A JOURNEY BACK five years to Euromoney’s 2002 foreign exchange poll (May 2002) shows that we identified a dominant theme of market consolidation then. We suggested that the market appeared set for domination by just five banks – much as today – and that consolidation was supposedly going to lead to a reduction in the number of trading venues, possibly to the extent that activity would become concentrated on just one. We wrote: “There’s no doubt that barriers to entry are rising in forex. To be a top-10 player in the market requires not only expertise and global presence but also good technology.”
Five years on it’s apparent that our judgement was both true and false. Technology and a global presence do play a key role in maintaining a position in the top 10. But technology has also allowed the entry of new players to the market – specifically those established to service the increasingly important retail sector – often on a virtual global basis. It has also attracted participants from other asset classes, not all of which are welcome, that have found it easy to access an efficient, transparent and extremely liquid market. The result is a market that has boomed, particularly in terms of volume – paradoxically, perhaps, at a time when volatility has seemingly been on a never-ending downward path.
Five years ago few would have predicted the increase in volumes. Back then, FX was emerging from a period when not too many outside the industry defined it as an asset class. To many, it was a mere sideshow, something bolted on to cross-border trades in other instruments, such as bonds and equities. Merger activity had removed several active participants from the market, and structural changes, such as the creation of the euro, had resulted in a severe decline in volumes. According to the Bank for International Settlements, average daily spot volume fell by almost a third between April 1998 and 2001.
A year later, there was more optimism. It seems that much of this was based on the early success of e-commerce. What was not anticipated was just how much this would facilitate market entry to previously untapped and unserviced sectors and the impact this ease of access would have, even if there did seem to be some tacit awareness that something was about to happen.
“We’ve achieved great strides towards offering clients a more holistic approach to foreign exchange, and they’ve rewarded us with a greater share of their business,” said Jim Turley, Deutsche Bank’s global head of FX at the time. “If we can achieve what we think we can, we’ll be in uncharted territory,” he predicted.
Fabian Shey, who is now global head of FX distribution at UBS, showed similar prescience. “We’re building a strategy about how to bring services to client types at the right price,” he said. “We need to know how to price and brand appropriately, and how to meet the demand of each client segment.”
At various stages over the past five years, the sell-side liquidity providers have struggled to do this and this has created tensions. Now, though, it appears they are once again largely on top of the situation. Moreover, the idea of market segments is now an accepted concept. So the market has not consolidated. It has remained segmented. Fragmentation often implied market inefficiency. Segmentation suggests that the market is sufficiently mature and liquid, and sufficiently technologically advanced, to cater for the vastly different needs of its many participants.
As a result, it can no longer be taken as a given that there will be a reduction in trading platforms and venues, even if many are still predicting it this year following State Street’s acquisition of Currenex. Just five years ago, the collapse of Atriax – despite its big backers – was widely believed to herald the same thing.
So looking ahead, how will the FX market develop in the next five years? Obviously, nobody can really be sure. “Five years is right in the middle between somewhat predictable and totally unpredictable, as defined by Bill Gates’ famous saying. And I think we are too far down the axis to really be able to make a qualified prediction,” cautions Saxo Bank’s chief executive, Lars Seier Christensen.
Despite that judgement, there are obvious questions that participants from across the spectrum want to see answered, including:
• Will volume growth continue at the same rate?
• Will the retail sector become an increasingly important area?
• Will there be an increase in regulation, especially if the retail sector continues to expand and in the post-Mifid environment?
• Can FX be successfully delivered as a single-asset solution, or is multi-asset the way forward?
• With the reported growth in programme and algorithmic trading, is there still room for the human trader?
• Will there be a reduction in trading venues?
• Is there a need for a central counterparty (CCP) in FX?
• Will options ever really trade electronically?
Volume growth still predicted
It seems that most industry participants are in agreement that volumes will continue to expand, although perhaps not at the same rate as in the past. “The infrastructure drive across the industry is geared towards sustained and growing volumes, so, yes, we expect volumes to continue to increase, both as FX is increasingly recognized as an asset class in its own right and as volumes continue to consolidate into the top tier,” says Ivan Ritossa, global head of FX and head of Asian trading at Barclays Capital.
Richard Leighton, global head of FX at Standard Chartered, agrees that volumes will keep on rising, driven by a wide variety of sources. “We certainly expect volumes to continue to grow in the next few years albeit at a slightly slower pace,” he says. “The combination of continued significant growth in global trade flows with new trade corridors developing between Asia and Africa, for example, combined with deregulation trends in the emerging power economies in Asia and the growth of institutional investor flows in the Gulf will result in significant growth in retail, institutional and corporate FX flows, not only in G10 currencies but increasingly in the currencies of Asia and the Gulf in particular.”
Andrew Brown, global head of FX at HSBC, also reckons that there will be growth at a reduced rate. “The current rate of growth is probably above trend and reflects the recent increases in the number of participants, especially the leveraged retail and the hedge fund clients who are using FX increasingly as an asset class in its own right,” he says. “The volume drop in 2001 due to the structural changes of the market have now been absorbed and the new entrants are taking full advantage of the electronic tools that have increased transparency and access to the markets in a way that has not been seen before… These new entrants seem likely to support the volume growth for a while although the rate of increase may decline,” he says.
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“The current rate of growth is probably above trend and reflects the recent increases in the number of participants, especially the leveraged retail and the hedge fund clients who are using FX increasingly as an asset class in its own right” Andrew Brown, HSBC |
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Like Leighton, Brown predicts that more business will flow from emerging markets. “HSBC’s experience within the emerging market space suggests there will be continued growth in this sector going forward,” he adds. As well as flow from emerging markets, there is little doubt that the retail market will also grow in importance. “Retail means different things to different people,” says Zar Amrolia, global head of FX at Deutsche Bank. It varies, he says, “from self-directed online trading, through to individuals trading with a private bank and to the ultra-high-net-worth individual trading via family offices. This flow originates from the retail sector but arrives to the market via different channels. We therefore believe retail flow is a significant percentage of our daily volume now, and in the future.”
UBS’s Shey shares these sentiments. “It is difficult to say how much FX business originates from the retail clients. In studying the turnover coming from banks and intermediaries that have a focus on the retail sector, however, both the growth rates and the absolute volumes are impressive,” he says.
Alluding to how technology has helped companies emerge to capture this flow, Shey adds: “The most successful retail intermediaries have leveraged best practices to reach efficiency levels that far surpass those of most traditional banks.”
Not surprisingly, the retail aggregators are in full agreement with the notion that their target sector will continue to grow. “We are definitely just scratching the surface in the private investor and asset manager space, both of which will grow in importance, not necessarily in relative volume, but in relative profitability,” says Saxo’s Christensen.
Greater regulation looms
One potential consequence of growing retail participation in FX is more extensive regulation. For most market participants, this seems not that much of a concern, possibly because on the whole the industry has done a remarkably good job of regulating itself. “The current FX construct of best practice aligned with geographic regulatory overlay has produced one of the most efficient and transparent financial markets and so it not obvious that the expansion of a new market segment will automatically lead to an increase in regulatory requirements,” says Barclays’ Ritossa. “However, we believe the regulators will be closely monitoring events and developments in the market and if we see a significant increase in the incidence of client/bank disputes then the regulators may look to review practices, though probably through the already established channels such as the [Bank of England’s] Joint Standing Committee.”
HSBC’s Brown thinks more regulation is almost inevitable. “An increase in regulation to cover the retail client seems likely as more countries come on line and also as a result of the anticipated growth in leveraged retail trading. This is a client segment which will demand a different sort of regulation and control which is in turn also likely to determine the ultimate pricing for this marketplace,” he says.
Amrolia believes this might actually lead to even greater participation in the market. “We would welcome this [regulation] as it would probably attract more users,” he says. “We are just not sure how it would be done.”
Multi-asset offerings not crucial
How important it will be to deliver FX as part of a multi-asset class solution is less clear. “This is still very important. Investment products incorporating multi-factor variables are increasingly popular with investors,” says Chris Mandell, global head of FX at Bank of America.
As a result, niche players will have to consider carefully what they deliver. “It will be important for them to focus on products, clients and trading styles where they have unique insight and access,” she says.
But while Deutsche’s Amrolia agrees that there is a growing demand for multi-asset solutions, he does not feel it is the be all and end all that some are predicting. “Regardless of the fact that FX is now an asset class in its own right, it has become more important to deliver it as part of a multi-asset solution, but it is not the most critical factor,” he says. “For example, a margined client now expects cross-product margining and is therefore likely to demand a cross-product platform too.”
He continues: “As long as niche players can provide value-added services there will always be a need for them. It may also mean that if they do not have the capabilities to offer their clients a technological solution, they may well look to partner with an institution that has a proven track record in that field.”
David Ogg, head of Lava FX, says there will still be plenty of room for single-product providers. However, he adds: “As clients focus their executions in fewer and fewer hands internally, the demand will grow for multi-product platforms. Companies that offer more than one product provide an environment in which clients can, and often do, cross-pollinate on to their other platforms. It is likely that the single-asset platforms of today will, over time, add products as they search for additional sources of revenue.”
Drew Niv, chief executive of Forex Capital Markets (FXCM), who views the market from two perspectives – that of a retail and wholesale aggregator – says: “I believe [single-asset platforms can survive], as at the end most users have fairly simple end user goals that can be met with single-dealer platforms.”
HSBC’s Brown is not alone in pointing out that many institutional clients might not necessarily regard a multi-asset solution as a must-have FX offering. “For the professional investor and wholesale marketplaces, where more complicated products are constantly being evolved, this is likely to be less important, as asset class specialization will continue and the product depth continues to develop,” he says. “The smaller, niche players will be able to solve this quite easily by linking up with the larger market makers to offer second-hand liquidity where it makes sense.”
Again it seems that flexibility will be the key. There might be an increase in multi-asset solutions for those who want it but even niche FX specialists will have a role to play. If they have to, they will source other assets from partners. But this might put them at a competitive disadvantage. “Single-asset platforms will survive, not thrive. Speculators, especially those who employ algorithmic trading, will gravitate to the multi-asset platforms over time,” says Mark Galant, chief executive of Gain Capital
The dealer’s demise is exaggerated
Much has been made about the impact that programme and algorithmic trading will have on FX. Here, it seems that market participants are looking at what has occurred in the equity markets but perhaps not altogether appreciating that the two markets are fundamentally different. However, there seems to be absolute consensus that reports of the imminent demise of the human dealer have been exaggerated.
“We definitely still see room for humans within FX trading,” says UBS’s Shey. “Program/algorithmic trading and the technology employed to make these strategies work have various uses within FX trading. Models are used to achieve efficient execution under specific market conditions, to generate revenue using high-frequency trading and to provide valuable information for pricing models. Program/algorithmic trading is thus not there to replace the human trader; it is empowering human traders to run and manage models based on observations over time, it is enabling the buy side to explore different trading strategies and it is giving the sell side the opportunity to provide a more complete offering to clients. At UBS our traders use the technology to their advantage but still manage flow manually where appropriate since we continue to see benefits from human trading.”
Deutsche’s Amrolia draws an analogy with fishing: “There are those ‘new traders’ who are more technologically advanced than ‘traditional traders’ and can develop black-box algorithms to market make and clear risk. They are essentially doing the same job, just with more analytical tools. To use a fishing analogy, people used to fish with a rod [of information]; now they fish with giant nets, but they are still fishing,” he says.
But there is no doubt that it will be a tougher environment. “The second, more traditional type of FX trader needs to be able to offer alpha to his client or firm to survive in the FX market of today,” Amrolia adds. “It could be his extensive market experience, it could be his superior trade execution or it could be his ability to link and extract value from multiple aspects of the markets that means he can add true value in the FX market. To refer back to the fishing analogy, the new traders may have the big nets but the traditional traders know where to fish.”
On the issue of platform consolidation, there is no shortage of clues from the past and the present. Six years ago, Atriax was advertising heavily ahead of its launch. “Welcome to the new, open, electronic FX market,” it proclaimed in an advert in Euromoney in May 2001. Just a year later, Atriax was gone, despite its big backers. To say there is an obvious similarity with the recent launch of FXMarketSpace is trite, but apposite nonetheless.
What is clear is that people are no longer talking about the absolute inevitability of platform consolidation and the emergence of just one or two liquidity sources. However, while trading venues have benefited from the increase in volumes – the pie, it seems, is big enough to provide a decent meal – some of the reasons touted for consolidation not having happened might actually make it more likely to happen over the next five years than people think.
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“None of these companies has generated anything resembling market ROI to their investors. There are other more rational fools out there, mainly large FX banks, who want to keep an oversupplied market of platforms so none gains real pricing power” Drew Niv, FXCM |
“The answer overlooked by many is that the easy-money trend that has propped up the tech sector worldwide in general through venture capital and private equity investments has also artificially propped up many FX platforms,” says FXCM’s Niv. “The truth for most is that they cannot ever hope to make revenues or profits that would ever generate rational ROI [return on investment] for their investors. In an easy-money environment, foolish investors are propped up by even greater fools who come and invest or buy these tech companies at even higher valuations, creating the impression that these companies are thriving and have very durable business models. FXall, Cognotec, Hotspot and many more that are still alive are only alive due to the succession of ever greater fools lured to invest in the next greatest thing.” Niv continues: “None of these companies has generated anything resembling market ROI to their investors. There are other more rational fools out there, mainly large FX banks, who rationally want to keep an oversupplied market of platforms so none gains real pricing power.”
Gain’s Galant makes similar points. “I think many of the firms are holding out, shooting for the brass ring,” he says. “They have achieved solid growth for the past several years and believe that FX volumes will continue to grow at a pretty fast pace over the next few years. They look at the P/Es of firms like ICE [InterContinentalExchange] or the valuation that Currenex received from State Street, and are holding out for a similar pay day.”
Even where there is a degree of logic in a platform merger, it might make more sense to let one potential constituent of a merger wither and die, as was the case with Atriax. Saxo’s Christensen says: “Most deals consist of technology, distribution and earnings components. In most cases, merging two technology platforms will lead to the virtual scrapping of the technology of one of the parties, and then the deal is too expensive when you look at what remains. That is also why the deals you have seen have been companies looking to buy the whole package, not buyers that already have strong technology.”
So what would happen if FX volumes were to decline? The implication is that many platforms would soon go bust.
“We are still in a growth phase, so we will not see significant platform consolidation until volumes begin to plateau,” says Derek Sammann, managing director, FX products at the Chicago Mercantile Exchange (CME). “We will see new entrants incorporating new differentiating factors to their platforms, which the market will weed out over time. But we are not yet at a point where all business models have been yet fully tested, so we will not see significant consolidation until this happens.”
Chip Lowry, senior managing director at State Street’s Global Link, points out that lack of standardization is another barrier to consolidation. “For consolidation to happen you need standards,” he says. “Standard protocols, standard market participants, standard market structures. We see the beginnings of those standards taking shape, but just the beginnings.”
Discussions with buy-side participants substantiate these comments. One corporate treasurer will deal differently to another, let alone compared with a hedge fund trader. Some will prefer single-bank portals, others multi-bank, where some want to access markets directly.
“Single-bank portals do not interest us at all,” says a corporate treasurer. “We presently use FXall, which, when it works, is perfect for our needs. Unfortunately, FXall is not very reliable.”
By contrast, a trader at a large hedge fund says he prefers dealing on single-bank platforms. “Both types of liquidity platforms can be good, but single banks generally provide deeper liquidity in non-mainstream pairs and don’t have brokerage and other charges. Also, few direct liquidity platforms handle forward dates,” he says.
Another fund manager makes similar points. “Our current requirements are best served by using single-bank portals, as the choice of FX crosses on liquidity platforms can be limited. If we were doing fewer crosses and larger amount we would feel more comfortable with a multi-bank platform.”
He adds: “We are happy with our sell-side institutions and some relations go back 10 years or more. However the world is changing and my feeling is that old-established relationships counts for much less today than a few years ago.”
To CCP or not to CCP
There seems no overwhelming desire to make use of a central counterparty in the FX market, even if credit has become a greater issue following the collapse of Refco in October 2005. The banks, which undoubtedly wield huge power in the market, seem largely underwhelmed by the notion.
“In an increasingly fragmented and potentially cross-asset market the case for a CCP is diluted whereas the case for cross-platform/asset PB [prime brokerage] services strengthens,” is the blunt view of Royal Bank of Scotland.
HSBC’s Brown is more circumspect. “This seems a hard one to justify in advance but it is, however, a thoroughly healthy aspect of the marketplace that new ideas are given a chance to develop, which may attract significant volumes and critical mass. The idea has been around for some time now and it is inevitable that the idea will be tested a number of times to determine ultimate acceptance. This kind of experimentation is the best scenario for all participants, both on the sell side and the buy side. There are undoubtedly sectors of the marketplace that will find a central counterparty model useful and that will actively use it. The absolute ‘need’ for such a platform will only really be proven over time,” he says.
But FXCM’s Niv feels that the rise of the CME might drive the wider market to embrace a CCP. He says: “It is my opinion that to the detriment of the overall market the CME is likely to be a major victor here [a few years out]. It has a few major advantages that will allow it to crush many existing platforms. CME has a legally protected monopoly by virtue of its non-fungible internal clearing house, whereby all contracts bought at the CME must be sold at the CME. This gives it lots of captive flow that serves as a base to subsidize its war with other platforms.”
He adds: “CME has been able to grow exponentially in FX by taking all the truly predatory customers that the banks have blacklisted and kicked off their system. It is one of the only venues left for the big arb funds to trade in.”
Saxo’s Christensen also alludes to these players. “There are participants that are simply uninteresting – toxic, if you will. No one can meet that demand long term, because it means you should be willing to burn money continuously,” he says.
Perhaps the CME should be applauded for finding a way to allow these toxic players into the FX market without causing too many problems for the big liquidity providers. The CME’s growth has almost certainly outpaced most other venues over the past five years, to the point where it can easily claim to be the second-biggest source of liquidity in the market. If it were to maintain its volume expansion over the next five years, would this mean that the wider FX market was forced to embrace a CCP model wholeheartedly?
The answer is probably no, as even the CME’s Sammann admits, although not surprisingly he sees the proportion of business that will pass through a CCP as increasing. He says: “There will always be a need to cater to customers who can only operate in a regulated environment due to the increased safety and insurance provided in such an environment, so we see centrally cleared models sit alongside bilateral models in the global FX market. The market in five years’ time will likely have parity of volumes split between these two models, as opposed to a bias towards the bilateral model in today’s market. We will see fewer but bigger bilateral credit platforms alongside at least two exchange platforms, creating a hybrid FX market landscape,” he says.
Electronic options
Another area of change that is widely predicted is that currency options will become increasingly traded electronically. “UBS has been trading options electronically for some time, driven by both clients seeking alpha and clients looking to hedge FX exposures,” Shey says. “We expect migration towards electronic dealing to continue as electronic access to derivatives is increasingly embedded in risk management products and services.”
BoA’s Mandell agrees: “Electronic trading is already happening and I think demand for this will grow but there is some work to be done around standardization to accelerate development of the electronic space for these products.”
The often completely bespoke nature of options might hinder this process. “The market has to be commoditized to become electronic,” says Jack Jeffery, chief executive of Icap electronic broking. However, he adds: “I think there will be opportunities in the option markets and it is a space that has not been fully exploited.”
Former sell-side options trader Galant makes similar noises. “Options will become more and more commoditized and as they do they will increasingly become available electronically,” he says.
The CME’s Sammann, another former sell-side option trader, says: “FX options have been very slow to migrate to electronic execution but this is based more on ingrained cultural dealing practices than anything else. FX options now are where FX spot was eight years ago – commoditized, low-margin products that are ripe for migration to electronic execution. There is certainly enough technology to migrate vanilla FX options to an electronic execution venue. However, the more complex products will require the voice brokers to intervene in order to build interest and size in the non-standard and very exotic FX structures that are increasingly being transacted. Complex risks will reside in the voice-brokered world, while the vanilla and standardized FX options will [eventually] migrate to electronic execution.”
Standard Chartered’s Leighton says that a lack of real demand from the buy side for electronic options, as well as fears of being picked off on the sell side, has held back the move. “On the buy side, customer demand has been lower than expected. On the sell side, some providers have been reticent to commoditize a product with multiple price inputs after being negatively impacted by bad behaviour with one-dimensional spot price delivery,” he says. “But it will come, primarily with G7 vanillas. EM currencies, especially those that are pegged, and some exotic products do create some challenges but if there is standardized documentation, process and protocol then electronic trading is the natural outcome.”
The options market is reminiscent in some ways of spot five years ago. It would be easy to assume that electronic trading of options will remain the preserve of primarily the banks, because they will only publish their full volatility surfaces on their own proprietary platforms. A couple of big trading venues might also be able to gatecrash the market.
But technology is also enabling other, non-traditional players in the same way as it has in spot, as Saxo’s Christensen is swift to point out. “We already stream prices in dozens of currency pairs, so both in single- and multi-bank environments, it makes a lot of sense… the benefits from automatic pricing and trading of options will be bigger than spot, due to the partly manual pricing generally involved in options trading today,” he says.
Conclusion
It seems that most participants believe there is still room for the FX market to grow. Opinions differ on the rate of growth. Overall, there is widespread optimism in the industry. The retail sector is predicted to play a key role in driving this, which might lead to regulation by stealth.
Although there is some demand for multi-asset solutions, this is not seen as a prerequisite for success. It seems that this will be a service that is available to those who want it and technology would appear, as ever, to be a facilitator in its delivery, even for those that might not be active in a specific asset themselves.
The vision of the dealing room of the future consisting of a man, a dog and a computer still seems some way off. Over the next five years, FX is predicted to remain segmented, even if the concept of using a CCP grows. There are just too many different types of participants with too many different objectives to be catered for by a single platform, whether it is single- or multi-bank owned, or completely neutral, like an exchange.
As for FX options, there is a belief that these will at least partly move towards electronic platforms. However, their often completely bespoke nature means that the voice brokers in particular still have extremely important roles to play in price discovery that it is hard to see being eroded.
“I don’t see segmentation going away. Nor do I think segmentation means less open,” says Global Link’s Lowry. “Segmentation means providing the right set of tools to each set of market participants,” he says. “Five-year look-aheads are always dangerous. What I can say is that disclosed and undisclosed models will continue to exist. Exchange models, single-bank models, multi-bank models will all continue to exist. Credit-based and margin-based models will continue to exist. The role of algo trading will increase. There will be more types of participants in the market than there are today. The big question for me is what is the role of regulation in five years? The m-word (Mifid) still looms large. There are new participants acting in the market for disparate reasons, using different venues that offer different market structures. I doubt one venue, vendor or trading model can meet the demands of all participants.”
