Evolution and diversification in FX over the past 3 years
Godfried De Vidts,Godfried De Vidts, President, ACI
Godfried De Vidts looks back over the last 3 years since he took up
the chair of the ACI.
It has been three
years since I took up the chair of the ACI, the leading global
association of wholesale financial market professionals and I would
like to thank our members for their support through a period of
significant change, growth and evolution in the global FX
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
Increasing diversity and
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
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
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
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
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
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
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
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
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.
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