Dramatic growth in both hedge funds and banks prime brokerage services show FX trading has finally come of age. Will the boom times continue? Richard House investigates.

The genie is out of the bottle as a wider community of investors actively trades foreign exchange as an asset class. A once-clear dividing line between the interbank market and non-banks has become so blurred it is today more practical to speak of a professional trading community. This community includes banks, their clients and infrastructure providers. For banks, there are numerous advantages to providing more direct market access to players beyond the interbank frontier. Yet to ensure orderly and diverse markets, both buyers and sellers must truly understand the wants and needs of these non-traditional players.

And as the market grows, relationships between banks and clients are evolving in important ways, signalling growth in such areas as advice and consulting. Banks have much to gain from these changes. Although FX is one of the world's largest markets, 70% of all trades are concentrated in a handful of major currencies. The market is based principally on over-the-counter deals between counterparties - not through an exchange with a central counterparty.

But a range of electronic platforms and portals are enabling clients to trade increasingly actively among themselves. Now, non-bank players want to enjoy the same advantages available to those in the interbank market, although they do not have banking licences. Offering the non-bank community the best of both worlds still requires a breakthrough dashboard product combining an electronic trading platform offering best prices with continued bank intermediation and support. Foreign exchange long seen as something of an infrastructure Cinderella serving risk reduction or the shifting of assets into bonds, equities, or global capital and trade flows - is coming into its own. Today its influence is pivotal for a much wider professional trading community including both real money funds and alternative investment funds.

Notable are the worlds 6,000 plus hedge funds whose FX trading activities are now believed to be driving daily traded volumes past the 1998 peak of US$1.5 trillion, up from the USD 1.2 trillion last recorded in 2001 by the Bank for International Settlements (BIS). No firm data is available till BIS reports again later this year, but evidence points to FX accounting for much more than the declared 5% of the roughly USD 1 trillion global hedge fund asset base. Three years ago, the BIS survey reported asset managers were responsible for 28% of FX market turnover a figure that has certainly risen since then. Spurred on by a two-year bear market in the dollar, a liberal regulatory regime, low interest rates, lacklustre performance in other asset classes and by dramatic growth in the credit and trading infrastructure available to fund managers -- the professional trading community has applied its skills to FX with generally sparkling results. Trading has also picked up as the consequence of the euro building a solid track record.

An increasingly crucial question in todays FX market is: Where is the herd?

The average currency fund produces a solid return, so institutional investors now understand and believe in this asset class, says Paul Skinner of UK fund manager Gartmore, assets in whose specialist currency fund grew by 89% last year. Across the board leveraged players including CTAs, managed futures funds, macro funds and those using model trading programs are all increasingly visible in currency trading. Whats notable, too is that currency trading has grown not simply on the back of macroeconomic factors, but also thanks to process and efficiency gains. Electronic dealing systems such as those offered by Reuters and EBS have driven much of the growth. So the traditional gatekeepers to market access the banks - have much to gain as the market grows and diversifies. In fact a bigger and more diverse market provides more for everyone. This paper will ask what is best for the orderly and efficient development of the FX market and how the wants and needs of this client base (the professional trading community) can best be supplied. We will examine the market from three perspectives: overall market dynamics; the professional trading communitys changing needs and wishes; and the benefits for banks of facilitating more direct market access for this community. The Marketplace The FX market has changed dramatically in the last decade. It is hard to overestimate the effect of real-time transparency on the market and the influence of direct access as a growth driver. Although the trading floors of a decade ago have been transformed, the modernisation process is not yet complete. Single or multi-bank portals offer buyers a price based upon the underlying rates available to interbank players, but with an added spread. So modern technology doesnt always offer the best market pricing. And though voice brokers may offer finer pricing, users dont get the cost control and efficiency benefits of automation and settlement. Bringing together automation benefits and the finest pricing is the next step.

On the sell-side the biggest development has been the growth of prime brokerage services where banks offer credit, trading tools, back office settlement and even investors inside a wrapper. In essence, banks have outsourced part of their proprietary trading risks to hedge funds (sometimes staffed by former employees) in exchange for a revenue stream. Banks are pouring into this area pursuing extra traffic volume and relationships for value-added sales.

Its a terrific time to set up a hedge fund in terms of what you get from the sell-side, says Justyn Trenner, CEO of UK research firm ClientKnowledge. He points out that more banks are getting into the business of supplying the needs of such funds than the market will likely sustain. Of course there will be a shakeout and some weaker traders will be driven from the market, he warns.

So, FX is an asset class on the move and so too is the money. There is a visible shift away from reliance on capital being the strategic asset, and towards intellectual capital as the new power. As a result, capital is following brainpower as it leaves larger institutions to set up hedge funds. In turn, these funds attract both capital and brains because of their freedom of action and much lighter regulatory burden. Banks complete the circle by offering credit to these players. By its very nature, FX has characteristics that are attractive to hedge funds. It is non-cyclical, highly liquid and it shows no strict correlation to other asset classes. Some economic players central banks are driven by factors other than profit maximisation. And the willingness of authorities to permit multi-year trends to build before moving to a firm policy response can create an ideal mix of volatility and trend. Prospects for revaluation of Chinas RMB and an eventual currency union in Asia create potential new scenarios around which to trade.

Because FX is such a liquid market with players from so many different arenas (corporates, governments, interbank, real money managers, etc), managers can enter and leave markets several times daily without unduly influencing prices. That at least has been the story so far although Michael Metcalfe, currency specialist at State Street Global Markets points out that diversity rather than size is the key to liquid markets. If too many players using the same risk model move together, the opposite applies. This is why information about positioning has lately become as valuable as on-market pricing data.

To make the best of these macro trends, market players need effect