
E-Market Dynamics: Changing the role of the FX Sell-Side
The global foreign exchange (FX) market has, in recent years, emerged as one of the most sought after markets on Wall Street. No longer just a by-product in cross-border transactions, FX has transformed itself into a legitimate asset class, which is increasingly leading to speculative activities from hedge funds and traditional asset managers, alike.


One major difference, of course, is the fact that the FX market is an OTC market that is dominated by dealers, whereas the equities market is exchange-driven. However, even in the equities market, dealers have tremendous market clout and, in recent months, have launched various non-displayed execution platforms in the hope of taking back some market share from the exchanges. Another difference is that the FX market is largely unregulated, whereas the equities market is arguably the most globally regulated asset class. Regulation in the equities market can be attributed to active retail participation, but in recent years, the retail FX market has also shown signs of robust growth. Future FX market structure
So the US$3 trillion question is what will the FX market structure look like in 10 years? Will bank’s dominance continue to erode, giving way to the other players in the industry; players that include traditional asset managers, hedge funds, CTAs, and proprietary trading shops? The obvious answer may seem to be yes, but the reality is that the large dealing banks will continue to dominate the global FX market.
Banks have long enjoyed the dominant position in the market, but with the FX market growth came an influx of technology to the marketplace. In 1995 banks accounted for 64% of all FX trading, but that figure has declined to 53% by 2004. In the same period, trading from non-bank financial institutions grew from 20% to 33%.

It is clear that the impressive growth in the active trader segment (i.e., hedge funds and CTAs) is driving a lot of trading volume in all asset classes across the globe and the FX market is certainly not an exception to this trend. The robust growth in spot trading, in particular, indirectly represents the growing market clout of hedge funds and CTAs in the FX market. The gradual and controlled openings of EBS and Reuters to this active trader segment are further signs that the future growth of the FX market will be influenced by the continued market penetration by this particular customer segment.
Growth of algorithmic trading
This group has also helped bring algorithmic trading into the FX market in recent years. With an estimated 7% adoption rate at the end of 2006, algorithmic trading is still clearly in its early stages in the FX market. However, this figure is expected to increase to approximately 25% by the end of 2010.

ECN’s & exchanges
Given all of the recent changes, it is clear that the FX market structure is evolving. But, how quickly is it evolving? While it appears that the dealing banks, despite stiffer competition and market uncertainty, are still in the driver’s seat, a potential threat to their dominance comes from two main sources: ECNs and exchanges.
The multi-bank ECNs, such as Hotspot and Currenex, threatened to bring down the wall between the buy-side and the sell-side by opening up their platforms to everyone in the market with equal access. While some of the smaller ECNs still do exist, they are more focused on the retail market, whereas Hotspot and Currenex have been acquired by Knight Capital and State Street, respectively. The innovative functionality that these ECNs have developed will be copied and launched by others (i.e., the recent launch of Accelor by FXall), but the niche focus of these ECNs will more than likely keep them from ever toppling the dealer supremacy.
With the launch of FXMarketSpace, an industry- first, OTC-centralized counterparty exchange model has now become a reality. Since it has only been a few weeks since the launch, its prospect for success remains to be seen. FXMarketSpace should certainly be attractive to the traditional Globex clients as well as those clients trading CME FX futures, especially those located in Chicago. The ultimate success of FXMarketSpace will depend on whether or not it can capture order flow beyond these client segments. In addition, given that a significant percentage of credit and settlement risk inherent in the FX market has been addressed by prime brokers and the CLS, it is not clear that the value proposition of CME-backed central counterparty platforms provide enough incentives for new users to rapidly adopt FXMarketSpace. Dominance of global dealing banks
The harsh reality for the rest of the market is that at least in the short- to medium-term, nothing drastic will happen in the global FX market structure to end the dominance that has been long enjoyed by a handful of global dealing banks. Despite constant external challenges and internal squabbles, large dealing banks still lead the global FX market. Their total numbers may have decreased over the last two decades, but their influence in the marketplace is still apparent. As they face direct competition from their customers, banks have found innovative ways to thrive in the ever-growing FX market. In the end, perhaps a new global ECN might emerge to centralize the FX market. There is no doubt, however, that behind that ECN will lie all of the major banks and their pricing engines.
So while dealing banks may continue to face new competition, they have enough ammunition to either fight back or simply adapt if they need to. They have enough capital to buy up new ECNs (or perhaps help start a new ECN for equity play) or any other type of competitors that might enter the marketplace. Instead of the death of bank dominance, the global FX market will continue to serve as the banks’ Neverland for years to come.