Look Back 2003

The major milestones and important events that have shaped the development of eFX over the last 12 months are once again reviewed by Justyn Trenner.

The last 12 months has seen significant, if subtle, changes in the global wholesale foreign exchange market. Some of the changes will have passed unnoticed by the clients who are the end users of the product and yet have profound implications on the economics of the business. Other changes are more visible and represent a maturing of developments over the past 5 years. In this overview, I will highlight and explain a few of what I believe are the most important.

Worldwide wholesale FX continues to be dominated by a small number of leading players. More specifically, in 2001 the top ten providers accounted for 59% of foreign exchange delivered to corporations and institutional investors, while by 2002 this figure had grown to 63%. In 2003, the number has dropped back to 59%, the same as two years earlier. Over the same time period, the concentration in the hands of the top three has fallen from 33% in 2001 to 32% in 2002 to 29% in 2003. All of this reflects, on the one hand, the decreased appetite for credit risk concentration on the part of the leading banks (and, therefore, their greater selectivity of which clients they will service) and the clients' own reduction of counterparty lists across products to only those providers that are core multi-product or multi-asset class service's of their organizations.

However, this is not the whole story. Underlying these changes is an increase, not a decrease of flows that the leading banks consider to be customer activities. This increase arises to some degree, in 2003, from a resurgence in underlying international foreign exchange activity by end-users, supported by an increased recognition of second-tier providers of the greater business efficiency of insourcing liquidity from primary liquidity providers. In this way, many banks that five years ago would have considered themselves market-makers across a range of currencies now position themselves as price-takers from the leading providers. Conversely the 41% of the market intermediated by banks outside the top ten in 2001 would largely have been dealt into the inter-dealer space; by 2003 much of that volume is now being dealt as customer volume back to the top ten providers as we predicted a year ago. Many more banks see their profitability in foreign exchange as predicated on credit (and priced accordingly).

At the same time, we are seeing a marked reduction – as alluded to above – in the numbers of core providers to whom corporations and investors are rewarding foreign exchange business. For example, the average European institutional provider list reduced from 7.4 in 2002 to 6.8 in 2003, while the average corporate provider list reduced from 6.8 to 5.5. This reduction was part of a worldwide trend.

Accordingly, as we see volumes maintained or increasing, and the number of sharers of that volume per client reducing, so the market places an increased potential reward on appropriate focus and segmentation of client opportunity. Indeed, the trend is further accentuated by the willingness of even very large clients in many cases to award their lead provider high percentages of their wallet, as high as the majority. This is a trend that applies not only to small corporate users but also large and highly active real money and leveraged accounts. How should a bank focus its business? Of course, this depends on the bank's position and ambition, although certain observations are axiomatic, in our view, for any profitable foreign exchange business.

The first consideration for any bank should, of course, be which client segments it wishes to address. The answer to this question will determine the depth and breadth of trading versus liquidity sourcing that it should undertake. To address a typical mid-tier corporate client base, it is hard to argue for the risk-taking implied in a significant trading operation; without an appropriate client base this is little more than a bank funded hedge fund operation.

A few news items carried about banks this year.

Year of the White Label

In November 2002, Integral Development Corp. deployed Citigroup's white label forex platform, CitiFXSM White Label. Tight margins have created a market environment where money center banks need to increase volume while mid-sized, regional banks need a low-cost technology option and the ability to offer more forex products to their customers without taking market risk.

In January 2003, we reported that Saxo Bank's White Labelling Partnerships program was doing well.

Since introducing its White Label Partner capability, Saxo Bank has established more than two dozen partnerships across the world including well-known retail brokerages, significant banking institutions and corporate partners. This year, with the introduction of online Futures Contracts, the pipeline for White Label Partnerships has accelerated even more.

In July this year HSBC announced that it was offering an outsourced FX trading service. Banks and corporate clients would now benefit in a number of ways, including being offered a purpose-built e-trading platform, the choice of price feeds either from HSBC or their own trading desk, and a range of up to 70 currencies including majors, minors and Emerging Market currencies and crosses.

HSBC partnered with Reuters, who will independently host and maintain the data as part of the service.

Online Derivative Pricing and FX Option products

In October 2002, we reported that ANZ had recently released a real-time internet based FX derivative pricing product called ANZ FX Online - Sphinx.

This web-based application enables clients to price a range of foreign exchange derivative strategies in real time. Pricing is available for vanilla currency options (Puts and Calls) and a range of structured FX Derivatives.

In July this year, our focus was on electronic trading of FX Options. We included an item highlighting Dresdner Kleinwort Wasserstein's FX Options pricing system.

Here, Vanillas, exotics and zero-cost hedging strategies can be traded in a few seconds. Vanillas benefit from both click-and-deal functionality and straight through processing (STP). FX exotic options are priced in a similar fashion and dealt through a secure online facility linked directly to the FX options trading desk for price confirmation.

In this summers edition we also looked at RBSmarkets.com the proprietary multi-product portal from Royal Bank of Scotland.

Here clients can now access 2 options trading platforms, delta-hedged options trading (volatility) and live options trading (premium) which are both embedded in the trading area of the site.

We believe that more and more second-tier banks are recognizing this. But there are those on the cusp, of being able to offer a credible service to a reasonable number of large corporate and institutional clients for whom a credible trading operation is of greater importance.

We believe that it is very difficult to offer foreign exchange to institutional investors without supporting fixed income and /or equities businesses. Those seeking to do so may need to re-focus their ambitions. On the other hand, if a bank has a significant loan book to larger corporations, there is an important opportunity to be serviced there. Similarly, if a bank has a unique geography/based currency strength, this also suggests the leverage that will justify a trading operation, for that currency at least.

Clearly, this a subject mired in internal bank politics. For those that find themselves on the cusp and believe that they have the relevant characteristics to enable them to secure a place at the top table with sufficient investors and large corporations to validate and pay for a trading based strategy, we suggest they should not underestimate the importance of the wider perspective and the involvement of and leverage from product relationships within the bank. It is important to recognize that liquidity sourcing is not only about sourcing spot business, but also about enabling a bank to provide a greater array of product – options, long SWAPS and so on – to its clients than would otherwise be possible. Having identified trading strategy and client segments, the bank must next consider the channels appropriate for the sourcing of liquidity (if insourcing is to be an important component) and for delivery to client segments (including to those banks that are outsourcing liquidity).

In terms of insourcing liquidity, the would-be client bank faces a wide choice of offerings. Firstly, a bank may choose to use the traditional electronic providers Reuters, EBS and the newly EBS-linked Bloomberg. However, none of these provides the real benefits of outsourcing liquidity implied in the total removal of carrying even stub-end business. The next set of choices fall neatly into the same camp as those choices facing traditional customers – online and telephone. In the online camp, there are the single dealer platforms of the major providers, the enhanced white-label versions of those - UBS is the one that has gained most traction so - far and the multi-provider platforms, in particular FXall, are attempting to gain liquidity in this space. In addition, Cognotec offers the more provider – neutral Liquidity Link, this is a service that Reuters now seeks to emulate. On the telephone, are all pushing hard to gain market share with Deutsche Bank achieving the greatest success at this time.At the present time, although many banks now have electronic white label products in the markets and UBS has a considerable number using their system, the majority of this business continues to be undertaken by telephone. We expect to see that change significantly over the next 12 months.

The most marked change in the corporate and institutional e-dealing space is the shift we note from single dealer platforms to multi provider platforms. We continue to believe that both formats for delivery of electronic foreign exchange have a long-term viable place. However, at the top end of the market, whilst electronic foreign exchange growth appears to have slowed the multi-provider platforms have all reported significant increases in volumes typically around threefold year-on-year.

FXall has recently reported moving to a cashflow positive status and State Street's FXConnect is achieving slightly larger volumes than FXall. Both have clearly, therefore, moved to a position of acceptance by the market. Currenex is still holding its own and all three systems now have reasonable numbers of adherents who have plumbed them through to achieve full connectivity benefits. FXConnect seems to be established as the platform of choice amongst the US and Australian investors while FXall seems the multi-provider platform of choice for large corporations internationally. These two are battling for primacy amongst European investors. Currenex continues to attract its own loyal following. It is harder to see the way forward for a number of the other systems.

The keys to e-commerce development and some of the most important developments that have been taking place and will continue to take place over the next two years are tied to the reduction of FX related costs. One set of FX costs arise through trading activity in the front office and we have outlined above how second tier banks can reduce these. First tier banks can achieve similar savings through increased autodealing – several banks now tell us that approaching or above 50% of overall numbers of tickets are now e-dealt.

All market participants, both buy and sell-side, can achieve significant cost and risk reductions through improved processing. The unequivocal success of CLS in the last year and its continued expansion across currencies is the most shining example here. Comparable benefits are being shared by those participants that are building straight through processing into their trading. Not only is the cost of an e-dealt ticket somewhere between 25% and 40% below that of a telephone ticket but the probability of incurring the much higher cost of a fail is also dramatically reduced. For this reason, there is now a recognizable premium for buy-and-sell-side alike to identify their preferred partners and plumb in the connections to them. Once this has been done the relationship is significantly stickier than was historically the case. Accordingly, as this becomes the norm, we expect to see the numbers of providers per client continue to reduce significantly and the pronounced segmentation now taking place across the market to become ever more evident.

Conclusion

In conclusion, what does this imply for clients? Firstly, that they should adopt an appropriate due process for determining and rewarding their providers. Secondly, that that due process should include the benefits of process-based savings, as well as, traditionally has been the case, pre-trade advisory. Thirdly, they should feel free to be very specific about the value-added in both pre-and-post trade and comfortable to demand higher standards and reward with higher quantities of their flow than has historically tended to be the case.

FX Prime Brokerage

makes it mark At the end of last year in our October edition we wrote about how Morgan Stanley's FX and Prime Brokerage divisions had worked together to create an STP suite of products for hedge funds doing international trading.

By combining the research, execution and allocation tools available from Foreign Exchange with the affirmation and reporting tools from Prime Brokerage, hedge fund clients would now be able to handle all of their currency needs. Clients could leverage existing STP standards including FIX for execution and allocation as well as SWIFT for confirmations.

April this year saw Andrew Coyne, head of Prime Brokerage at Deutsche Bank, tell us about the creation of DB eSwitch. DB eSwitch performs the functions of trade matching, allocation and booking in a way that allows Prime Brokerage Operations to monitor the life-cycle of each trade on an exception basis.

A critical point of differentiation is that this system receives the give-up data direct from the client trade capture or back office systems. Clients were no longer required to advise the FX Prime Broker of the trade, they just simply booked it in their own system.

In early summer, JPMorgan announced that along with two other banks, they would be the first prime brokers on a new inter-bank prime brokerage service from EBS. Prime Brokerage had taken another big step by entering the inter-bank market with the launch of this EBS Prime Broker product.

The service went live in May targeting banks that for one reason or another were not seeing the best prices.