"EBS [Electronic Broking Service] is an unfortunate thing," says the chief spot trader at one important market-making bank. "Too much information is being given to the market."
EBS was set up in 1992 by a consortium of 13 banks headed by Citibank when it seemed that Reuters would gain a stranglehold on foreign exchange dealing technology. To that extent, EBS has succeeded. There are still more Reuters screens offering electronic brokerage than EBS screens, but at the major banks, EBS has become shorthand for "electronic brokerage", just as "Reuters" is synonymous with "trading-room screen".
So why the discontent? The refrain is the same from bond, equity, loan and derivatives markets: liquidity, transparency and turnover are going up; but margins, fees, bid-offer spreads and profitability are falling.
Dollar/Deutschmark bid-offer spreads have tumbled from five-hundredths of a pfennig two or three years ago to two-hundredths of a pfennig now. The number of active players quoting continuous two-way prices has fallen to fewer than 15. Big banks now have to trade up to $1 billion at a time, in a market with a daily turnover of $1.2 trillion in the global forex markets.
Price-takers
Both Reuters and EBS offer electronic brokerage, a trading system in which banks and brokers deal over screens displaying the best available bid and offer prices in a number of different currency pairs. Either price can be hit at the touch of a button and a ticket is printed automatically. Trading currencies electronically has brought much greater transparency: even end-customers now have a clear insight into market conditions. It also enables smaller banks to deal directly with each other, bypassing both the voice brokers and the big banks.
This new form of dealing is particularly useful in metro business (tickets of less than $5 million), a section of the market in which many voice brokers, at one time, refused to deal at all. The small ticket end of the market is where electronic brokerage has made most impact. The average ticket size on EBS is $3.6 million and it is smaller still on the Reuters system, Dealing 2000-2.
This helps to explain why electronic brokerage has had the curious effect of shrinking both liquidity and margins. Liquidity is more than high turnover; it means ready access to large amounts of money at two-way prices on demand. Traditionally, metro business provided liquidity for larger banks and voice brokers which could charge larger margins to do the deals. Now small banks have become price-takers, thereby draining liquidity out of the market.
The fact is that, as one trader puts it, "Reuters and EBS are just another couple of brokers". He points to a difficulty with serious implications: "Now you put deals into the system only when you want to trade. It's order-driven, not market-maker-driven. Only the biggest banks continuously quote two-way prices any more. The rest are price-takers, not providers of liquidity."
Another trader argues that "electronic systems will never be as good as a broker continuously shouting prices". During periods of high activity, he says, traders just won't have the time to enter their prices into the system.
Volatility
"Electronic brokerage has been around for a couple of years, and has led to a continuation of a trend in the market to concentrate liquidity and power with a small number of institutions," adds Nick Beecroft, head of foreign exchange at Deutsche Morgan Grenfell in London. "This has led to a reduction of liquidity when it comes to handling large amounts."
"Liquidity means access to prices on demand - a buy and a sell price. A lot of smaller players don't bother to post two-way prices any more," Beecroft argues. "They no longer have an interest or a need to do so. Electronic brokerage has removed the lower layers which used to act as the lubrication of the forex market. This means that the larger banks are more able to move markets."
That's not as large a problem as it seems: it is mitigated by the fact that the voice brokers are now obliged to quote lower bid-offer spreads and this probably offsets the slight reduction in liquidity. The real dilemma is what happens when the markets go wild and there no longer is a sufficient number of voice brokers to cope.
"When the market is busy," says Beecroft, "prices tend to disappear from the electronic brokerage systems. So at the very time that you need a two-way price, there are fewer people around who will make one."
So when the market breaks down it is even more likely to create volatility. Some traders reluctantly agree that there is possibly more volatility in the normal intraday market, but it is not particularly significant.
Beecroft believes that the new development really moving the markets is the rise in exotic options, especially knock-ins and knock-outs. "Option bookrunners often face the need to enter into very large hedge trades," he says, and this can move markets when quite a few mature at the same time.
Reuters began with Dealing 2000-1, its conversational forex dealing system; indeed, Reuters now has a monopoly in electronic conversational dealing. David Silverman, an executive vice-president in charge of transaction products at Reuters, is enthusiastic about the way that his systems have changed the market. Traders call each other electronically, conduct a typed conversation in English, agree a price and receive a ticket produced automatically by the computer. An interrupt button can call off the deal at any point until it is struck: this avoids the difficulty which sometimes arises during voice conversation when one person finalizes the deal at the same time as the other calls it off. Moreover, traders can conduct several trades at once.
"[Dealing 2000-1] is the de facto standard," says Silverman. "I see a long history and a long future for it. There are 1.5 million conversations every week, the dealers get to maintain personal contact with each other, it's possible to structure quite complicated deals and everyone uses it: small banks can join in with the big boys very easily."
Dealing 2000-2, which has a half-share of the electronic trading market, has been installed on about 4,500 desks worldwide, while EBS is on around 1,500. These systems have changed the way that forex traders work: they now get as much information through their eyes as through their ears. Dealers say it took a while to get used to the new method of dealing, but now they are all happy to work with computers.
"Electronic brokerage was not dependent on breakthrough technology," says EBS chairman Peter Bartko. "It's actually old technology. What made electronic brokerage take off was that the dealers' attitudes changed. They were willing to try something new."
But there's a difference between giving traders a new method of dealing and actually changing the market. While some of the smaller voice brokers are finding life more difficult, the sea-change which had been expected has failed to materialize. "We expected our ticket sizes to be larger than they have been," says Bartko.
EBS has carved itself out a niche in the Deutschmark/French franc market. Since the EBS price can generally be considered as the market price, there's no reason then, in theory, why simple arbitrage in the forex market should not be completely automated.
Banks with very large positions to unload still prefer the relative confidentiality and strong relationships which they have built up with market-makers. They reason that, if you try to sell $500 million in $5 million and $10 million chunks on the electronic systems, the rest of the world will realize very quickly what you are up to.
Some traders spend all day looking at very liquid currency pairs - dollar/Deutschmark, Deutschmark/yen and yen/dollar, or the dollar/Deutschmark/sterling trio. Their job is to monitor fluctuations in quoted prices, looking for one-hundredth-of-a-cent arbitrage in one of the crosses.
Automated trading
This is not done for less liquid crosses, which are generally quoted off the prevailing market rates to either the dollar or the Deutschmark. The peseta/Ecu cross, for instance, is just derived from the Deutschmark/peseta and Deutschmark/Ecu rates. It will never be so much out of line with them that the difference will exceed the two bid-offer spreads.
So why employ a trader at all? A computer is capable of monitoring the market feeds. When it identifies an arbitrage opportunity, the machine could conduct the relevant trades itself, without the assistance of a highly-paid human. Yet both traders and the electronic brokers are adamant that this will never happen. "We do not allow machines to deal with each other," says EBS's Bartko. "It's got to be a person." Traders dismiss the possibility out of hand: the arbitrage opportunities occur only very briefly, with one of numerous other banks and brokers, as well as the electronic systems. Completely automated trading is still science fiction.
Electronic brokerage has made the markets more transparent and accessible. High volumes, low volatility (only 1.5% in the Deutschmark/French franc cross) and the emergence of ever-bigger market players, such as Chase-Chemical, which concentrate liquidity into ever-fewer hands has meant lower bid-offer spreads, changing relationships between the leading forex banks and fewer voice brokers.
It sounds like the same story that is heard in every market - but with a twist. The next time the hedge funds decide to hit Europe, or any major currency takes a dive, there will be fewer market-makers and voice brokers able to keep the market liquid. The market's ability to absorb exogenous shocks is being eroded. Compiled and written by Katharine Morton |