â€¢ How sustainable is this growth?
â€¢ How does a sell-side convert this to net revenue, rather than being mown down in the stampede?
It is only by answering these two questions that we can consider what should be the priorities of the sell-side in relation to e-fx.
The semi-annual surveys undertaken by the Fed, the Bank of England and now other central banks suggest a growth of up to 100% in the last 12 months. However, allowing for the specific timing of their surveys and, we believe, a trending away from regional centres of forex to reporting out of major centres, it is safer to believe the market is up by around 70% and now materially exceeds $2.5 trillion daily.
From ClientKnowledgeâ€™s annual Forex Study (among 2,000 clients worldwide), we see non-bank financial institutional volumes up from an average of $17bn annually to around $38bn. However, it is important to note that much of that growth is driven by some 100 names at the more aggressive end of the market, both algorithmic traders and macro-directional funds taken more frequent more substantial bets in the search for alpha.
We believe that the market will continue to grow, underpinned by one core factor and facilitated by another.
The core factor driving the market is the growth in international trade. Analysis we have undertaken covering a range of markets over the last 10 years shows a loose correlation between the growth of international trade in a country and the trading in its currency, by general corporations, interbank and by investors. Moreover, our read of the data suggests that as markets liberalise and the currency becomes more fungible, so the rate of growth in currency accelerates. This effect, in turn, can be expected to accelerate with the facilitation of alpha-seeking flows. Of course, alpha in foreign exchange is not a zero-sum game â€“ there are always fundamental trades (retail, commercial, corporate, central bank and some investment activity) that must be done without regards to returns. Additionally, as returns become harder to find in majors, so minors and emerging markets currencies become more active.
For these reasons, we do not expect the growth in the market to stop any time soon; and we do expect the effects of greater liquidity and the intrusion of the more aggressive flows to make themselves felt across a broadening array of currencies and instruments. For instance, whereas five years ago, fewer than 10% of investors traded even plain-vanilla options, we now see a fifth trading structured products, rising prospectively to a third or more in the next year.
Impact of algorithms
Much has been said about the dramatic growth of algorithmic trading in foreign exchange. Arguably, the term is used to cover two distinct types of activity. The first of these is electronically-managed order placement to minimize market impact and obtain best execution.
The second of these combines the order-placement mechanism with some model-based electronic intelligence for trade-generation and execution. It is the latter type that has the most impact on the market, with multiple electronic decisions per second facilitating, for example, latency and more general mispricing arbitrages that punish poor sell-side electronic risk management and position-taking.
It is interesting to note, then, that the sheer number of market participants trading on a fully algorithmic basis has not materially increased on a year ago. It is still only undertaken by around 10% of institutional clients. However, they tend to be very large accounts and each average approximately $100bn annually of electronically flow (a substantial increase on 12 months ago). Interestingly, the same houses are typically very significant traditionally-executing leveraged funds, with an average of around $30bn of non-algorithmic activity.
These are the funds whose technology and weight of flows make the most demands on the sell-side. They can shift liquidity rapidly from one venue to another and from one group of banks to another. As we have noted, they sniff out mispricing with unerring exactitude and are force sell-sides to be much more demanding of their own systems, reviewing the nature and extent of risk they wish to manage through different tools and desks.
Addressing risk on the sell-side
We have argued in our paper â€œFX, market and technology â€“ The outlookâ€ (May 2006 available from www.ClientKnowledge.com) that it no longer makes sense to consider e-fx as a simple alternative distribution method for a foreign exchange product whose technological requirements for manufacture are somehow isolated from those of distribution. This becomes evident when we consider the impact of these flows on sell-side trading.
As noted above, the first determination for any sell-side must be of the extent of the risk (in amount, time-horizon, source of position, credit exposure and market direction) that the bank wishes to warehouse versus laying off. Since the nature of the risks will vary and the returns should be measurable, the bank will need mechanisms and, arguably, workflows and staffing that separate client-derived risk from proprietary risk (as well as an approach for sharing or segregating knowledge between the two).
The client-derived risk positions, and the underlying pricing from the market and the impact of both of these on the book position of the bank can â€“ or rather inevitably, even at the most conservative, corporate-flow oriented sell-side, will â€“ move in realtime (now measured in times faster than the EBS/Reuters refresh rates). The implication of this is that banks must have realtime risk management mechanisms in place. These are mechanisms that refresh in sub-second periods on the amount of client-derived risk to hold or to lay off, preferably linked to the mechanisms to lay off that risk and skew the prices being made through distribution channels.
We at ClientKnowledge find ourselves now working with a range of sell-side firms on the optimal business approach and conceptual modeling of trading to address these challenges.
Inevitably, we see a growth in the use of electronic tools to manage risk and maximise the retained spread from client activity, as well as monitor the combined risk across the various modes of a multi-faceted bankâ€™s market participation. In turn, these tools will facilitate the bankâ€™s determination of which currencies, instruments and client segments to which it wishes to service as a full-service provider, where it wishes to benefit from the manufacture of other banks as a value-added reseller (for example, a regional European house of anotherâ€™s emerging European currencies) and where it wishes to play the role of value-added distributor (the provider of the otherâ€™s emerging European currencies).
Outlook for market-places
In the last two years the markets and journals such as e-FOREX have been alive to talk of market-places. However, at the time of writing, EBS and Reuters play much the role that they have for the last decade with the addition of Hotspot as a space for position-taking active funds. Currenex and Integral have successfully channelled modest amounts of flow from specific sources across FXtrades and FXInside respectively and FXMarketSpace has received much profile but is still several months from launch. Lava and espeed are yet to make an impact â€“ both have initiatives afoot. The market continues to be based on the fundamental model of buy-sides selling risk to, and in limited cases acquiring it from, liquidity providers, overwhelmingly banking institutions.
This is a model that works well and for which most buy-sides would feel they pay an acceptable price for the risk transfer. The possibilities which the various initiatives described above raise are:
â€¢ The market-places will change the model;
â€¢ They will provide an alternative routing for risk transfer but the model will remain fundamentally unchanged;
â€¢ The new mechanisms will simply, if successful, displace existing ones in the same model.
It is our belief that since the present model works, the principal challenge for sell-sides over the next year, driven by e-fx, will be to improve their risk and trading models and mechanisms. That done, the new models should be expected to impact the marketâ€™s overall model only at the margin and, therefore, we foresee the likely outcome between the second and third option set out above. Space here, sadly, does not permit us to explore our reasoning and how that impacts different banks. Suffice it to say that the answer to that conundrum will depend upon and should be driven by an understanding of a particular bankâ€™s franchise and consideration of how its value can be maximised.