Recent research from TowerGroup* has highlighted many of the obvious contradictions in the FX market. TowerGroup senior analyst Tom Price points out that as the market grows, it has increasingly embraced electronic trading. Obviously this has resulted in a decrease in trading on the telephone but, as Price notes, voice communication is still commonly used in emerging market dealing, which is very much expanding.
Price observes that the market has certainly leant towards greater electronic trading and that competition has encouraged fragmentation. This is much the same as what happened with US equities in the 1990s. He asks the question, however, whether the fragmented marketplace can survive.
What has happened, says Price, is that different portals have been able to carve out niche roles. But he asks whether the various portals will remain viable as the market becomes increasingly commoditized. Again using US equities as an example, Price asks whether it is now time for the FX market to consolidate. “TowerGroup believes that the FX marketplace is maturing and that consolidation of FX execution venues will occur over the next two to three years. When markets mature, the number of execution venues contracts. For evidence, we need only look at the equity markets,” says Price.
Although there is no doubt that US equity markets did fragment as a result of competition, which also happened in FX as a result of technology, Price does state that developments in one market should not necessarily be taken as proof of what will happen in another. The FX market, he says, is already far more efficient than equities, especially in terms of volumes traded and spreads quoted. Therefore, it is inevitable that the FX market’s future path will follow a different route to US equities, even if there are lessons to be learnt from that market.
Price does not mention the fact that there is a sense in Europe that the looming implementation of the Markets in Financial Instruments Directive will lead to a fundamental restructuring. Specifically, European equity players believe the market is about to fragment. So whereas not so long ago many would have predicted that the FX market would pool to resemble equity, there is now a growing belief that equity will fragment to resemble FX. The size of the market, together with the narrowness of bid-offer spreads, should make it obvious to all that FX is a far more efficient marketplace than equity. So perhaps FX should be held up as the template for what an efficient market looks like.
It is clear that the major players will continue to back every new venture that is touted. Also, technology can help in pooling liquidity. As Price highlighted, there are numerous contradictions about the FX market. But ultimately, the market will take its own course. The problem participants have is trying to work out what that will be.
*Foreign Exchange: Libretto for a Night at the Opera (Products, Traders, Methods, Motivations)
Electronic Foreign Exchange: Tip Sheet for a Day at the Races (Handicapping the Execution Venues)
