Richard, it’s been said that one of the objectives of your business career has been to transform finance into a ‘high tech’ industry and make it into a true engineering science. How successful do think you’ve been with that?
On the one hand it has been a big success and on the other hand, very disappointing. My wildest dreams have been surpassed on the intellectual and research side. We have made fascinating discoveries beyond my imagination. But it is difficult to transform these rewarding insights into real products that change how the financial system functions.
There is resistance within the industry to accept innovation, even when it can make a substantial contribution to stabilise the financial system and address the real causes of the ongoing crisis. I find this incredibly frustrating. Yet the game is not over and the situation could change at any time. At last, a few people are realizing that the remedies proposed thus far to resolve the current crisis will fail and that there is need for a new approach. This is where we come in, so I am hopeful our efforts will help bring about a positive change.
Why did you decide to set up the Olsen group of companies and what services do they offer?
High frequency finance (HFF) is a dynamic theory that explains economics and, in practical application, can be used in financial market analysis and to construct financial products. It is a new technology in the same way biotechnology or computer sciences are new—they all bring innovative approaches to existing problems. As a theory, HFF is comparable to relativity or quantum theory in physics—both are distinct from classical physics just as HFF is distinct from classical economics. HFF analyzes tick-by-tick price data in search of the footprints of the buy and sale flows that explain the price action. This technology can be used for market making, to manage assets, to create new option products, to stabilise financial markets—the technology has myriad applications and may be deployed in many different contexts.
To facilitate the development of new HFF products I have established separate companies that pursue different business opportunities, in the hope that they are more adaptable and nimble than a general-purpose company:
Olsen Financial Technology (OFT) collects high frequency data, which is a pre-condition for applying the methodology of high frequency finance. The most exciting product of OFT is an outsourcing service. For a fixed subscription price, banks, hedge funds, or university research institutes, for example, can access a huge repository of tick data without having to worry about daily maintenance and filtering.
OANDA provides a wealth of information services related to currencies and is a foreign exchange market maker. The spread that OANDA offers its trading clients is unsurpassed and is a big draw for traders—both retail and institutional—who are in search of the most cost-efficient and reliable platform to trade.
Olsen Ltd. is an asset manager for both institutional and retail customers. It offers an online facility to open managed accounts, and a dynamic hedging service that generates incremental ‘alpha’ and efficiently reduces foreign currency risk. There is also a suite of information services, in particular a scale of ‘market quakes’ equivalent to a Richter scale for foreign exchange markets. Olsen Ltd.’s asset management services are non-correlated with the strategies of other managers, so the investor has a high diversification effect and a good return profile compared to the available risk budget.
You are also Chairman of OANDA, which uses innovative computer and financial technology to provide online FX trading and currency information services. What types of client have traditionally been attracted to the firm and how have you been extending your customer base?
Traditionally, OANDA was purely a retail platform. Yet it was our intention from the beginning to transform the company into a market maker that serves all participants in the foreign exchange market, be they private individuals, companies, or mid- to low-tier banks. We introduced our fxTrade trading platform in 2001 and over the years, most of our customers have discovered us through word of mouth. We did not engage in traditional marketing and sales practices until last year because a principle we firmly believe is that success only happens when your products are so good, they become viral. So our efforts are devoted to making the products truly exceptional—building on the strong foundation we have established as we actively market OANDA moving forward.
A few years ago you famously co-published The Forex Trader’s Bill of Rights, which talks about traders having access to a free, open, and stable forex market operating with technological efficiency. Do you still subscribe to all of the concepts of that paradigm and if so, how close are we to achieving it?
To be perfectly frank, I am even more determined to make these ideas a reality today. The economic crisis is proof of what can happen when the foundation of the economic system is not rock solid. For example, in The Forex Trader’s Bill of Rights we mention the need for paying interest by the second. If the world’s financial industry regulators would realise that second-by-second interest rate payments are essential for market stability, we would be a lot closer to truly beneficial reform of the financial system.
In what ways do you believe the technology provided by platforms like OANDA’s fxTrade helps to ensure liquidity within the FX market?
For markets to be liquid, market makers need to provide consistent pricing. OANDA’s pricing engine is robust and consistent and has the best prices in the industry, which makes a significant contribution to overall market liquidity.
Our ability to provide 24/7 pricing—including weekends—further contributes to liquidity, not just during regular business hours, but also on holidays. We need ongoing pricing just as we need basic utility services, such as electricity and water supply, which are supplied around the clock, In addition to offering prices on a 24/7 basis, we create a level playing field for traders by offering the same price to all customers regardless of transaction size.
From what we can tell, this single price makes it possible for our platform to net—or match—more buyers and sellers than other FX brokers. Essentially it means we make better use of liquidity and thus contribute to a more efficient use of liquidity on a global scale.
Today, the erratic nature of liquidity in the FX markets is in a large part caused by the absence of intra-day interest rate payments. If intra-day interest rates can oscillate, then ultra-short-term interest rate movements can contribute to balancing supply and demand, thus reducing price volatility of exchange rates. OANDA has the technology to introduce second-by-second interest rate payments on a broad scale. Going forward, we intend to play a bigger role in improving FX market liquidity by promoting our concept of second by second interest rate payments.
Many trading firms still face difficulties in securing clean and filtered high-frequency data for their trading models. Do you think this will remain a problem and therefore a potential bottleneck to the continued growth in algorithmic and high frequency FX trading?
Data quality has actually improved, because trading is computer driven and thus fully electronic. Yet the data includes spurious effects due to operational issues that are not linked to trading; these distort the underlying price series. For example, prices in the foreign exchange markets come to a virtual standstill at 5 p.m. EST for approximately 15 minutes, to allow the large investment banks to execute daily batch jobs and sync their computer programs. Such distortions must be filtered out to cleanse the data so it is of an appropriate quality to be used with increasingly sophisticated algorithms. So yes, the problem of securing clean and filtered high frequency data will persist and will remain an ongoing concern. This is why I believe that hedge funds and other businesses that use using high frequency data should outsource this activity to a specialized provider.
You have been working for many years to demonstrate persistent predictability in financial markets. Do you believe that this theory holds true in FX, which has such a huge number of market participants each seeking to achieve their own different risk management or investment objectives?
Though many people find it hard to believe, it is true that liquid markets demonstrate persistent predictability. In a liquid market such as FX, every instrument—for example, EURUSD—shares the following property: the sum of all price movements, i.e. summing up all the price movements up and down during the course of a year, is an astounding 1600%. This 1600% is 53 times larger than the total price risk of roughly 30% of the maximal change in price level from 1st January and 31st December. During the course of one year, there are lots of price overshoots, when the price has moved too fast up or down. At U.S. Non-Farm Payrolls, for example, it is a frequent occurrence that the price moves 0.5% in only one minute. If the price movement would continue at the same rate, then the total price movement during the course of an hour could be approximately 30%. Clearly this is not sustainable. The predictive technology can identify overshoots, when the price movement is too fast, and take advantage of these opportunities.
Economic models deal with time series, so the meaning of time is of key importance. We do not rely so much on physical time, but on a more general concept called ‘intrinsic time’. Intrinsic time resembles a point and figure chart, where a new time interval starts whenever a directional change of price of a minimal size occurs. Using the concept of intrinsic time, we have discovered 12 new scaling laws—essentially we have made a quantum leap in how we formulate our predictive models. These scaling laws identify typical statistical properties of the foreign exchange market or for that matter, any liquid market. One of these scaling laws states that if the price has moved down by 1% from its last high, the price move will on average continue by another 1% before it reverts. The same is true for other thresholds, so if the price has moved down by 0.5%, it will continue to move down by another 0.5%. The importance of these scaling laws cannot be exaggerated. They provide a dynamic frame of reference—the necessary foundation for building powerful predictive models.
FX now stands at a regulatory crossroads with the industry facing a critical time as it comes under the spotlight of lawmakers. What are your views about increased regulation in Retail FX and do you believe the bespoke nature of FX products, many of which cannot be standardised, are really suitable for a central clearing model?
The retail market will continue to undergo regulatory scrutiny—a necessary thing considering the excesses committed by some FX dealers in the past. But let us hope this drive to protect investors does not descend into over zealousness that hampers the markets or traders’ freedom of choice.
The broader question is how will the over-the-counter foreign exchange market respond to the challenge that trades should be routed through an exchange and cleared by a central counter party? If the regulators go ahead with the current proposals it will reduce liquidity in the foreign exchange markets—not a good prospect.
There is a better way one can reduce counter party and systemic risk. The foreign exchange market needs to adopt the principle of instantaneous settlement with second-by-second interest rate payments. With instantaneous settlement, the over-the-counter market could route its trades through a centralized exchange that would serve as a pipe to process the transactions. The market makers with their instantaneous delivery service do the heavy lifting of making a market. The exchange would be a pure conduit for settlement and would provide every player fair access to the market. The outcome could be an exchange that combines the advantages of an exchange with an over-the-counter market—an ideal world for both market makers and currency traders. We need to get the regulators to understand that instantaneous settlement with second-by-second interest rate payments is the essential innovation necessary to transform safety in financial markets and make them more efficient.
Last year we launched Currency Investor magazine which focuses on FX as an asset class. For those investors seeking currency returns from a managed account program, what advice would you give with respect to their due diligence process?
Due diligence means you have done the research necessary to fully understand the ‘unique selling proposition’ of the manager. Does the manager add an expertise that is not replicated by another manager in my portfolio? An investor must understand what the manager does and how this activity complements his portfolio structure. FX is a great investment space because investments can be made with partially funded accounts. If you take the cost of capital into account, FX is one of the best asset classes; even more so, because FX exposure exists literally in every investment portfolio. If you invest with an investment manager, who successfully deploys a counter-trend strategy, it is possible to generate added alpha, while at the same time reducing risk.
For over ten years e-Forex has been focusing on the extraordinary impact technology continues to have on the development of FX trading. In your opinion who has benefited the most from this revolution, the buy or sell-side?
I think it is fair to say that both the buy and sell side have made gains from the growth of the FX industry yet clearly, the buy side has benefited more because before technology made it possible to trade currencies online, the FX market simply was not open to the average investor. Before the advent of the online retail broker, FX was a “closed” market open to only a select few large, multi-national banking firms.
The fees these firms charged made it economically untenable for a small investor to deal in currencies. It is not only the retail investor, who has benefited from this development, but every buy side firm. Spreads have come down for all the participants, so this is definitely a benefit for everyone.
The sell-side has also profited from this development. Profit margins with the big banks are way up in foreign exchange. So the trend towards electronic Forex has been positive for everyone. There is, however, the exception of the mid-sized banks, who in the past successfully competed in the Forex markets, but have lost their competitive edge, because they were not able to make the necessary technology investment.
Are we now trapped in a technology arms race where, ultimately, only a few large global sell-side firms will emerge with the necessary investment resources required to deliver a full spectrum of online FX services to maintain their competitive advantages?
Financial market players have always used technology to outwit competitors—indeed the same could be said for any industry. It is simply human nature to use all the tools at your disposal to succeed in achieving your goals. So we have computerized algorithmic trading today, but it is no more revolutionary than tickertape and telephones were in the late 1800s, when this earliest form of electronic trading replaced the “pad shovers” who ran prices from the trading floor to broker offices.
That being said, I believe there is a problem when those in the industry concentrate development efforts on creating advantages for themselves, rather than committing to an efficient market. My colleague Michael Stumm, who is CEO of OANDA, touched on this topic in an op-ed he wrote last year for the DealBook section of the New York Times, entitled “Market Gamers or Market Makers?”
To the surprise of many, during and since the financial crisis, trading volumes in FX have held up reasonably well. Over the next few years are you confident we will see significant growth within FX and if so, what factors will influence this?
My belief is that FX will continue to grow. There are a number of factors contributing to its growth. FX will gain greater acceptance as an alternative asset class and will grow in favour with investors—partly due to the inherent benefits of FX trading, but also because the poor performance of established asset classes will convince investors who would otherwise ignore FX to take a closer look.
For example, most of the major economies are still in recovery mode following the recession, so interest rates remain at or near all-time lows. As a result, yields in fixed income instruments remain equally muted. And while the stock markets have undergone a rally in the past two quarters, the collapse of another sovereign country in Europe (or a similar event) could quickly cause these gains to evaporate.
Over the longer term, I believe there will be further consolidation within the FX industry that will result in fewer, but stronger, FX brokers. Competition will drive trading costs even lower and should see the advent of even more innovative trading solutions, which in turn will attract more investors to FX.
The FX market will accelerate rapidly in a global economy growing at breakneck speed. China is a prime example of this rapid growth. Yet the Chinese yuan is hardly traded in the FX market. This will eventually change and will lead to massive growth in emerging market currencies. Furthermore, there will be more and more investment strategies designed to profit from the large number of price overshoots which generate alpha by contributing to market stability. In a complex system, such as the human body, ‘turnover’ as measured by the amount of blood circulation in relation to the body’s weight. Within fourteen minutes the heart pumps 70 litres of blood; by the same measure the global spot FX volume should be 4,000 trillion USD. So we have a long way to go.
Oanda is well known for being a pioneer and has launched numerous FX related trade, technology, investment and information resources. Over the next few years where will you be looking to maintain that track record and deliver more innovative products and services for the benefit of all FX market participants?
OANDA has created a solid foundation for its product. The objective is now to broaden the product range and to lower spreads even more, but also create auxiliary services that make OANDA unique. Why not introduce trading in the intra-day yield curve, i.e. trade a 10 minute and a 1 hour interest rate, just as we can today trade a 1 week interest rate? Stay tuned for news from OANDA.