The global FX market, the world’s largest and most liquid asset class, continues to grow and evolve. Fueled by market volatility, massive adoption of electronic trading, increasing adoption of high frequency trading (HFT), and retail market growth, the FX market has shown incredible resilience through the last decade, even through the aftermath of the global financial crisis of 2008 and 2009.
As the FX market has gone more mainstream and FX has become accepted as a legitimate asset class, potential for increased regulatory supervision has emerged in recent years. Regardless of any regulatory threats, however, a genuine, industry-initiated effort seeks to introduce enhanced transparency into the market and provide a fair trading environment for both institutional and retail clients in the following ways:
• Growth of electronic trading
• Increasing adoption of FX algorithms and HFT
• Push toward increased transparency and transaction analysis
• Requirements for best execution and regulations
Fueled by these industry-led initiatives is the next phase of competition in electronic FX trading market. Over the last 12 to 18 months, new FX venues have emerged at a rapid pace, often touting increased transparency, low latency, and cost-effective trading as key characteristics of their competitive offerings.
Key market trends
1. Volume and Electronic Trading
Global FX trading volume has seen tremendous growth over the last decade. At the end of 2012, average daily trade volume in the FX market reached an estimated US$4.68 trillion despite a slight decline from the previous year (Figure 1), representing a vibrant market compared with other asset classes. Continued adoption of electronic trading will play a key role in fueling the overall growth in FX market as well as the penetration of HFTs. Another factor that cannot be ignored is the overall contribution of the burgeoning global retail FX market.
Electronic trading has become the main mode of trading in FX and now accounts for more than 60% of all trading done in the global FX market (Figure 2). Moreover, Aite Group expects to see electronic trading adoption to continue in the FX market, reaching 70% by the end of 2013.
This reality does not predict the end of voice trading, however. Typically, voice has a bigger role when large trades are being done. In addition, during times of severe market volatility, it is common for clients to rely on their relationships with banks to get much-needed color into where the market is headed and to get it via voice. This was certainly the case in 2009, when, following the record volume of 2008, the dramatic dislocation of the general global economy created much uncertainty in the marketplace, leading to widened spreads and lower trading volume. During this time, reliance on high-touch, voice-driven trading became crucial for clients seeking to navigate market uncertainty.
2. Regulatory Changes
On the regulatory front, the Dodd-Frank Act in the United States and EMIR and MiFID II in Europe have created an enormous opportunity for multidealer trading platform providers to register themselves or, later, their affiliates, as SEFs. To be granted SEF status when that day comes will legitimize MDP FX electronic platform vendors’ status and forever transform the landscape of electronic trading of FX derivatives such as FX options and NDFs.
While most of the changes forged by the Dodd-Frank Act focus on FX options and NDFs, Aite Group believes there is a growing sense of inevitability that the rest of the FX market will ultimately experience an increased level of regulatory change in coming years. It is even fathomable that foreign exchange markets, the most dominant form of OTC market structure, may one day evolve into some form of highly regulated globalized exchange.
The Dodd-Frank Act, EMIR, MiFID II, and other similar regulatory reforms all paved the way for the transition to the changing market dynamics that usher in the next phase of OTC-to-exchange-style trading and centralized clearing. This transformative movement poses the next challenge—for all market participants and the execution venues that they have chosen to trade, that is—to demonstrate that “best execution” is indeed being achieved and the principle of achieving it is being followed.
3. Growing Awareness of TCA
Institutional asset managers have long employed TCA as a tool to measure execution quality in equities for at least 20 years. TCA is important to this audience because these money managers have a fiduciary obligation to achieve “best execution” for the assets that they manage on behalf of their clients. As FX is gradually recognized and treated as a separate asset class from stocks and bonds, the notion of fulfilling best-execution obligations in FX and subsequently using FX TCA services is a natural progression of this industry’s maturation process. Furthermore, although using FX TCA to gauge execution quality is still in its early stages and is generally confined to the institutional investor community, the concept of best execution and how to measure it will soon become a requirement of many electronic FX trading platforms as the whole FX industry ramps up its electronic trading activities.
Competitive landscape in e-trading venues
The first generation of FX electronic trading venues initially emerged in the interbank market in the early 1990s. Both Reuters and EBS have remained traditional powerhouses in the electronic FX market since their launches, supported by the dealing banks that relied on the two venues to manage their risk in a timely manner.
The second wave of significant changes in the electronic FX market occurred during the late 1990s, when numerous electronic platforms surfaced to address trading issues in the client-to-dealer market. While most of those venues, such as Atriax, Lava, and FXMarketspace, ultimately ceased operations due to lack of market adoption, the few that survived, including Currenex, Hotspot FX, and FXall, form the backbone of today’s established FX ECN players.
Over the last couple of years, we have witnessed the next wave of new FX venues flooding the marketplace. Table A shows a sample list of new FX venues that have launched recent years.
There are numerous reasons for the entrance of new FX venues into a competitive landscape that had been fairly stable until a few years ago:
• Traditional electronic venues such as EBS and Reuters have been gradually losing market share to HFT-oriented market-making or proprietary trading firms, providing much-needed hope for new entrants to build attractive levels of liquidity unthinkable even three years ago.
• Dealing banks have become increasingly dissatisfied with the current group of FX venues due to (1) what they perceive as certain practices that favor automated trading firms and (2) the outdated trading infrastructures of existing platforms. Both of these may lead to potential opportunities for new venues.
• New participants from non-FX markets have entered the space looking for faster, more streamlined, transparent FX trading venues similar to what they are used to in equities and futures markets.
• Continuing regulatory changes in the OTC derivatives markets across different asset classes such as fixed income, commodities, and equities are leading to growing expectations from global FX market participants that similar obligations will be eventually applied to the FX market.
• FX clients are becoming more sophisticated and looking for more choices and efficiency in trading FX electronically.
• The existence of an FX ecosystem has drastically lowered the cost of entry for new market players.
Most of the FX venues have to date experienced increases in volume over the previous year (as of March 2013 compared with 2012 levels). After a historic loss of market share leadership to Thomson Reuters, ICAP (EBS) aims to recapture its leadership position.
The market share race between these two firms is intense, with only a single percentage point separating them. CME has become a major player in the FX market, representing 15% of market share with its FX futures dominance in the exchange market.
FXall is the third-largest FX venue; representing 13% of the market share, it continues to solidify its growing presence in the FX market. FX Connect and Currenex round out the top five venues, representing a healthy market share of 12% and 9%, respectively (Figure 3).
The FX venue landscape has never been this competitive, and the entrance of new FX venues seems to foretell a brutal market share battle over the next 12 to 18 months.
The global FX market, the world’s largest and most liquid asset class, continues to grow and evolve. It has bucked the trend in volume declines over this past two years that were seen in other asset classes such as stocks and bonds, with a bottoming in its own trading activity in Q3 2012, and has staged a strong comeback ever since.
This pickup in FX volume is further fueled by the Japanese yen’s recent rapid depreciation, which has led to a boom in new trading interest. As a result, a surge in speculation by retail investors and hedge funds, as well as new hedging activities by institutional investors and multinational corporate treasuries, continues.
New emerging trends that will impact the health and dynamics of the global FX market in 2013 and beyond include the following:
• As the FX market has gone more mainstream and FX has become accepted as a legitimate asset class, a genuine, industry-initiated effort seeks to introduce enhanced transparency into the market and provide a fair trading environment for both institutional and retail clients alike.
• Fueled by these industry-led initiatives, the next phase of competition in electronic FX trading market has begun. Over the last 12 to 18 months, new FX venues have emerged at a rapid pace often touting increased transparency, low latency, and cost-effective trading as key characteristics of their competitive offerings.
• Banks are increasingly relying on internalization of client order flow to manage their market risk, but they are also leveraging their connectivity to various client-to-dealer platforms to manage their overall P&L and relying less on the traditional interbank venues such as EBS and Reuters.
• Partially caused by new technological innovations as well as by market structural changes as a result of new demand-supply dynamics and new regulations, more choices than ever in electronic trading venues now confront the end customers of FX. Customers can choose to trade electronically via RFQ/RFS in single or multi-bank platforms, ECNs with streaming quotes and central limit order books, or exchange style trading that supports pre-trade anonymity and full post-trade transparency.
• Key findings by government-sponsored FX regulatory bodies indicate that the average trade size of spot FX transactions has already dropped two- to threefold over the last three years, while the number of trades has gone up more than 50% during the same period. With expected continued growth in HFT volume and increasing market participation by retail traders, the average trade size of spot FX is expected to decrease even more in coming years.
• Although using FX TCA to gauge execution quality is still in its early stages and is generally confined to the institutional investor community, the concept of defining and measuring execution quality will soon become a requirement of most electronic FX trading platforms, the whole FX industry ramps up its electronic trading activities.