The emergence of a clear bulge bracket in foreign exchange should raise questions for all participants in the industry. According to Euromoney’s 2007 FX poll, just five banks now account for around 61% of client activity. This is up sharply from even just a year ago, when the top five had a 54% market share. In 2002, it was around 45% and a decade ago it was less than 29%.
Such consolidation in a financial market intuitively seems unsustainable. It suggests that the smaller players will struggle to gain sufficient flow to run viable businesses, and that ultimately the bulge-bracket banks will find that they cannot get out of the positions they accumulate from their dominance of the market.
Clearly, though, most of the hundreds of banks that are active in foreign exchange outside of the bulge bracket are not offering the product as a giveaway service. In other words, decent profitability is not as dependent on market share as has frequently been suggested. A recent paper* by J Scott Armstrong, a marketing professor at the Wharton School of the University of Pennsylvania, suggests that too often businesses focus on beating their competitors and the measurement they use to judge success is market share. According to Armstrong, companies that focused on profit maximization instead posted stronger returns on investment than those whose only goal was market share.
Of course, the FX bulge bracket will argue that they are as focused on profitability and a return on investment as those outside the top five. Also, because of their dominance, they have the firepower gained from their market share to continue to invest heavily in a business that is increasingly described as an expensive arms race. But it would be interesting to see a table of who is generating the biggest return on investment in FX.
The question still remains of whether any bank can have too much market share. A decade ago, that might have been the case. Banks needed other, primarily bank, counterparties to offset the risk and flatten the positions they had accumulated as they went about their business. Part of this process would have been to use the brokers and there was still direct interbank dealing. In other words, banks were reliant on each other for the provision of liquidity.
Switch forward to the present and FX is starting to look like the new paradigm of financial markets. In FX, internalization, which has been much predicted as the coming thing in other markets, has already occurred. Market makers and those who distribute their prices, such as retail aggregators, are incredibly efficient at matching up buyers and sellers in house.
Daily turnover in spot is now probably averaging around $1 trillion. The volume transacted on the various portals that act as quasi-exchanges, such as EBS, Reuters, the CME and the likes of Currenex, FXall and others, accounts for less than half of this. These various middlemen might even account for less than a third of the spot market’s total flow.
This goes some way to explaining why many participants in FX simply no longer see the need to pool liquidity on to a single, highly liquid central marketplace.
The majority of the buy side seem content with the level of accessibility they have to the market. They have real choice about how they transact their business, whether done directly with a bank or through the proliferation of portals that exist; those that wish to make rather than take markets can easily do so, either on regulated exchanges or through the use of a prime brokerage arrangement.
What would call into question the viability of the market’s current structure would be a massive and sudden increase in volatility. If, and only if, this led to a severe decrease in two-way internal flow, which hindered the ability of risk takers to flatten their positions, the market would have to reconsider the issue.
This, for the moment, seems an unlikely outcome.
*Myth of market share: can focusing too much on the competition harm profitability?
