Sang Lee Managing partner of the Aite Group
Sang Lee Managing partner of the Aite Group

Retail FX Market: Growth, Consolidation, and Evolution

With the passing of the Commodity Futures Modernization Act (CFMA) in December 2000, the Commodities and Futures Trade Commission (CFTC) became officially responsible for regulating the retail FX market, thereby legitimizing the existence of the burgeoning retail market. Today, the retail FX market is booming with strong adoption across all major financial centers.

First Published: e-Forex Magazine 38 / e-FX Industry Report / January, 2010

While the retail FX market is focused on providing products and services that target retail clients, the definition of what a retail client entails is not so straight forward. In fact, most retail FX firms would also include small hedge funds and CTAs among their clients. The typical profile of a true retail client could vary widely from those high-net-worth individuals with more than US$1 million in average account size to small-time retail clients with a mere US$250 in account size.

Due in part to broader acceptance by retail customers, the retail FX market has experienced phenomenal growth in the past few years. After a slow start in the mid- to late-1990s, retail customers have finally become more familiar with currency as a legitimate asset class, and not just as an inevitable by-product of a cross border transaction.

Of course, retail investor acceptance is just one reason behind the market’s staggering growth. Some of the other key factors behind include the following:

Acceptance as a legitimate asset class. FX has indeed become widely accepted as a legitimate asset class. The active trading market is not the only venue through which retail investors can participate in this growing marketplace. Similar to other asset classes, those with short-term speculative incentives can engage in active trading using many of the available global FX retail firms. However, there are signs that a growing number of options are becoming available for those investors with a more long-term perspective on FX as an asset class.

Global nature of a market that is open 24 hours per day. FX is a truly global market that is open 24 hours per day. This simple fact provides added convenience for those retail customers that may only have time during the evening hours to conduct most of their trading. Since the FX market is open at all hours, the down side of trading in after-hours such as drastically diminished liquidity, can be avoided.

Highly liquid and accessible market. Despite the fact that the FX market is largely unregulated and over-the-counter (OTC) in nature (at least in the cash FX market), it is incredibly liquid. Even in low, volatile market conditions, there is always someone on the other side that is constantly providing trading opportunities.

Ease of access to market. Even less than a decade ago, gaining access to the FX market was difficult, as a handful of global banks dominated every aspect of the market. However, the emergence of the Internet as the key connectivity infrastructure for retail trading combined with the development of sophisticated and reliable retail FX trading technologies have contributed greatly in nurturing the overall growth of the retail FX market.

Regulatory acceptance. In most countries, local securities regulators have jurisdiction over various types of retail FX trading. In the U.S. market, the passing of the Commodities Futures Modernization Act of 2000 (CFMA) provided legitimacy and support for “off-exchange” trading of FX products for retail customers.  In addition, the higher net adjusted capital requirements have eliminated weaker service providers and reinforced the competitive positions of those legitimate FX retail brokers.

Active market education. A lack of understanding was one of the major impediments in the retail FX market. Thanks to the accessibility supported by the Internet and the aggressive educational campaigns by leading retail FX firms, customer education has become widely spread and has lead to the development of a more sophisticated retail FX client base.

Migration of customers from other markets looking for higher returns. Similar to the institutional FX market, a significant percentage of active retail customers have migrated from other asset classes, looking for higher profit margins. Not surprisingly, the most common migration path has been from the equities and futures markets.

Availability of technology. Even with regulatory and market structure changes that are favorable to the development of the retail FX market, without the availability of reliable and cost-effective trading platforms, the current pace of growth in the retail FX market could not be sustainable.

Gradual customer on-boarding. Most (if not all) of the major retail FX firms provide a demo account funded with thousands of dollars of virtual money. These demo accounts provides live prices and all of the margin and collateral features to simulate a live trading environment. This is an extremely important step in account acquisition, especially when courting novice FX traders.

Key market trends

The growing legitimization of the retail FX market through various regulatory changes and availability of technology have certainly aided in the overall growth of the retail FX market. Over the last couple of years, a few key market trends have emerged to help define the further evolution of the market:

Adoption of automated trading systems. Similar to what has happened in the institutional market, sophisticated retail FX traders have turned to automated trading strategies to take the emotion out of their daily trading activities. Depending on what the trader wants to achieve and their tolerable risk levels, specific trading strategies can be automated to drive trading volume. The popularity of automated trading systems in the retail market has reached a point where even on eBay, one can find variety of automated trading systems ready for purchase. Aite Group estimates that automated trading systems account for approximately 35% of the overall retail FX market.

Figure 1: Projected Market Share of Automated Trading in Retail FX

Figure 1: Projected Market Share of Automated Trading in Retail FX

Market consolidation. Driven by stiffer competition and higher adjusted net capital requirements, the retail FX market has gone through massive consolidation over the last 12 months. With the net capital requirement moving from US$10 million in September 2008 to US$20 million by May 2009, smaller retail FX FCMs have either exited the market or have been consumed by the larger players. As of Q3 2009, U.S. retail FX had about 15 retail FX brokers − a drastic decline from over 30 at the end of 2007.

Growth in emerging markets. Going beyond the major financial centers for currency of United States, UK, Japan, Hong Kong, and Singapore, many retail FX firms are discovering new revenue opportunities in emerging markets, including China, Southeast Asia, Latin American and the Middle East. For certain retail FX brokers, while the total number of clients from traditional FX market centers still account for a significant portion of their client base, an increasing percentage of revenue is actually coming from clients based in emerging markets.

Market Sizing

In 2001, the estimated average daily trade volume in the retail FX market stood at US$10 billion, representing 0.8% of the overall FX market. By the end of 2006, the average daily trade volume reached over US$60 billion, representing over 2% of the entire market and signaling plenty of room for future growth. At the end of 2009, the retail FX market is expected to reach US$125 billion in average daily trade volume, representing over 3% of the global FX market. This is an impressive growth considering that the overall global FX market has declined in size from US$4.3 trillion in average daily trade volume in 2008 to US$3.7 trillion in average daily trade volume by Q3 2009.

Figure 2: Average Daily Trade Volume in FX (In US$ Billions)
Source: Bank for International Settlements, Bank of England Foreign Exchange Joint Standing Committee (JSC), New York Foreign Exchange Committee, Singapore Foreign Exchange Market Committee, Canadian Foreign Exchange Committee, Tokyo Foreign Exchange Joint Standing Committee, Aite Group estimates

Figure 2: Average Daily Trade Volume in FX (In US$ Billions)

Source: Bank for International Settlements, Bank of England Foreign Exchange Joint Standing Committee (JSC), New York Foreign Exchange Committee, Singapore Foreign Exchange Market Committee, Canadian Foreign Exchange Committee, Tokyo Foreign Exchange Joint Standing Committee, Aite Group estimates

 
Figure 3: Market Share of Retail FX
Source: Bank for International Settlements, Bank of England Foreign Exchange Joint Standing Committee (JSC), New York Foreign Exchange Committee, Singapore Foreign Exchange Market Committee, Canadian Foreign Exchange Committee, Tokyo Foreign Exchange Joint Standing Committee, Aite Group estimates

 

Figure 3: Market Share of Retail FX

Source: Bank for International Settlements, Bank of England Foreign Exchange Joint Standing Committee (JSC), New York Foreign Exchange Committee, Singapore Foreign Exchange Market Committee, Canadian Foreign Exchange Committee, Tokyo Foreign Exchange Joint Standing Committee, Aite Group estimates

Conclusion

The potential growth of the retail FX market appears limitless at this point, as potential key competition is still missing from the competitive landscape. One such group is the major dealing banks that have, to date, functioned simply as liquidity providers to the leading retail FX players. As evidenced by the direct entrance of Deutsche Bank and Citi into the retail market, Aite Group expects other dealing banks with significant retail businesses to seek new revenue sources from the retail FX market.

One glaring absence from the retail FX market has been the traditional online brokers in the United States, such as Charles Schwab, E*Trade, and others. In the past, the lack of regulatory guidance and reputational risk may have played a role in dissuading these firms from providing FX trading as part of their active trading platform. However, as they continue to focus on enhancing functionality within their active trader platforms, most of the traditional online brokerage firms will have no choice but to seriously consider the addition of FX into their overall asset class coverage or risk losing out on capturing this most liquid market to specialized retail FX brokers and large global banks.

Whether through the use of active trading firms profiled in this report or increasingly through other FX-related products, such as FX deposit products, FX funds, or FX ETFs, a growing number of retail clients are turning to FX as an asset class to diversify their portfolios and to achieve the higher returns that are unlikely to be gained from more traditional asset classes.