Volumes and liquidity in electronically-traded foreign exchange are rocketing as institutions look to currency trading to meet their investment needs.
A simple but major factor in the growth of e-FX has been the growth of FX trading generally - a natural product of booming global equities. TowerGroup predicts that the daily average trade flow in FX will top $3000bn (€2321bn) in 2007 – up from $1770bn in 2004.
Justyn Trenner, CEO, at researchers ClientKnowledge, reckons we won’t reach $3000bn in 2007, but there should be more than $3500bn traded daily by 2010. He says that 60 per cent of that is currently traded electronically. This should rise to over 75 per cent by 2010.
Mr Trenner adds: “Given that this is on a rising underlying number of trades, we are looking at a doubling of e-trades by 2010.”
As another indicator of growth, EBS – the spot FX trading system – now reports daily volumes of $145bn. This is up from $100bn a day in 2003 and less than $40bn in 1995.
Other reasons for the growth in e-FX include:
- Regulation – as fund managers use the technology to try and prove best execution;
- Enhanced technology including algorithmic trading (see article on page 47);
- Greater accessibility through prime brokerage which allows institutional investors, including commodity trading advisers (CTAs) and hedge funds, to get pricing and liquidity by trading directly in the global FX market;
- Greater efficiency.
Fast and efficient
Chip Lowry, senior managing director, State Street Global Link, Europe, says: “E-trading allows you to trade more frequently and more efficiently. That is bringing in hedge funds who want to trade currency as an asset class. That in turn is growing the market.”
Mr Trenner at ClientKnowledge says: “Traditional users – such as asset managers and traditional corporations – typically use e-FX to get trades done more quickly with fewer errors. They are not so driven by improved pricing and transparency of prices, though that helps.
“The more aggressive asset managers treat FX as an asset class. They want to use those electronic intermediaries who help them find a better price or help them to manage trades algorithmically.”
Richard Estes, head of e-commerce for global markets, Bank of New York (BNY), says: “Five years ago, online trading was about transparency of price. Now it is about straight-through processing and post-trade services like confirmation matching and third-party notification.”
According to TowerGroup, these new business models have fostered greater buy-side participation and an increasingly diverse selection of e-FX execution venues.
FX trading is still dominated by the large dealing banks, but exchange-like models fuelling a bid-and-offer market are challenging the traditional request for quotes. With the appearance of new execution venues, it has become easier for traders to enter the FX market and reduce the risks associated with these transactions.
Tom Price, a senior analyst in the securities and capital markets research service at TowerGroup, says: “Players that engage in FX trading range from national central banks and dealer banks all the way down to day traders in an arcade. These myriad investors have many different reasons for participating in the FX marketplace, and their individual motivations determine their specific methods and venues for trading.”
But has the market become too fragmented? Wouldn't it be easier if everything was traded on one exchange?
Giovanni Carriere, consultant, Greenwich Associates, says: “Fragmentation is hurting the market. If you have ten or 15 ways to get your prices and access liquidity, you will never know if you are getting the best price. Or you might choose to search for your quotes in multiple channels at the same time, which will take longer.
He says that if there are a number of systems, straight-through processing will not always work in any situation for any kind of transactions. And some investors say fragmentation makes it harder to understand what’s going on in the market.
Others say that the diversity of venues is a good thing. State Street’s Mr Lowry says: “I don't buy the fragmentation argument, I think of it as segmentation. We are seeing more venues and there will be more to cater for the greater number of participants and types of participants. So it won’t hinder development, quite the opposite.”
One new entrant will be FX MarketSpace – an innovative new platform set up by CME and Reuters – which is to be launched soon. But even as new venues start up, TowerGroup says it expects consolidation of these venues over the next two to three years. Multi-bank portals will be the most affected by venue consolidation, and TowerGroup estimates that only two or three will remain once the dust settles.
It says that FX electronic communication networks (ECNs) will be the next stage in the evolution of the market. These will become the platform of choice for traders that treat FX as an asset class.
In January, State Street, which already owns trading platform FX Connect, acquired another platform, Currenex. The former serves traditional asset managers while the latter is more geared to active currency managers and hedge funds.
Mr Lowry says: “There will be consolidation in the market. Some venues will close, some will be bought, and others will open. I guarantee someone will say the whole market is about to go to an exchange model. But I think we are going to a segmentation model.”
Mr Estes of BNY agrees: “I don’t see it as fragmentation, rather as different initiatives to facilitate the needs of different segments. For the asset manager, multi-bank portals like FXall and FX Connect strive to maintain the client/bank relationship by automating the execution process between the two sides. They are not altering the counterparty relationship, but rather maintaining the model of trades between the two counterparties.
“For more active hedge fund managers, other platforms aim to change the terms of the counterparty relationship. These include Hotspot FX, Currenex, and the upcoming Reuters-CME joint venture FX MarketSpace. They allow anyone to trade with anyone else, separate from the traditional credit relationship. In effect this changes the roles of who is the client and who is the market maker.”
Alternative models
There’s no doubt new initiatives are evolving. Those that were originally based on the traditional client/bank relationship model are now trying to introduce alternative models and functionality to attract some of the newer market participants.
FXall, for example, launched QuickFill a couple of years ago to serve the algorithmic-based trader. Meanwhile, its QuickOMS trading interface continues to appeal to the traditional asset manager.
FX MarketSpace will try to separate hedge funds from dependence on their prime broker’s credit, and instead trade with anyone on margin via a centralised clearing counterparty. Mr Estes says that this could be an improvement on the model used by Hotspot FX and EBS Prime.
He says: “Fragmentation may still continue because technology cannot always solve the needs of different market segments. State Street’s acquisition of Currenex – a platform with a different functionality and client base than its existing FX Connect platform – is testament to this argument that different models are needed to serve these segments, and do more things for more client segments.”
But consolidation will be a crucial factor for investors. Mr Carriere of Greenwich Associates says: “Our research says that, for investors, the question is which channels will become more important over the next few years? The most common answer is third party, multi-dealer platforms. If there is consolidation, it will be more successful platforms taking over less successful ones – not the latter cutting costs and reducing services.”
A major catalyst for growth in electronic foreign exchange trading has been the influx of hedge funds and other investors who treat FX as an asset class. What strategies are they using to extract returns above an index – or alpha – from FX and how sustainable are these returns?
One method for improving returns is the currency overlay. Mr Estes says: “On an international trade, you are exposed to exchange rate risk. Typically, investors can generate alpha by using an active hedging or currency overlay program - which determines the timing and scale of currency hedging - rather than leaving the portfolio unhedged.”
However, he says that trading FX as an asset class is trickier than with equities. “It is a little different from the equity markets, where you might put in a long-short strategy to increase alpha. In FX, you are always buying a currency and selling another. If you are long on one you are inherently short on the other. The same rules that allowed one currency to appreciate against another one at one time in the market, may not work at another time.”
According to Mr Trenner at ClientKnowledge, there are two main ways of extracting alpha. One is by taking a view on the direction of the FX market. The other is by spotting mispricing. He says: “If it is priced even marginally differently on a single bank system, by quickly buying here and selling there you can take large, riskless positions that net you alpha.”
To do that you need a system that is able to execute the trade faster than somebody else. But, inevitably, as more people have cottoned on to this trick, those opportunities have reduced over the last 12 months. Mr Trenner predicts that they will go on reducing as the sell-side learns how to price faster and more accurately.
He continues: “Some sell-sides have already done that successfully - like Deutsche Bank, Bank of America and Morgan Stanley - but others have yet to do so. The latter, in the last year, have tended to pull back from markets where they might get burned. They are no longer standing there giving up alpha, so it is harder to come by.”
Mr Lowry at State Street Global Link says: “There have been a number of theories of how FX moves and there are perhaps some inefficiencies in the market. The so-called forward rate bias has to do with how currencies move in relation to their underlying interest rates. If you have a certain trading model, you seem to make money on that. Hedge funds have been using it for years and are still making money on it.”
However, he agrees that they are not doing it as well as they used to, because there are more hedge funds exploiting these inefficiencies. Nonetheless, he claims that FX alpha is sustainable depending on your tactical model.
