Arin Ray Analyst at Celent
Arin Ray Analyst at Celent

Evolution of FX Trading: Models converge and competition heats up

The market for Foreign Exchange (FX) is the largest and most liquid financial market. The FX market plays an important role in facilitating global trade and enabling cross-border payments, along with being an asset class that is widely used for hedging and carrying out speculative trades.

According to the Bank for International Settlements (BIS), FX is also the largest asset class by average daily turnover, which reached US$5.3 trillion in 2013 and has been growing steadily for a long time. The period between 2001 and 2007 saw average FX daily turnover grow at 18% per annum, dropping to 6% per annum from 2007 to 2010, before picking up pace again between 2010 and 2013 when it grew at close to 10% per annum. Among foreign exchange instruments, FX spot and swaps are most widely transacted with each accounting for roughly 40% of total FX turnover. Moreover, both these instruments have witnessed high growth in turnover in last 3-4 years. Although off a small base, turnover of FX options grew by 60% during the same period. 

The growth in FX volumes during the period 2004-10 was primarily driven by carry trade activities when interest rate differentials among several currencies provided opportunity to investors to invest in other currencies. However, loose monetary policies in the developed world in response to crisis of 2008 and subsequent Eurozone crisis meant interest rate differentials diminished and volatility in exchange rate fluctuations reduced among major currencies. 

As a result growth in FX trading since 2010 has been driven by a different factor – the need for hedging of internationally diversified portfolio. As yields in developed economies plunged in the aftermath of the crises, investors increasingly invested in international equities and emerging market equities and bonds looking for higher return. The need to hedge exposure to exchange rate fluctuations arising out of diversified portfolio has been driving FX turnover since 2010. This has been aided by sudden and temporary rise in volatility in some currencies due to unexpected central bank actions.

Furthermore, the cost of execution (bid-ask spreads) has greatly come down for many emerging market currencies in the last decade making trading in those currencies a lot easier for international investors. Consequently the share of emerging market currencies in overall FX trading has gone up (from 12% in 2007 to 17% in 2013). This growth emerging market currency trading has been primarily driven by growth in offshore trading of these currencies, i.e., investors domiciled in other countries (than the home currency) trading in them. This is further evidence of the fact that investors hedging their international portfolio have been driving FX volume in the last few years.

The integration of the emerging markets and their currencies with the developed ones has been greatly helped by electronification of trading. Electronification of FX trading has fundamentally altered the role of players participating in this market. Earlier FX trading used to be dominated by a few large dealer banks.  

With electronification of trading their importance has declined and consequently share of inter-dealers in FX trading has declined steadily, from 63% of turnover in 1998 to less than 40% in 2013. A factor in the decline of interdealer market share has been the increase in internalization of trades by top banks. Internalization means matching of trades from buyers and sellers internally by using bank’s own liquidity pool instead of using an externally provided trading platform. In addition to saving execution costs, internalization also allows dealers to reduce market impact for large trades. Even though the concept of internalization has been in existence for many years, it has picked up steam in recent years for a number of reasons:

  Electronification of trading and heavy investments in technology means banks are now more capable of handling trade orders coming from different desks and divisions internally. 

  Low volatility in major currency pairs, as seen in the last few years, reduces the risk of sharp currency swings and hence risk associated with internalization. 

  Some banks have moved their voice traders onto in-house aggregators which makes internalization of trades easier.

Electronic trading has also allowed newer players like hedge funds, proprietary traders and retail traders to trade FX easily, and their share has been consistently growing. As a result non-dealer financial institutions, who accounted for just 20% of turnover in 1998, now account for over half of all trading turnover. This broad category includes smaller banks, mutual funds, money market funds, insurance companies, pension funds, hedge funds, and central banks, among others. Within this large group of non-dealer financial institutions, the dominant players are banks, institutional asset managers and hedge funds who together account for almost 90% of this group’s total turnover.

Evolution of FX Trading:  Models converge and competition heats up

Electronification of trading has reduced the role of voice trading, though it still accounts for just over 40% share. On the other hand, preference for electronic execution has been steadily rising and now accounts for around 57%.

The rise of electronic trading in FX has resulted in growing popularity of trading platforms and electronic execution venues.  Among trades executed on electronic trading systems, execution methodology can be broken down toward preference for execution at an inter-dealer, single dealer or multi-dealer platform. However, the distinction among these traditional segments is becoming less clear.  Figure 3 opposite shows the evolution of technology in FX markets over the past few decades. A major innovative cycle was seen during 2000 to 2005, which witnessed the emergence of multi-dealer platforms (MDPs) and electronic crossing networks. This phase coincided with increasing share of turnover by non-reporting dealers such as asset managers and hedge funds.

From 2005 to 2010, we witnessed top tier banks ramping up their single dealer platforms (SDP) offerings to compete with MDPs on major functionalities as well as additional services such as research, analytics, and risk management capabilities. SDPs also invested in cutting-edge technologies such as low latency execution and market data, algorithmic trading, and front end tools as well as in enhancing user experience which helped them counter the growing popularity of MDPs. This period also saw inter-dealer platforms opening up to non-dealers via prime brokerage arrangements to combat the growth of the MDPs.

Evolution of FX Trading:  Models converge and competition heats up

From 2010 onward, a new trend has emerged, with many regional banks upgrading their own single-dealer platforms to protect and grow their client segment franchise. Although already very competitive, the FX market is likely to become even more competitive because market segmentation is blurring quickly. Some of the recent developments that hint toward this trend include:

  Retail focused platforms (such as Gain Capital or Integral) are now going after the institutional market.

  Institutional MDPs operating in the dealer to client market are going after both end of the market – interdealer and retail.

  Interdealer platforms are acquiring dealer to client platforms. 

The blurring of market segmentation is also reflected in the fact that product and client segment coverage of several platforms are expanding and players are looking to target the entire spectrum of product and clients.  In the product space we observe that while a few players focus exclusively on spot or derivative products, a large number of providers are looking to cover the entire product spectrum – spot, swaps, forwards, options, futures, NDFs, metals etc. Along with expanding product coverage, leading FX platforms are also tapping into new client segments to widen sources of liquidity. Even though a few players are specializing in niche client segments such as high-frequency traders or corporates, there is a trend to make the platforms attractive to a wide range of players in the buy and sell side. 

The evolution of FX platforms will be further influenced by ongoing and upcoming regulatory changes. In the last few years, banks have been heavily focused on understanding the evolving regulatory regimes of Dodd-Frank, MIFID II, EMIR, Basel, and Volcker Rules. These changes were brought in in the wake of the financial crises to reduce systematic risk and migrate trading for certain OTC derivative swap products from bank to client bilateral OTC execution over to a centrally cleared and reported regime, where execution occurs on a new type of platform. Such platforms are called swap execution facilities (SEFs) in the US and organized trading facilities (OTFs) in Europe. As a result, the business model for large banks in OTC derivatives has needed to change from one based on revenues generated through market-making and proprietary trading activities associated with providing clients with bilateral risk pricing, to a fee-based agency execution model where the bank routes client trades through to execution venues, and provides fee-generating post-trade services around collateral optimization and margining finance. 

Evolution of FX Trading:  Models converge and competition heats up

While FX swaps and forwards received exemptions from trading and clearing requirements imposed on derivatives, many platform providers have created their own SEFs resulting in proliferation a number of them. FX turnover at such SEFs is still low in volume, and the notion that MDPs might benefit in gaining share because of SEFs is yet to materialize. In order to ensure that SDPs remained relevant to clients for OTC derivatives, the largest banks have implemented SEF liquidity aggregation services within their SDPs, enabling clients to route swap trades through to SEFs for execution, and provide clients with post-trade collateral optimization services through SDPs. New regulations regarding capital and margin requirements may make some FX instruments more expensive to trade over the counter, and force some of them to migrate to standardized venues or exchanges. The shift may be nominal for overall OTC FX trading, but due to small base of exchange trading of FX instruments it may be significant for the exchanges.


The growth in the FX turnover is likely to continue. Asia will be a major driver of growth with the liberalization of Chinese Renminbi likely to drive more activity involving the currency. It should be helped by further electronification of FX trading activity. Demand for more electronification will be bolstered by the calls for more transparency in FX, especially in light of recent revelations in this space. The segmentation among different type of platforms will continue to blur and make the space more competitive. Even though cost of developing technology has come down greatly in recent years lowering the barrier to entry for new players, the platform provider space is likely to see consolidation in the short-medium term due to growing competition. Lastly regulations will influence the FX trading landscape and accelerate some of the changes taking place. One trend that has remained unchanged amidst all the changes in the FX space is the geographic distribution of FX trading activities. Europe has dominated FX trading activity for a long time with over 50% share in turnover, notably due to the dominant role of London as an FX hub. This trend is likely to continue in the future.