Justyn Trenner CEO & Principal, ClientKnowledge.
Justyn Trenner CEO & Principal, ClientKnowledge.

Look Back

Justyn Trenner provides our regular overview of the key milestones in the growth and development of eFX over the past year.

Last year, in these pages, ClientKnowledge noted that the market had shifted, over the last ten years, from a broadly, simple single-dimensional market (from interdealer brokers to sell-side to buy-side) to a more complex multi-dimensional space, where those definitions were much harder to apply. 2005 has seen two par-allel evolutions along similar lines, both materially fuelled by technology. The first is the changing roles and types of trading, rendering the old neat segmentation into providers and clients inadequate.

The second is the growth of aggressive, or alpha-seeking, activity (and outsourcing of liquidity) which tend to oblige market participants to be more disciplined about why and how they trade and, not insignificantly, how they process their trades.

The background to all of this is a growing and healthy market-place. Three lots of data recently issued paint a congruent picture: sell-side surveys by the Federal Re-serve Bank FX Committee and the Bank of England Foreign Exchange Joint Stand-ing Committee, covering dealers’ activities in their respective centres and Cli-entKnowledge’s annual study into buy-side activity, speaking to more than 2,000 corporations, real and leveraged money-managers, client banks and other interme-diaries. Together, these paint a revealing picture of the significance of these different participants and how the market’s structure is evolving.

The Bank for International Settlements’ most recent triennial surveys of the foreign exchange market have revealed a sharp drop in overall volumes between 1998 (US$1.5trn) and 2001 (US$1.2trn), followed by an even more marked rise as at 2004 (US$1.9trn).

Look Back
The Fed’s FX Committee and the Bank of England’s JSC surveys suggest a con-tinuing growth in activity – in the range of 17-20% between the second half of 2004 and first half of 2005. They are both consistent with the growth measured by Cli-entKnowledge. However, whereas the central banks track the overall volume, we at ClientKnowledge focus upon the wholesale client space – corporations, client banks, real and leveraged money. It is the change in the balance of activity between differ-ent types of participant that, we believe, reveals the most interesting story.

Loosely speaking, between 1998 and 2001, the overall volume of wholesale clients was little changed – the roughly 20% reduction in volumes was principally a nearly 30% drop in banks’ dealing volumes, implying a reduction in risk appetite and pro-prietary and market-making activities. Conversely, the growth since that point – marked by last year’s BIS data and the combine analysis of different sources this year – has been consistent as between buy-side and sell-side.

In some ways, that is a surprise. We might have expected the reducing numbers of market-making sell-sides to have led to a shift in the balance from the sell- to the buy-side.

The willingness of second-tier foreign exchange banks to outsource market-risk by passing through client flows to principal liquidity providers led to a marked reduction in

“It is the change in the balance of activity between different types of participant that, we believe, reveals the most interesting story”
Look Back
volumes by these firms as measured by ClientKnowledge in the period 2003 to 2004. As more banks exited the market-making game (depending on the currency pair, around 10-20% of banks active in that pair between 2003 and 2004, with a further 5-10% again from 2004 to 2005) and reduced trading head-count, we expected vol-umes with second tier banks to go on falling. However, they have not – they have stabilised.

There are two reasons for the change. On the one hand, those making markets (typically in their domestic, minor currencies) are seeing increased activity there, while on the other hand, those banks are seeking to replace market-making with proprietary trading. In reality, this is a smarter business proposition – trust traders for their ability to unearth pure currency alpha and lock in spread with mainly corporate and captive clients. In effect, therefore, we would suggest that the balance of sec-ond-tier bank volume has tilted a little more towards the quest for pure currency ex-cess returns, increasing not only the size of the so-called alpha space but also the numbers and types of player.

Similarly, the traditional money managers have shown a sharply increased appetite for the pursuit of leveraged strategies (and fees). In early 2004, ClientKnowledge re-corded about one third of leading managers allocating at least some money to alter-native strategies, a number that had increased to about two-thirds by 2005 – and have rapidly increasing assets allocated accordingly.

Look Back
So along with an increasing number of pure-play hedge funds and CTAs attacking the currency markets, there are more traditional names with both dedicated funds and more aggressive overlay approaches. This sector – the leveraged and highly actives money managers – has increased in dealing volume by a remarkable 80% between 2004 and 2005.

Look Back
Taken together, then, it is clear that any reduction in sell-side market-making appe-tite is offset by sell-side proprietary risk appetite, while the overall growth in volumes is truly driven by the increased variety of currency alpha-seekers.

The search for alpha, in turn, is supporting, as noted above, healthy opportunities for niche banks – those with a particular currency specialisation, while the ability to pass through non-specialist currencies is ensure the viability of client servicing where the bank is willing to shoulder the credit risk of market access (either, typically, for corpo-rate clients or for prime brokered parties). This is facilitating a healthy medium-term outlook for the foreign exchange businesses at a wide variety of banks.

We believe that this has one simple and important implication - there is little prospect of market dysfunction caused by excessive consolidation. There remains and is likely to remain an adequate supply of market participants of different varieties to ensure plenty of liquidity. Indeed, whereas in the past one could readily divide the market into buy-side (clients, price-takers) and sell-side (providers, price-makers), those simple appellations have intermingled. We now have a multi-dimensional market, with a single institution, even from a single desk, playing the role of both client and provider, price-taker and price-market.

The growth of types of leveraged player has been facilitated to a material degree by the impact of technology. By way of example, look at the range of prime brokerage offerings.

Routes to market: diversity breeds diversity
These developments have both tended to facilitate and been facilitated by the in-crease in the possible routes to access the market. There has been a good deal of speculation over how quickly e-dealing would replace the phone, whether multi-provider platforms would render single-dealer sites obsolete, whether an exchange might ultimately displace the dealer-intermediated market-place model altogether.

The reality, thus far, has demonstrated that plurality tends to win out. On the first point, the phone is still used for more client volume than the keyboard. While the trend is clearly to increase take-up, it will be a long time – and much longer than many of us thought five years ago – before the phone bows out, particularly for larger trades and trades where managers wish to discuss the execution with some-one closer to the market.

In terms of dealing portals, the most important feature of the last twelve months has been the increase in connections from buy- to sell-side using application program interfaces (APIs). These are the balls of code (or plug-in applications) that permit a bank’s trading system to be routed directly into a client-selected interface such as an order management system or even an algorithmic trading program (on which more below). The multi-provider platforms enjoyed rapid growth since their inception through to earlier this year while some banks, mistakenly in our view, made devel-opment of their own offering secondary to their participation in these. However, our analysis suggests a marked slowing in that growth while much of the increase in take-up goes to banks’ own systems, whether by way of their web portal, a white-label proposition or an API. In parallel, we have seen material take-up of the inde-pendent exchange-style Hotspot FXi, where users can see depth of book and make anonymous matches and similarly EBS Prime Pro has attracted some meaningful flow. The Chicago Mercantile Exchange has also been carrying a daily volume that would compare favourably to any of the multi-provider systems online (US$46bn daily for June) – much of it was non-traditional fx users, such as arcades and previ-ously non-fx oriented CTAs.

Look Back
Yet each of these (including the wholesale client user component of the flow on EBS) would struggle to measure a few single-digit percentage points of overall daily FX volume. The CME’s volume, a significant amount in its own right, of course, equates to about 2% of the daily OTC market.

The reason for the proliferation of venues at which to transact and routes to those venues is precisely the increased depth and level of trading in the entire foreign ex-change market-place. The reduction of friction facilitated by the use of computers in generating prices and buy/sell orders, in undertaking trades and in settling trades (along with the relatively falling cost of commissioning and running those computers) all contribute to ensuring that many similar and different propositions can find their niche. Many corporations and smaller investors are likely to wish to trade over sin-gle-dealer systems and the phone. At the other end of the scale, consolidators and algorithmic traders may be the first to adopt APIs but others will follow as their order management systems allow them to determine their own preferred digital desktop setup.

This is not say that all of the systems available today will be around and in the same form in the not-too-distant future. Just as the previously bank-owned TradeWeb is now part of the Thomson family, so we should look for some consolidation and changes in ownership. We might also wonder whether those offering a new mecha-nism or kind of market-place (such as the exchanges and exchange-style offerings) might gain loyal followings while those who are simply routing consolidators might be displaced by improved direct connectivity (surely bank API-to-order management system is more efficient than bank feed-to-multiprovider platform-to-order manage-ment system).

Facilitating a more efficient market
Most of the above has focused on what is driving dealing and how and where the trade is effected. However, as we noted earlier, two important areas where IT has made life dramatically easier are in enabling certain types of client to access the market, through prime brokerage, and in lowering the risk and costs of completing the trade.

Prime brokerage previously suffered from two constrictions: a limited supply of worthwhile clients meant that banks’ operations struggle to achieve viable scale; and the manual approach to booking and processing trades led to a constant struggle for the bank to remain ahead of its clients’ limits. Clearly, that has changed, with tech-nology killing two birds with one sophisticated, but affordable, stone. From the cli-ent’s perspective, this increases ease of access to counterparties of all kinds, both banks other than their prime broker in bilateral trades and other anonymous counter-parties over a system such as EBS or Hotspot; and ready application of the leverag-ing of the margin similarly increases the volume that can be traded.

Look Back
In the meantime the costs and reliability of settlement have both improved through straight-through processing implementation and the advent of CLS third party.

In combination, these factors are tending to reduce the friction in trading (tickets are easier to write and cost less), which in turn means that trading profit per volume (whether on the buy- or sell-side) may be squeezed but the point of viability of a trade also falls. Consequently, more trades are being done and new ways are being found to exploit the opportunties (such as so-called high velocity trading).