The Foreign Exchange Joint Standing Committee (FX JSC) was established in 1973, under the auspices of the Bank of England, as a forum for banks and brokers to discuss broad market issues. The membership of the Committee includes senior staff from many of the major banks operating in the foreign exchange market in London and representatives from brokers, corporate users of the foreign exchange market and the Financial Services Authority. Given the importance of developments in e-commerce for the structure of the foreign exchange market, the FX JSC decided to set up a subgroup of experts from this field to advise it. This is the third of a series of annual reports produced by this subgroup.

Developments In Electronic Platforms

At the time of our report last year, the market's attention was clearly on multi-bank portals following the closure of Atriax. Multi-bank portals were able to offer STP and were advancing in providing new functionality for customers. Proprietary bank systems were being used to support pricing into the multi-bank portals but were not seen as competitive in their targeted market sector.

In 2003, proprietary bank systems have been back in focus again. Banks are focusing upon targeting flows through prime brokerage, white labeling and liquidity-exchange models, and proprietary systems are central to these models. Banks that have aggressively marketed their proprietary platforms reported to the subgroup that they saw much higher volumes across these platforms, than through their participation in the multi-bank portals. A common trend for all banks is that e-commerce volumes are growing.

Proprietary systems can also offer more tailored and integrated services. Many foreign exchange trades are a bi-product of another transaction such as a payment to a foreign supplier or foreign currency security purchase. If a foreign exchange trade can be integrated into this process then the convenience factor can play in favour of the proprietary bank system.

Multi-bank portals

The market leaders are still FXall, Currenex and FXConnect. FXall and Currenex have tended to attract corporate customers whereas FXConnect has tended to attract fund manager clients. However, all are looking to expand their customer base into other sectors, increasing competition between the portals.

The daily volumes through these portals are estimated to have risen rapidly from $7bn per day in May 2002 to $14bn per day by October 2002 according to one survey1 and anecdotal evidence suggests that volumes have continued to grow into 2003. However in the same survey it is estimated that trading over multi-bank portals only accounts for 7% of the wholesale foreign exchange market.2 As a comparison, the April 2001 BIS Triennial foreign exchange survey3 estimated total daily average foreign exchange turnover at almost $1.2 trillion. The subgroup believes there is evidence that banks may be more willing to provide liquidity through a variety of multi-bank portals than a year ago.

FXall reported that its average daily trading volumes were $7.5bn in April 2003.
FXConnect reported that it averaged $10bn per day in April 20035
Currenex do not release trading figures, although third party estimates suggest the average daily trading volume is between $4.5bn and $6.5bn.

There are geographical differences in foreign exchange e-trading take-up. In Europe and the Americas, 35% of larger organisations (defined as those that trade more than $2.5 billion in a year) trade foreign exchange electronically, while only 25% of such organisations in Japan do.

The multi-bank portals are seen by some as pricing and connectivity utilities with the banks picking up the vast majority of the transaction costs, as well as a significant proportion of the initial investment capital. All platforms face the challenge of making the pricing model more equitable to both parties and may seek to achieve this through product innovation and the addition of value added services.

A new development is end-user to end-user matching systems, such as Hotspot FXi. These enable customers to post bids and offers anonymously, as well as to hit market prices. Banks provide liquidity by making prices but are unable to take prices. This model is primarily attractive to hedge funds and professional foreign exchange trading entities. As yet no one is offering a full market based model where customers can post bids and offers and banks can trade both customer and bank prices. The subgroup thinks it is inevitable that this type of model will evolve.

The multi-bank portals have strong brand names and may expand into other Treasury related businesses. The subgroup believes that it is likely that there will be further consolidation or withdrawal from the multi-bank portal business at some point, and that further consolidation is unlikely to cause any disruption in the markets. In fact it would strengthen the position of the remaining portals given that uncertainty still exists in the market, particularly following the closure of Atriax.

Prime Brokerage

This is an arrangement under which a client's (often an institutional fund or a hedge fund) foreign exchange deals are cleared through a single counterparty (the prime broker). The prime broker is usually a large, highly rated money centre' institution which allows the fund to initiate trades, subject to credit limits and collateralisation, with a group of pre-determined third party banks in the prime broker's name, not in the client's name. These third party banks are skewed towards those of a higher credit quality but are limited in number. An attraction for the prime broker is that the business provides a stream of fee income in return for use of its balance sheet and credit assessment facilities, which it may view largely as fixed costs. The third party may also welcome the prime brokerage arrangement because it enables them in effect to accept the fund's business without having to incur credit risk to it only to the prime broker. Prime brokerage also allows for a reduction of operational risk for the client because all its positions are with the prime broker.

The leveraged fund community makes widespread use of prime brokerage accounts, but there are a few examples of other institutions such as corporates and small banks doing so too. At present, prime brokerage accounts are much more common in the US than in Europe, but some market participants report that they expect the practice to grow in Europe if the number of leveraged funds based there continues to increase.

Provision of liquidity and provision of credit are becoming two distinct services within the foreign exchange market. Competition has already put significant downward pressure on the fees charged for foreign exchange prime brokerage and as this trend continues banks may feel pressured to increase their exposure to more risky names, particularly in the hedge fund sector. Customers often have multiple prime brokers and it is becoming more difficult for a bank to monitor a customer's overall exposure. Banks are mitigating these risks to some extent through margin accounts and improved technology. This enables them to manage cross-product risk, cross-product netting and margins more effectively.

White-Labeling and Outsourcing

White labeling is the outsourcing of liquidity provision by a bank to a third party through an e-commerce platform. The customer deals with their relationship bank (hereafter referred to as the white label' bank) via an e-commerce system and a back-to-back deal is automatically generated between the white label bank and the third party bank (the liquidity provider') to pass the foreign exchange risk to the latter.

For the liquidity provider, the attractions of white labeling are the ability to attract greater