After a tumultuous start, eFX is finally hitting its stride. Both the major multi-dealer portals as well as several independent platforms have all recently reported a significant rise in transaction volumes. As success is never without controversy, some market participants are now questioning the impact of electronic trading on market liquidity and volatility. Truth be told, the uptake of electronic trading has not had a material impact on FX market liquidity to date. It is, however, drastically altering the market landscape and affecting both buy and sell side market participants in a variety of ways.

To begin, it is important to make the distinction between dealer-to-dealer and client- to-dealer electronic trading. While current estimates figure electronic trading on EBS and Reuters 3000 to account for more than 60% of all interbank volume, only 15-20% of customer-to-dealer transactions are currently transacted online. Notwithstanding the current usage, lets consider the impact of eFX on each group.

Instant Liquidity

For end users, the benefits of electronic trading are numerous: greater efficiency, reduced costs and, of course, improved price discovery and transparency. With the proliferation of eFX platforms over the past few years, end users have their choice of liquidity sources, including multi-bank and single dealer platforms from both banks and well-established independent firms.

Moreover, the availability of real time streaming prices on many platforms provides end users with instant liquidity.

Recent reports put the average trade size conducted via one of the largest multi-dealer platform at roughly $3.5 million. While this might seem low to some observers, the average trade size on EBS is just $2.5 million. So while its probable that many end users are reluctant to transact large deals (>$25mio) electronically, a more likely scenario is that end users find the instant liquidity an especially appealing aspect of eFX platforms, and the ease of trading online facilitates more deals, albeit smaller ones.

Assuming the largest buy side clients (with the most aggressive liquidity requirements) gravitate to the multi-dealer platforms, its safe to assume there is more than enough liquidity on electronic platforms to meet the needs of the vast majority of end users.

Information Advantage

For the banks, with the benefits of eFX come a host of challenges. Banks long dominated the FX market by restricting access to price and other market information. Today, customers can easily gain access to multiple real-time price sources via electronic platforms, contracting bid/offer spreads and thus profits for many FX banks.

The prospect of lower revenues, coupled with banking consolidation, has left fewer banks willing to assume the risks associated with FX market making. As a result, the lions share of FX liquidity is now in the hands of a few large, global banks. The BIS reports that in 2001, 75% of FX transactions in the United Kingdom were conducted by 17 banks compared to 24 banks in 1998; in the United States just 13 banks captured 75% of the turnover, down from 20 banks in 1998. Worldwide, its estimated that only 20 banks now quote two-way prices on a wide range of currency pairs.

This loss of the information advantage is felt most acutely by local and regional banks. In the past, these banks were able to profit from the decentralized market structure and the lack of price discovery by acting as an intermediary between their clients and the interbank market. A local bank would get a customer order and offset the trade with a regional bank, who would then turn it over to a market maker. In this common scenario, one economic transaction would hit the market several times as it changed hands, propping up volumes and creating the illusion of deeper liquidity.

Liquidity Shift

The rise of electronic trading further shifts the balance of power away from small- to mid-sized banks by enabling end users to trade directly with a market maker. Firms like Cognotec and white labeling services accelerate this trend by enabling banks to completely outsource their FX business, route customer trades directly to a market maker and, at the same time, more efficiently service their customers.

Competition also plays a hand here; most banks now realize they must offer their customers electronic trading capabilities and purchasing or leasing off the shelf technology is the fastest means to that end.

So while electronic trading has, to a large degree, shifted liquidity into the hands of fewer market makers and almost completely disintermediated the local and regional banks -- the overall impact to FX liquidity is diminished because electronic trading has made it possible for new liquidity sources to enter the market. Independent firms like GAIN Capital and others have captured a significant percentage of the market share once owned by these mid-tier banks.

Willing to take a much higher degree of risk relative to their balance sheets, these firms provide liquidity to smaller buy side clients, as well as to a new class of market participant, the retail day trader. In fact, volumes reported by the largest and most established of these firms rival, if not exceed, that of many small- to mid-sized banks.

And what about volatility? FX volatility over the past several years has declined. At press time, EUR/USD traded in a five big figure range for the six past months. Why? The introduction of the Euro caused a systemic change in the FX market, one that could very well dampen volatility long term. In addition, volatility always trades in ranges and right now we are in the midst of a low point. However, because volatility is mean reverting, it will eventually snap back to its historic mean (minus any long term impact from the Euro).

Liquidity will suffer further when volatility returns to the market. Larger intraday moves create additional risk, which will cause further attrition from the ranks of FX market makers. Within the next few years, its likely that less than a dozen true FX market makers will remain.

eFX Fuels Risk Issue So while liquidity has indeed decreased over the past few years, the uptake of eFX is not the main culprit. Rather, the root causes are 1) a decrease in the number of banks due to consolidation, and 2) fewer banks willing to take risk as an FX market maker.

However, eFX is exacerbating the latter issue. As the volume of trades conducted online increases, FX volumes will further contract as a result of disintermediation, and margins will contract due to increased transparency, both of which will further reduce FX market liquidity.