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.

First Published: e-Forex Magazine 28 / e-FX Industry Report / July, 2007

The FX market’s size is astounding and its growth has been remarkable. While it is often stated that it is the largest and the most liquid market in the world, one cannot truly appreciate its sheer size until it is compared with other more well-known asset classes. For example, in 2004 (the last time the Bank for International Settlements published their industry standard figures on the global FX market), the average daily trade volume in the highly liquid U.S. fixed-income market stood at US$821 billion and the average daily trade volume in the global equities market was US$167 billion. By comparison, the FX market reached US$1.88 trillion in average daily trade volume by end of 2004.

The FX market has come a long way since the days of telephones and telex. Certainly, the launch of RFQ-driven multi-bank platforms was a small step for the FX market, but a giant step for customers who, overnight, had electronic access to competitive prices from multiple banks. And innovations in streaming pricing and then the launch of FX ECNs have pushed the market into a brave new world of electronic trading. In this world, machines are gradually taking over mundane trading activities, and banks are afraid of being run out of town by their own clients. Low latency trading is becoming increasingly important to newer players, and the use of algorithms continues to grow. In other words, the FX market appears to be heading down the same path as the equities market. Among the obvious similarities are the degree of market fragmentation, a highly liquid and active trading environment, the adoption of algorithmic trading, and increasingly tightening spreads.

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%.

While some of the drop in bank participation can be directly attributed to rounds of consolidation that have occurred in the global banking market in the past decade, the loss of market share is even more likely due to the technological advances ushered in by the other players in the industry, including the asset managers, hedge funds, CTAs, and proprietary trading shops.  In fact, it may be said that perhaps more than in any other market, technology has played a crucial role in the evolution of the FX market.

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.

Another interesting phenomenon in capital markets is that some of the traditional long-only firms are moving into the hedge/alternative sphere. This convergence of long/traditional with hedge/alternative is going both ways. Several long-only houses have moved closer to hedge, and several hedge firms have begun to launch long-only funds. In addition to their strategies converging, their pricing structures have converged as well; a few long-only funds have begun offering performance-based fee structures. One could certainly argue that this trend was one of the key variables in State Street’s recent acquisition of Currenex, so that with the combination of State Street’s FX Connect and Currenex, the combined entity would be well positioned to handle these changes.

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.