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July 2000

A true exchange for forex


Last year it was equities. Last winter it was bonds. Now this summer foreign exchange, by far the largest market, finally embraces e-commerce. Single-dealer platforms will still be needed, but might only account for 25% of the volume. The seven-bank consortium behind FXall.com has grabbed all the headlines this month, but it is already a year or more behind two independent ventures, and years behind State Street’s FX Connect, which since April has allowed other dealers on to the system. Why has it taken so long for forex bankers to accept the multi-bank approach, and what are the consequences of leaving it this late? Antony Currie investigates




Josh Levy never intended to be part of an uprising. He left his job as a currency trader at Goldman Sachs early last year to join Valhalla Forex, based just a few minutes' walk from his former employer, on the 15th floor of a building on downtown Broadway in New York.
The grandeur of its Wagnerian name belies its size: it is a small organization, specializing in proprietary trading in the forex spot markets, although it also dabbles in forwards.
Within weeks he had become exasperated with his dealers and market-makers. "We had good price discovery brokers so we knew within three pips where the price was," says Levy. "But the bid-ask quotes we were getting from the dealers were often quite far off the fair-market value. If the price was really 90-93 sometimes, especially in fast markets, we'd get prices which were four or five pips off the market, sometimes more."
Having worked at a broker-dealer, he ought, one might think, to have been better prepared.
For a start, Levy does not include Goldman in the group which so frustrated him. "I've been on the other side, but I also didn't think things should be as bad as they are. We saw widespread acute and chronic lack of service.
It was eating into our P&L."
Only equities investors tend to get much publicity with such complaints, although the execution costs of trading bonds is also coming under greater scrutiny. Somehow the foreign exchange market tends to be forgotten,which is surprising given that it is by far the largest of the three. On average $1.5 trillion is traded in foreign currency each day, which some estimates put at seven times the combined size of the debt and equity markets. Quoted prices can change 20 times in the space of a minute, the most active rates up to 18,000 times a day.
And yet the telephone and human intervention are the primary tools for doing business.
Despite the introduction of systems such as Reuters and the electronic broker system (EBS) into the inter-dealer market in the early 1990s, the broker-client relationship saw virtually no technological advances and had to rely on the inefficient method of telephone trading in a fragmented, unregulated, rapidly-changing market until very recently.
Furthermore, despite having the word "exchange" in its title, the foreign exchange market bears none of the hallmarks of an exchange-trading environment. It is the least regulated and policed market, even by over-the-counter market standards, and lacks a coherent fee structure, which leaves customers at the whim of their liquidity providers. "Making money off the customer is the name of the game," says Levy. "Reading and anticipating customer strategies before they deal, front running orders, using customer limit orders as free options for the market-maker, and running stop-loss orders prematurely for profit, all are commonplace to a dealer/market-maker in forex trading. The SEC and CFTC have put exchange-traded futures brokers and equity broker-dealers in jail for less."
In their more candid moments the bankers will admit this, although only off the record. "We'd be more than happy to have formal fee structure put in place," says a banker who works in e-forex at one of the leading banks. "We do have a fee structure of sorts, and that is to lie to our clients," he continues with a wry smile.
And the foreign exchange desks can be big money spinners for the banks: in the mid-1990s, for example, Citibank was making 30% or more of its profits from that division.
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Little wonder, then, that the banks have hardly been quick off the mark to extend the transparency and greater efficiency afforded by EBS to their clients. Not even JP Morgan, one of the more active of banks in the e-commerce arena, has forged ahead in the forex market. LabMorgan has been the incubator of several of the more innovative ideas, such as the multi-bank bond platform MarketAxess, but not in forex, even though the second-in-command (and the man who has run it since last year, before Nick Rohatyn was put in charge) is Thorkild Juncker, previously the JP Morgan's head of foreign exchange.
The banks will provide reasons for forex lagging behind in adopting e-commerce solutions. One of the more cogent arguments is put forward by Paul Thrush, head of foreign exchange at Barclays Capital. "Banks have followed a huge range of different strategies with foreign exchange. Some regard it as an extension of research, some as a more efficient clearing and settlement process that sharpens price discovery. There's never been a common view on how to use the product."
Most banks had in any case been concentrating on developing their own platforms, whether closed-system or web-based. Again, though, this is on the whole more beneficial to the banks, allowing them to cut costs by transferring on-line what they have done over the phone for years.Few try to address fee structures or market manipulation.
Another reason is that the overall service structure of foreign exchange is so different to other markets. "Fixed income has been driven heavily by competition over research," says Lars Olesen, e-commerce manager for Citigroup's global foreign exchange group. "The idea of co-mingling the research and the pricing on a multi-bank site fits well in that market where pricing is more transparent. It's just not been a theme in forex."
Then the arguments get more flimsy - it was a Y2K issue, say some, despite the fact that several initiatives in debt and equity were announced last year, and a slew of debt initiatives early this year. Or they claim that clients don't want it. Internet delivery only ranks eighth in order of priority for customers in Euromoney's forex survey last May. True, but clients consistently demand good pricing, execution and processing from their brokers, something which the internet and other electronically-provided systems can, if done well, improve upon. What is true, of course, is that for many investors and traders the internet is still not fast enough, and security worries still persist.
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