market was dominated by four banks, according to a report from the New York Fed.
Now analysts estimate that over 600 clients use prime brokers and at least 20 banks offer the service as a core foreign exchange product. This growth has been driven in part by funds that have formed prime brokerage relationships with the prime banks that use prime brokerage, largely through new counterparties bringing unique additional liquidity.
There will be continued growth of both banks and funds trading FX through prime brokerage relationships. The FX market appears to have adopted prime brokerage as a successful way to generate additional liquidity and bring new and diverse participants to the market as it preserves the role of banks as natural clearers.
Yet hedge funds are not the only prime brokerage clients. Commodity trading advisers, small banks, asset managers and pension funds use the service. Five years ago, less than 1 per cent of daily dealer-to- client volume was FX prime brokerage, a figure that has risen to 25 per cent according to Traiana, the prime brokerage software provider.
Prime brokers typically charge clients a fee on a volume basis for trades conducted so this growth has produced a welcome income for banks that offer prime brokerage services.
And according to the New York Fed, prime brokerage provides efficiency of scale with respect to transaction processing and technology investment, allowing banks to leverage their technology and operating infrastructure.
It says that as foreign exchange execution continues to migrate to electronic platforms, prime brokerage presents an opportunity to build a fee business into an institution's electronic foreign exchange platform to extract investment costs.
Improved technology has had significant impact on the ability of prime brokers to detect early warnings of problems within client portfolios. The technology is there for real-time risk assessment, but it remains up to the investors in hedge funds to ensure that managers have good risk controls.
The growth of black box trading Automated FX trading is opening up the field to a wide variety of market participants, reflected in growing FX market volumes, particularly from non-traditional players Trading FX used to be a game stacked heavily in favour of the high rollers of the major FX banks. Volume was everything, meaning not only high revenues and customer poll leadership, but also pricing power when trading with the lesser mortals of the market.
The well known FX players continue to gain customer support thanks to their extensive reach and the quality of their services. Yet in some respects it is in fast growing arena of automated FX trading that the playing field finally levels out for all market participants irrespective of size or type.
Automated trading - whereby financial instrument prices are requested and trades executed by computer - is in one form or another as old as computers themselves. However, it has only been since the automation of markets themselves that genuine automated trading has been possible.
Automated trading began to make its presence felt in stock markets and then derivatives exchanges as increasing numbers of banks, hedge funds and trading arcades traded on a high frequency basis first the stand-alone instruments, and then cash instruments versus derivatives as well.
Such automation functionalities were not initially available in the FX market but that has since changed with the introduction of API-based trading by EBS.
A level playing field
Of course the attraction for many in getting involved is that once they are up and running, there is little in market terms to differentiate between automated trading operations, irrespective of the status or size of the firm.
At the same time as bigger does not have to mean better, it does not have to mean smarter either. Irrespective of who you are, the principles for automated trading remain the same. Many participants design a model, test it using historical data and if it works, switch it on and watch with interest. This is reflected in increasing FX market volumes, particularly from non-traditional market players. The hedge fund community is obviously very active now, but certainly the big growth sector in FX is retail.
This is good because the market is getting bigger in terms of more participants and this also gives the opportunity to sell more products. However, the electronic FX business is becoming more and more sophisticated, and questions have been raised about the profitability of that business.
,br>Algorithmic trading in various forms has become more common, particularly among the hedge funds. They are becoming more sophisticated clients to the banks and not always profitable to deal with. But, on the other hand, if a bank is deriving prime brokerage fees from such clients, it can still be worthwhile.
Much of the democratisation of automated FX trading can be attributed to the increasing sophistication and openness of the available technology. Historically, many of the trading and development platforms offered to smaller professional and retail FX participants used proprietary scripting languages that were somewhat limited in terms of flexibility and power. That is changing in two respects. Automated trading looks certain to become an integral part of the FX markets for the future and will undoubtedly change the dynamic of the market.
A safety net for the prime banks
Some members have reported that their back offices are finding it hard to maintain the increasing volume of tickets which need processing, due in part to the pace of the growth in the market, which has outstripped even the most bullish estimates, but also the sheer volume of tickets and reduced size of tickets from black box traders.
In short, more traders are trading smaller ticket sizes, but in greater numbers - and it's not just the algorithmic traders. In fact the volume of tickets processed is rising faster than the total notional dollar amounts traded, and it is this which is putting bank back offices under pressure and adversely affecting their margins, because of the high costs associated with ticket processing. It is no secret that a well managed back office can itself contribute to cost reductions. However, it is no longer a question of simply passing through ticket volumes. They also have to be handled efficiently.
If any major ticket netting solution is to work in this space, the providers need a number of variables to be in place, including the right access to global counterparties across both developed and emerging markets and appropriate distribution channels to reach them.
The lack of an effective ticket netting solution in spot FX has long been a bug bear to the industry. Then there is the small point that it all has to be underpinned by sound technology. The Holy Grail for any bank investing in technology is for a service which is as close to 'plug and play' as possible which meets the needs of their front, middle and back offices.
This call has been answered by Traiana and EBS with the NetLink offering for prime broking banks which nets prime bank to customer business at set times during the day.
I also read with interest recently that the CLS board is also reviewing the possibility of launching a netting service as they adapt to the changing landscape, a welcome response to market need.
An exchange model for FX?
Adding to the excitement is the emergence of a new potential player in the market, FXMarketSpace from the CME and Reuters stable with a fresh look at the exchange traded model for FX.It would certainly seem that the market has in part found its own synthetic exchange in the clearing and settlement solution handled by prime brokerage and CLS - it works and barriers to entry are coming down report many participants.
My view is that choice has to be a good thing for the market and there is a question over whether the use of a single counterparty for clearing, the CME's engine, as opposed to the prime broking banks, may restrict that choice, as indeed could the location of their matching engine in Chicago, benefiting those who are physically closer to it.
Liquidity has traditionally been very difficult to move and there is no doubt the FXMarketSpace team face a challenge. Many customer sign up to monitor progress on new platforms - whether they actually use them is another matter. Either way, many will watch with interest to see how the new offering develops.
The ACI now and in the future
Our work at the ACI over the past three years has focused on market developments and the need for the organization to adjust to a vigorous, ever-changing market environment.
Only the fittest can survive and as the Council will elect a new president for the coming 3 years, the foundations of ACI are now ready for a renewed growth, to achieve its mission statement to be a leading global association of wholesale financial market professionals contributing to the market development through education, market practices, technical advice and networking events.
The market is changing rapidly and automating all the time and it is imperative that the ACI focus on meeting those challenges by being fast and efficient itself to solidify the organisation's rightful leadership role in global FX.
