Could the expansion of EBS Prime unleash a new phase of e-Forex growth?

While EBS Prime is some way from establishing itself as a true buy-side system, the implications of its possible success cannot be overstated argues Peter D’Amario.

Electronic foreign exchange trading volume has doubled in each of the past two years, but new research from Greenwich Associates suggests that current growth rates could appear modest if the consortium of banks supporting the main interbank FX trading system holds together through its planned expansion into the wider market.

For the past several years, the FX market has been bifurcated between enthusiastic electronic traders and those that refrain from eFX completely. Most FX users that have not yet traded electronically tell Greenwich that they simply see no compelling reason to change the way they trade. However, the cost-benefit calculations of these FX holdouts could change radically if the EBS Prime trading system is able to overcome hurdles (such as the recent decision of Deutsche Bank to opt out of project) and successfully extend its service to the FX buyside.

In its current incarnation, many FX users see the benefits of e-trading as simply not worth the risk of losing direct contact with salespeople from whom they receive market color and other valuable information. In addition, some users do not feel that the benefits of e-trading outweigh the costs of getting started with the technology. But that analysis could change dramatically if suddenly users were granted access to an electronic system that provides enhanced liquidity, and tighter spreads.

Of course, there are no guarantees that EBS Prime will be able to deliver on these promised benefits — even if it can convince its bank supporters to remain committed to an expansion that might erode their own margins by making wholesale prices available to the general universe of FX traders. However, Greenwich Associates research suggests that the establishment of a centralized, market-wide trading system could overcome one of the main impediments to eFX growth: the lack of a universal STP solution.

Already, one-in-three eFX users cite STP as one of the key benefits of electronic trading, and nearly the same proportion point to the reduction in trade errors as an important eFX feature. However, electronic trading systems as presently constructed do not easily facilitate STP from the perspective of FX customers. Full back-office integration between a company and its FX bank still requires a significant investment of time and money, and once a company has made that commitment, it is in effect, married to that dealer or system unless it’s prepared to duplicate the process with additional banks or trading platforms.

It is in this respect that the expansion of EBS Prime, or the establishment of another centralized trading platform, holds the potential to unleash a new wave of eFX growth. If customers can achieve STP by integrating their systems with a single platform to which the supporting banks conform — and which incidentally offers better pricing and more liquidity — the benefits of electronic trading will eventually compel many of today’s eFX detractors to log on. It is this creation of a single common platform, eliminating the need to create multiple STP solutions for multiple platforms, that will reduce this particular barrier to entry.

eFX Growth
Even without such a central system, electronic foreign exchange is growing at a pace far exceeding that of global FX trading as a whole. Overall FX volume grew by about 25% from 2003 to 2004, with much of this growth attributable to cyclical market factors including U.S. dollar fluctuations, global political uncertainties and rising commodities prices. Growing corporate FX activity and the active trading of a new class of “professional” FX investors — including hedge funds and “customer” banks — are also serving to inflate foreign exchange trading volumes.

eFX growth rates in 2004 easily topped this market-wide expansion, with electronic volume more than doubling from $7 trillion in 2003 to almost $16 trillion in 2004 among foreign exchange customers interviewed by Greenwich Associates in late 2004 as part of the firm’s annual global FX research. In particular, sharp increases in bank e-trading volumes helped drive the growth: Globally, increased FX volume on the part of banks accounted for more than $6 trillion of the total increase.

Across the market, most of the increases in electronic trade volume in 2004 came from companies and institutions already trading electronically. Existing eFX users increased the proportion of their total trade volume executed electronically from 43% in 2003 to 48% in 2004. In the United States, eFX users now direct more than half of their total FX trade volume through electronic systems. Electronic traders in Europe executed just less than 50% of their volume online in 2004, and eFX users in the Asia/Pacific region directed 43% of their volume to electronic systems.

Global eFX volumes also benefited from the entry of new users over the past 12 months. The proportion of FX users executing some portion of their foreign exchange trades electronically increased from 39% in 2003 to 44% in 2004, with financial institutions leading the charge. Seventy percent of banks traded electronically in 2004, as compared with 62% the prior year, and the proportion of asset managers trading electronically increased from 37% to 42%. The proportion of hedge funds trading FX electronically increased from 36% in 2003 to almost 50% in 2004.

Despite the addition of these newcomers, a sizable portion of the FX market remains resistant to the allures of e-trading. While the proportion of FX trading institutions reporting to Greenwich that they have no intentions of trading electronically in the next 12 months fell slightly from 2003 to 2004, it still stands at 42% of the market. A full 48% of corporates, which in general have lower average trading volumes than other FX users, still say they have no plans to trade FX electronically.

The world’s largest FX users are also the most likely to trade electronically. Fifty-eight percent of FX users with foreign exchange trading volumes in excess of $10 billion traded electronically in 2004, as compared with less than 50% in 2003. At the same time, electronic trading usage among mid-size FX traders was stable about 35%, and usage among smaller companies and institutions increased from 21% in 2003 to 28% in 2004.

FX users in the United States and continental Europe lead the world in terms of eFX adoption, with 55% of all FX institutions in the United States trading online, and 52% of Continental institutions trading electronically. Forty seven percent of U.K. FX traders used eFX in 2004. At the other end of the adoption spectrum, only 21% of Canadian institutions traded electronically in 2004, as did only 27% of Japanese FX traders and one in three traders elsewhere in Asia.

Electronic Trading: Benefits and Needs
To date, electronic trading’s biggest draw has been its speed, efficiency and convenience, as opposed to better pricing. When asked by Greenwich Associates to name the benefits that they have realized from trading electronically, 65% of eFX users cite faster executions and almost 60% note convenience, efficiency and increased productivity. Companies and institutions with FX trading volumes under $1 billion seem especially interestedin the efficiency and productivity gains delivered by electronic trading, since professionals at smaller companies and institutions often have multiple responsibilities, as opposed to those at larger FX users, which generally have dedicated staffing.

Only 34% of electronic traders name tighter spreads as a central benefit of electronic trading — a finding that suggests significant opportunity for EBS Prime and its wholesale pricing. One possible explanation as to why spreads on electronic trades have not compressed further than they have is the continued popularity of single-bank trading systems, which lack the price discovery mechanism of many multi-bank platforms, and the notion that multiple multi-dealer sites tend to disperse liquidity across multiple platforms rather than collect it in one large pool. There is no consistent sign that multi-dealer platforms have stopped multiplying, with Reuters now attempting to move into the customer space.

In electronic FX, the proportion of traders using single-bank or proprietary systems actually increased from 45% in 2003 to 51% in 2004, and the proportion of eFX traders using both single-bank and multi-bank systems grew from 12% to 17%.

The single-bank systems continue to find success despite the fact that — due in large part to the deeper liquidity of the multi-bank platforms — multi-bank systems outscore proprietary platforms on customer satisfaction scores. This resilience on the part of proprietary systems can be attributed in some measure to customers’ desires to access FX research electronically and the continued importance of credit relationships in awarding FX business. However, FX customers also have needs — such as their need to trade through their own bank’s accounts as opposed to a clearing system — that are distinct from those in of traders in markets like fixed income, in which multi-bank platforms have achieved a near monopoly on electronic trading.

A Redefinition in e-Forex
In many respects, FX customers’ unique needs serve to explain why the eFX market has yet to witness long-predicted consolidation, and why, by contrast, the ranks of electronic trading service providers continue to expand. What we are now witnessing in the market can best be termed a redefinition, as opposed to consolidation, as new providers customize their business models to serve segmented markets such as hedge funds and retail customers.

It remains to be seen if the business models of the market’s niche providers — or even those of the larger, mainstream providers — will be strong enough to withstand the expansion of EBS Prime, assuming the company is able to convince its bank consortium to continue to provide liquidity to the system in return for what will amount to credit charges. Already some smaller competitors that targeted middle-market FX users have found that success in the niche market is largely dependent in finding a niche that produces sufficient trade volume to support their business. If the inter-bank system is able to execute its expansion plans, its extension into the customer side of the business will have profound implications for these service providers, and indeed for FX as a whole.

While EBS Prime is some way from establishing itself as a true buy-side system, the implications of its possible success in the venture cannot be overstated. Through its wholesale pricing and liquidity, the system could potentially attract enough users to position itself as a centralized platform for electronic foreign exchange trading. Centralization in turn could open the door to an STP solution that facilitates easier integration of company systems with those of multiple FX banks. If such an STP system were to emerge, Greenwich Associates would expect to see many FX users that currently do not trade electronically adopt eFX, setting the stage for explosive growth in electronic trading volumes, and possibly starting in motion the long-awaited bout of consolidation among eFX providers.

Greenwich Associates conducted in-person interviews with 1,436 users of foreign exchange services at large corporations and financial institutions on market trends and their relationships with their dealers. Interviews were conducted in North America, Europe, and Asia between September and December, 2004.