Exchanges: Donohue says CME is leading the market

The debate about whether or not the foreign exchange market will ever fully adopt an exchange-traded model has been raging for years. It is likely to continue, with proponents and detractors able to put forward good arguments why it will and why it won’t.

A frequent claim is that activity in the exchange-traded FX market is minuscule when compared with the over-the-counter environment. Ostensibly this appears to be true but a more complex, different picture lies underneath the bare figures.

According to the most recent Bank for International Settlements Triennial Central Bank Survey, overall daily activity in April 2004 in the OTC FX market totalled about $1.9 trillion. By contrast, notional volume at the Chicago Mercantile Exchange, by far the largest regulated FX marketplace, came in at just $17 billion a day during the same period, less than 1% of the total turnover. Since April 2004, the FX market has continued to post strong growth in turnover; daily activity now is thought to be in the region of $2.5 trillion. Although CME volumes have grown far faster than OTC volumes, the exchange still only accounts for about 2% of total market turnover. However, as most market participants are aware, the figures are misleading.

The CME’s main FX products are futures, which although effectively outright forwards are primarily used as proxies for spot. According to the BIS, spot accounts for about 30% of total FX turnover. Expressed this way, the CME has a market share of about 5.5%. However, again the figures are misleading since the big FX players seek effectively to internalize as much spot business as they can. What they do not match up spills out onto various execution platforms. Of these, the most important are the big two electronic brokers, EBS and Reuters. EBS handles about $125 billion a day, and Reuters about $50 billion. In such a context, it becomes plainly obvious that the CME should be regarded as the third major player in the spot FX broking space.

The CME’s chief executive, Craig Donohue, believes that the exchange is capturing market share because there is now a broader demand for an exchange-traded FX market. “We think we’re seeing some real underlying shifts in the foreign exchange market which are very favourable to the CME and the exchange model,” he says.

He continues: “Looking at data from institutions, such as the Bank of England and Bank for International Settlements, it seems clear to us that the dominance of the banks is decreasing in terms of the number of transactions that they are the counterparties to, relative to much more robust growth rates in the leveraged fund community, such as hedge funds and commodity trading advisers and asset managers. We think that is telling; it’s the leveraged funds in particular that tend to prefer the market model and the trading efficiencies, whether those are anonymity, immediacy of execution, straight-through processing or the central counterparty clearing guarantee and the more level credit playing field. We think that the growth we’re experiencing, which is disproportionate to most of the other interbank platforms, or dealer-to-client portals and ECNs, is just a reflection of those basic trends in the marketplace.”

As the OTC players continue to bicker among themselves about whether or not to open up fully the formerly wholesale-only platforms to all market participants, the CME has quietly got on with providing a marketplace where participants are not excluded because they have smarter trading programmes or poor credit. The CME’s faster growth rates suggest that it has, at least for the time being, hit on the better strategy.

“We’re beginning to see the actual evolution of the market confirming a lot of what we’ve been saying for a while,” says Donohue. “We’re not making the argument that there’s no value to an over-the-counter market – even in our own markets we have a variety of different market models, structures and trading dynamics. But we do believe that increasingly foreign exchange is a commoditized market and very amenable to an open access, anonymous, central order book market structure, with centralized clearing. I’m not trying to deny that there is competition [to the CME], with banks trying to deal bilaterally with clients rather than through an order book. The issue is how the market will adapt, not about we’re going to be winner take all. There are already changes in the marketplace that everyone has to respond to.”

The old, commonly expressed argument that it is cheaper to trade in the OTC market is dismissed by Donohue. “For the most part, people in these markets are focused on transaction costs, market impact or slippage costs,” he says. “I don’t think you can argue that exchange fees are in any way a significant percentage of the total cost. That is empirically demonstrable. I think there’s a real trade-off between the fragmentation of liquidity and the increase in liquidity costs versus the decrease in exchange fees. I think, on a net basis, the argument is in favour of a single, deep pool of liquidity. It is always going to present a more efficient market.”

Injurious to efficiency

Donohue believes that fears of a monopolistic situation if the FX market is pooled onto a single execution venue are overstated. “Look, there’s an oligopoly of five to six major bank players, out of all the hundreds actively involved in foreign exchange, dominating the interbank segment, as well as the dealer-to-client segment,” he says. “I can make an argument about how injurious that is to an efficient market. If we had 200 banks on an equal footing with the big six, wouldn’t that improve the efficiency of the market?”

Looking ahead, the CME’s expenditure on technology, which Donohue says has been a major factor in its success, leaves it well positioned to move forward strongly, especially as more bandwidth-intensive trading strategies and programmes are unveiled. “We’ve invested more than $1 billion in our technology over the last seven years. I think there are very few existing competitors who can compete with what we’ve done. The development and investment cycles are too long. You can’t do it in a year or two,” he says.

It remains to be seen whether the FX market will move to an exchange model or whether the CME will become the major spot FX trading venue. But for the moment, it looks well placed to capitalize on such a development.