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Is the global foreign exchange market moving towards an exchange-like structure, where all customers get the same prices and the banks are no longer the only liquidity providers?
There is certainly movement in that direction. The traditional separation between the interbank market and large customers is breaking down. More and more trading platforms are offering anonymous execution at high speed, and an increasing amount of liquidity is coming from hedge funds and commodity trading advisors who demand equal access to the best prices.
That does not mean, however, that trading is poised to concentrate on any single platform. Instead, liquidity is fragmented among many different platforms that operate under different rules and target different types of customers. This year, three new platforms were launched: FXMarketSpace, Accelor, and LavaFX Interbank. Though it is too early to say whether they will be successful, together they are pushing the forex market closer to a more exchange-like environment.
For the futures industry, there are at least two aspects to this evolution that deserve particular attention. First, the FXMarket- Space platform represents the first attempt to bring a central counterparty into spot foreign exchange trading. If it succeeds, the demand for clearing services will rise significantly, creating opportunities for the banks that are active on this platform.
Second, there are signs of a feedback effect, where innovations in the way products are traded in one asset class quickly appear in other asset classes. Dark pools, algorithmic trading, co-location, makertaker pricing, smart order routing—all of these innovations are appearing in the global foreign exchange market as well as in equities and futures markets. Banks and trading firms that are exposed to the latest market structure innovations in one asset class may well find that the experience will give them an edge in other markets.
Since the beginning of this decade, foreign exchange has become an asset class in its own right. International trade and investment flows still drive a large amount of trading, but much of the growth in the last five years has come from the increased participation of hedge funds, commodity trading advisors, and proprietary trading firms. These firms trade foreign exchange not as a necessary sideline to their main investment activity; they view the market as a trading opportunity in its own right.
Celent, a consulting firm, estimates that non-bank financial institutions currently trade $316 billion per day in spot forex transactions worldwide, representing 34% of a total spot market daily turnover of $932 billion. Celent says that the volume of trading by hedge funds and commodity trading advisors is growing faster than any other segment of the market, and observes that the demands of these customers are driving the evolution toward exchange-like features. For example, it is now standard practice for platforms to offer application program interfaces that allow the direct electronic communication of orders, and many of these API connections are based on the FIX protocol widely used in the equity markets.
Another parallel to the equity markets is the fragmentation of liquidity across many different trading venues. There are at least half a dozen electronic trading platforms that are accessible to institutional traders, and one of the major challenges for anyone in this market is to monitor the pricing on all these venues. Trading firms that are experienced with high-speed arbitrage across multiple markets are well suited for this market. By the same token, banks that are accustomed to providing liquidity to corporate customers often find it necessary to overhaul their technology as they come into contact with this new generation of market participants. Many of these firms are capable of split-second arbitrage, prompting banks to post only real-time prices.
The core interbank market still accounts for the majority of trading. Celent estimates daily spot forex trading in the interbankmarket at $456 billion, 49% of the overall $932 billion. The overwhelming majority of this trading is conducted on two platforms—EBS and Reuters Dealing—and the banks that dominate this market are the principal providers of liquidity across the entire landscape of the forex market.
The rise of the non-bank financial institutions has forced these two platforms to change, however. EBS, which was acquired by ICAP in April 2006, now provides access to its interbank market to a limited number of hedge funds and regional banks through its EBS Prime platform. This gives these players access to the tight spreads and deep liquidity available in interbank trading, with credit provided by participating banks and prime brokers. Reuters took a different approach, forming an alliance with the Chicago Mercantile Exchange that ultimately led to the formation of FXMarketSpace in 2006.
Space FXMS is the first platform to offer the benefits of a central counterparty to the forex market. Trades are netted on a multilateral basis instead of bilateral, so the net particiexposure is lower, and credit concerns are less of a barrier to access. FXMS, which is based in London, the largest center of the market, offers only spot trading at this stage, but over time the goal is to offer forwards, over-the-counter options and swaps as well.
“We’re adopting the futures exchange model, with price/time priority and a central limit order book. Everyone gets access to the same prices, and all prices can be hit,” explains Mark Robson, the Reuters executive named to run the joint venture. He contrasts that model with the common practice on most of the more established interbank and multibank platforms, where the customer’s ability to trade is restricted by factors such as credit lines and the banks that provide the liquidity screening the customers and adjusting their pricing to the customer profile. That may work for corporate customers and institutional investors interested in the overall banking relationship, but it is far from optimal for the speculative community, he explains.
The FXMS platform went live at the end of March, and during the first three months volume rose steadily. Robson cautions that it will take a long time for FXMS to capture a significant share of the market. At this stage, FXMS is concentrating on bringing on board the many firms already connected to Globex, the CME electronic trading system that is the basis for the FXMS platform. Robson also stresses the importance of globaldistribution; not only does Globex have a global network, Reuters has more than 100,000 desktops around the world that can be used to access FXMS.
“The reason why Reuters and CME came together is that we thought there was a large group of customers who were being underserved by the existing platforms,” explains Robson. “Some of the multibank platforms are very strong at serving the needs of asset managers, and the core interbank platforms are tailored to serve the needs of the banks. The ones left out were the API traders. The existing platforms are trying to serve them, but there’s a tension between the different customer segments. If they try to cater to the high-frequency traders, they erode their value for the keyboard traders. And there are a lot of banks that don’t want the hedge funds coming into their market and hitting their prices.”
Looking farther down the road, Robson also sees potential demand among smaller banks that do not have the credit relationships in place to trade in the interbank market. There are 17,000 customers who use Reuters screens to buy or sell forex, but less than half can participate on a best price central limit order book in the Reuters interbank market, he says. Many of these potential customers are in emerging-market countries, where booming international trade is driving rapid growth in forex trading. Robson notes that FXMS just opened offices in Tokyo and Hong Kong to serve customers in Asia.
Royal Bank of Scotland is one of the banks that have been active on FXMS from the start. Andrew Cheesman, European head of forex prime brokerage in the bank’s London office, says his group is working closely with the bank’s futures division to bring customers on board. “It’s a new platform and they are starting to establish a solid customer base with a steady daily volume. There has been a high level of interest in the platform and we have a strong pipeline across our customer base which will be going live in the coming months,” Cheesman says. There are a number of FX customers looking to use the platform who do not have the required level of CME membership to trade in their own name. Using RBS as their Prime Broker allows the cost of collateral and all fees to be included in one dealt rate which is more efficient for customers used to trading on a clean FX line,” he adds.
In June, average daily volume reached nearly $1 billion a day, less than 1% of the overall spot market, with peaks as high as $1 trillion in a single day. July, however, was another story. Average daily volume fell back to $539 billion, even though volatile conditions drove volume on some of the more established platforms to record highs.
Robson is confident that as more users connect to FXMS, the amount of liquidity available on the system will rise, spreads will tighten, and volume will improve. Eight new trading users joined the system in July, bringing the total to 40. Currently there are also 13 clearing firms live on the platform, and another seven in the pipeline.
Nordea, the biggest bank in Scandinavia, was one of the first banks to express interest in the platform. Kenneth Steengaard, head of e-Markets at Nordea, explains that the reason was quite simple. The bank sees trading in certain currencies as a core competency, so “we need to be present on any platform where a core currency is traded.” But Nordea still has not gone live on the platform. Steengaard says the onboard processing has been “fairly difficult,” especially relative to other platforms. Nordea is also wrestling with the decision whether to join as a customer or as a clearing firm. Buying a CME membership is expensive, but coming in as a customer means having to pay prime brokerage fees to another bank, which it is not accustomed to doing when it trades on other platforms.
“The hedge funds are used to paying the prime brokers for access to liquidity, but from our point of view it means we would pay a double set of fees,” he asserts. Steengaard says Nordea is still interested in connecting to FXMS, but that the commercial aspects for midsized banks with no membership on CME might be prohibitive in competition with other interbank venues currently emerging.
Speed of execution is an important issue in the futures industry and some of the more advanced trading firms are running systems capable of making thousands of trades in less than a second. FXMS can match that kind of speed because its trades run through Globex. A firm that co-locates its server next to the central processing engine in Chicago can get an order filled on FXMS in 25 milliseconds, according to the CME. That is a big attraction for high frequency trading firms interested in bringing their black boxes to the spot forex market.
FXMS is not the only platform boasting high-speed execution, however. In fact, both of the other two platforms introduced this year can match trades in well under half a second, and one of them–Accelor–is targeting the exact same customer segment.
Accelor was created by FXall, one of the largest multibank platforms in the forex market. Its operating model is similar to the electronic communications networks that revolutionized U.S. equities trading. The platform offers anonymous trading and a central limit order book with equal access by all participants. Its technology supports a wide range of order types and execution styles, and participants have access to not only the best bid and offer, but also full depth of book, completed trade information and historical data. In terms of speed, Accelor claims that orders are acknowledged within three milliseconds and filled within 20 milliseconds, exceptionally fast for any asset class.
Phil Weisberg, chief executive officer of FXall, explains that Accelor was created in response to two trends. “We noticed a few years ago that customers were becoming more experienced in managing market risk, and they realized that they could save money by executing their orders themselves instead of paying a spread to the banks. We also saw another type of client come into the market that had developed a proficiency in making markets electronically in other asset classes, and had adapted their models and computers to forex. They were not part of the interbank market, but that did not mean that their pricing was not as tight as what we were seeing among the banks. So we asked ourselves what aspects of the current market structure could be improved to address these trends.”
Weisberg emphasizes two characteristics that distinguish Accelor from other platforms. First, no distinction is made between clients and banks, or between high frequency and low frequency traders. As with FXMS, the rules are the same for everyone. Second, all participants get information not only on what is trading but also what is in the order book. “Accelor is one of a limited number of platforms showing the depth of book, and market data subscribers are also able to see a full order book echo with more granular data that is not available on other venues,” Weisberg states. He adds that firms active in other asset classes such as equities are used to having access to this level of market data, especially if they are using algorithmic or automated trading strategies.
Accelor began trading in February and claims to have attracted the support of leading banks, prime brokers, and broker-dealers such as ABN Amro, Bank of America, Citi, JPMorgan, RBS, and UBS. FXall is not disclosing Accelor’s volume to the public, however, so it is difficult to judge its success to date. Average daily volume on FXall as a whole, with Accelor included, reached $50 billion in July, with a single-day peak of $87 billion. By way of comparison, the volume of forex futures traded on the CME reached $77 billion in average daily notional value in July, the highest level ever for a non-roll month.
Does having a central counterparty give FXMS an advantage? Weisberg agrees that some market participants may prefer to use a CCP, provided that the cost is relatively low, but he thinks it is unlikely that the major banks will see it that way. As for hedge funds, he says the forex market “has a very welldeveloped prime brokerage function. If they can’t access credit from a bank, there is quite a large number of broker-dealers with experience in managing margin extensions.” He also points out that firms focused on forex may see an advantage in having all of their trades netted with a single counterparty, but hedge funds active in a wider range of asset classes may prefer to book all of their trades with a single prime broker and thereby get the benefit of cross-asset class netting.
The third platform launched this year is based on a very different model than FXMS and Accelor. LavaFX Interbank, a foreign exchange platform, has its roots in its existing buy-side foreign exchange ECN marketplace, but its latest innovation is an attempt to resuscitate the old interbank model on a more advanced technology. David Ogg, the chief executive of LavaFX, says his new platform is aimed at providing banks with a platform where they can trade amongst themselves. The platform, along with its “Darkroom” facility, operates something like a private club, where large positions can be moved back and forth without exposure to the wider market. This makes it similar to some of the so-called dark pools in the equity world, such as Pipeline, that allow broker-dealers and institutional investors to privately trade large blocks of stock among themselves.
LavaFX’s interbank market has been live since May. No information about its trading volume has been made public, but Ogg says it is growing quickly and has participation from “almost all of the top 15 banks.” One reason why banks are interested is that this structure helps prevent what the banks view as predatory tactics such as “latency arbitrage.” He explains that as the high-frequency traders came into the forex market, their superior technology allowed them to take advantage of the banks that failed to update their quotes on a real-time basis. This problem was compounded by the fact that liquidity was fragmented across so many platforms. A bank that unintentionally offered different prices on different platforms because it transmitted quotes at different speeds often found itself on the losing end of trades, even if pricing discrepancies existed for only a few milliseconds.
For this type of platform, a central counterparty is hardly necessary, Ogg asserts. The major banks already know each other very well, and settlement risk has been largely solved through the use of CLS, a special purpose entity created with central bank encouragement several years ago. CLS, which stands for continuous linked settlement, provides a mechanism for banks to settle both sides of their forex trades simultaneously, thereby eliminating the possibility that banks in different time zones might pay their side of a transaction at different times. CLS also allows banks to settle their forex trades through a net payment in each currency, rather than on a transactionby- transaction basis. An estimated 60% of forex trading is settled through CLS, and nearly 1,500 banks, brokers, funds and corporates use it for their forex transactions.
The other critically important feature of LavaFX is its technology. The platform was created by Lava Trading, a technology firm now owned by Citi that additionally develops advanced trading solutions for the U.S. equities market. Lava Trading is best known for its easy-to-use systems for viewing and accessing liquidity available in multiple exchanges, trading platforms, and other venues.
Ogg joined the company in 2004 from HotspotFX where he was the founder and CEO. HotspotFX was the first institutional forex platform to adopt an ECN-like structure. Ogg says that most forex platforms have relatively simple functionality. Traders can trade on a price or put in a limit order, and that is about it. LavaFX, on the other hand, has a large number of complex order types built into the platform that can help reduce the market impact of a large order and give a trading desk new ways to execute their trades. For example, a “variable time slice” functionality allows traders to tell the platform to break up an order into smaller pieces and submit those pieces into the market at different times, with both the size of the pieces and the timing of the intervals programmed to vary within a range. Some of the advanced functionalities were adapted to FX from other marketplaces, Ogg says, and others were developed specifically for forex trading. All of them are built right into the platform, and operate natively so there is no delay in execution.
Given the evolution in forex trading platforms, algorithmic trading is certain to play a larger role in the forex market, according to many industry experts. Celent estimates algorithmic trading accounts for approximately 20% of the overall market, with higher percentages on those markets where direct market access is allowed. Originally developed by hedge funds and proprietary traders for their own use, the forex market is now seeing these trading tools and strategies spreading to other types of customers, partly because banks and independent vendors are offering them as a way to spur business. There are even signs that algorithmic trading is moving down to the retail level. Saxo Bank, a Danish firm that is one of the leading aggregators of retail customer flow, began this year to give its clients the ability to analyze market data and input trade parameters into its automated trading system, which then monitors forex prices and executes the trade as soon as those parameters are met.
Another key driver will be the growth of trade and investment in the BRICs—Brazil, Russia, India, and China. Now that Russia’s currency is convertible, and with India and China heading in that direction, the expectation is that the most rapid growth in forex trading will be outside the mature economies of Europe, North America, and Japan. The total size of the forex market, currently estimated at around $3 trillion in turnover per day, is forecast to grow to $4 to $5 trillion over the next three years. Forex futures trading is also booming on exchanges such as Brazil’s BM&F and Japan’s TFX. The CME is the only one of the big four futures exchanges with a stake in the game.Will the other futures exchanges take a look?