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Foreign Exchange

Foreign exchange debate: If it ain’t broke, don’t fix it

In all the talk of regulation, the distinction between settlement risk and counterparty risk seems to have been blurred. The FX market survived the crisis best.

Foreign exchange debate part one: The illusion of normality? 

Foreign exchange debate: Learn more about the panelists


Executive summary

• The FX market is one of the great successes of the crisis

• Settlement risk, not counterparty risk, is the key issue and CCPs do not solve it

• More users should and will migrate to CLS

• There will be more ECNs and the market will be better for it

• Structured derivatives, while still valid, have become less popular

Simon Brady, Euromoney Clearly in this post-crisis world, there is much talk of regulating the OTC markets. Where are we in this process as regards FX and what needs to be done?

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HE, UBS It’s a hot topic. The FX industry has been involved in detailed discussions on this both under the auspices of the Bank of England FX Joint Standing Committee and in many other forums.

In 2008 we had the Icelandic crisis, we had banks failing, and many of us were personally having to manage counterparty risk on a day-to-day basis. This was a reminder of the core of the FX business, which is transferring very large amounts of money around the world and making sure both sides of the transaction settle. Yes, credit risk is important, but the most critical part of counterparty risk in FX is settlement risk – the exchange of principal on the day of settlement. If the counterparty fails before the day of settlement, you lose your mark-to-market P&L; however losing the entire face value of a trade due to a settlement failure is a completely different order of magnitude. FX settlement risk was one of the biggest systemic risks in the financial markets, which is why we all implemented CLS. And the system worked.

Settlement risk is key

The recent regulatory focus has been upon credit risk, which is what central counterparties (CCPs) address, not settlement risk. Our message, collectively as a market, is that CCPs do take care of some risks but that there is a danger that they distract us from the much more important job addressing the remaining significant settlement risk in the FX market. This is where the regulators should focus in FX.

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JWC, Record I agree. Speaking from the buy side, we are big fans and users of CLS and big users of netting agreements as you would expect. Clearly we would like to reduce residual mark-to-market credit risk through a CCP but only if we can do that without affecting spreads or liquidity or crucially the kind of flexibility that one gets in forwards on maturity date and size and so on.

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SF, Threadneedle The key point is that the FX market survived. There was no major central bank intervention during that period that I am aware of to stabilize the market. That is a testament of the market’s strength.

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FJ, SG Remember, we are not talking about the financial industry having to bear the cost. The people who will bear the cost of CCPs are the end users. When the regulator says, "I want a solution that minimizes risk", then we need to take into account the price – what the community and the economy is going to pay for these solutions. If regulators want a blanket solution for any type of OTC derivatives then they have to accept that such a solution will affect spreads and liquidity, and users will pay for that. These increases in costs feed through to affect trade, jobs, prices and so on. One has to consider the balance of risks and costs for the whole community.

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MW, Credit Suisse CLS is a great thing. Thanks to CLS we survived the crisis and thanks to CLS the FX industry was and is able to grow; without CLS today’s daily turnover would be impossible. However, only about 50% of daily global turnover is settled through CLS; what about the other 50%? That is where the effort should be made: to make more currencies CLS eligible, to have more banks becoming clearing members or third-party clearing members and so on. The single most important thing to do to reduce risks in the FX market is to make that 50% into 80%. That is the goal we should jointly work towards.

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DB, Deutsche The crisis would have been a lot worse if the banks had stopped doing FX with each other. A lot of people used FX to fund over the period of the Lehman bankruptcy. Without CLS the crisis would have been a lot, lot worse.

Instantaneous settlement?

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RO, Oanda Just to be provocative, CLS is just a halfway house and doesn’t really address the issue. If we think about it, the current way of settling precludes interest rates being paid at a shorter interval than overnight. The big issue is that to halt a currency in free fall one has to hike interest rates – one-day interest rates. If we had instantaneous settlement then it would be possible to hike the second-by-second interest rate and you could get markets to clear straightaway. What we have to remember is that almost 95% of the volume is intra-day. No-one pays interest because there is no instantaneous settlement. My proposal is let’s go for instantaneous settlement, with second-by-second interest rates.

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HE, UBS The consequence of that is that we would also need second-by-second cash management capability.


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DB, DeutscheAnd we need the banks to be open, because there are some banks that can’t pay non-US dollar amounts on US public holidays.


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RO, Oanda Yes, but the currency market is, if anything, a public service. The whole world depends on it and we cannot, because of a few hundred million dollars that have to be spent on IT technology, say we will not do it.

SB, Euromoney It is a bit utopian.

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HE, UBS It sounds utopian, but it is true. FX is different from other OTC markets, like the interest-rate markets and the credit default swap (CDS) markets, because so much flow goes through the FX market, which is fundamental to the economic working of the planet. If you look at some of the other markets like interest rate swaps (IRS), it is basically a discussion among 40 or 50 people across all the institutions. The FX market has hundreds of thousands of people who use the market day after day after day. If that breaks, everything breaks. From that perspective FX market efficiency is fundamental to the entire financial system.

SB, Euromoney Martin, what do you think of that?

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MW, Credit Suisse It is a very interesting point. One way or the other we have to evolve into that set-up in the future. I like the concept, but obviously there are a lot of question marks and technology has to be able to cope with second-by-second interest rate payments; we can hardly cope with two-day settlements, to be honest.

Boosting CLS

SB, Euromoney How do you get the other 50% of volumes into CLS?

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MW, Credit Suisse Two things: make more currencies eligible and simply have more banks using a CLS clearing system. There has been a big uptake ever since the crisis on third-party CLS member banks and that needs to continue.

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HE, UBS The number of accounts in CLS has gone up: it used to be a few hundred, now it is about 5,000 or more. All the big participants are now in and the buy side is being converted. It used to be the banks trying to persuade the buy side to join CLS and the buy side tending to believe that it was expensive and unnecessary. Now the buy side has seen that counterparty risk is real and it wants to be in CLS. The problem now is the thousands of other people in the market who may only do a few trades a day. That is a whole challenge by itself but it is a more important and difficult challenge than the CCP challenge the regulators are focusing on.

SB, Euromoney So what are the regulators saying at the moment? Have you come up with your carefully worded rebuttals of their desires for a CCP and what is their response?

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HE, UBS There has been a European process and there has been a US process. The US process has been to draft legislation first and then argue about it afterwards. The European approach, in contrast, has been to consult everybody first and then come up with legislation.

In the beginning it looked as if the European approach was going to produce a much more nuanced outcome because they looked at each asset class individually. They looked at the CDS market first and said, "everything onto CCP, because that is a systemic risk. Interest rate swaps: long-dated and significant credit risk – yes, probably on. FX – short dated and already has CLS, FX is not a problem."

In contrast the Americans initially said, "everything onto exchanges, everything onto CCPs". However, the Americans have now realized that it does not make sense to include the whole FX cash market in the new legislation, realizing that the issues we talked about are real issues and it would probably create many more problems than it solved. So the US will probably end up not mandating the use of CCPs for FX; that is the key thing.

However, the European Commission recently announced an intention to create a "paradigm shift" across all OTC markets, including FX. So the process continues.

Furthermore, people often confuse exchanges and CCPs and say, "put it all onto an exchange". They are two different things. Exchanges are execution venues, CCPs are post-trade clearing mechanisms. You can have either one without the other, or both, or neither.

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MW, Credit Suisse If you need evidence that the market is self-regulating then look at how many people are entering into CSAs [credit support annexes]. Before the crisis it took years to get an Isda CSA signed; now the buy side is coming to the banks to say, "how about a CSA?". That said, it still takes too long.

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PD, Shell We maintain a standard Isda across all our FX dealing banks. However it can still take a long time to get Isdas agreed.

SB, Euromoney I’ve heard two years. I’m still thinking that from the perspective of the regulator, everything you’ve said makes me more scared, not less, because you’re telling me we have an unregulated system at the heart of the global economy.

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HE, UBS: To repeat, the big ‘elephant’ risk in the FX market is still FX settlement risk and our priority should be to tackle all the remaining settlement risk that is not yet dealt with via CLS and other mechanisms. If instead we focus on taking that business which is already safely on CLS and additionally routing it through CCPs in search of relatively minor credit risk benefits, we distract ourselves from the much more important task. We tackle a mouse, not the elephant!

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DB, Deutsche Exactly. Counterparty risk is not a red herring – it still exists, but it is the mouse, it is not the elephant. And by the way, let’s say the CME is the only clearing house for FX. Are Europeans going to be happy? Are the Japanese? Are the Chinese going to be happy with all their counterparty risk being in one place in Chicago? That is a big issue that people are only just starting to think about now. It’s essentially about sovereignty over one’s currency.

No to single CCP

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JWC, Record Any network where there are multiple connections between centres is stronger than a network that only goes through one point; the internet demonstrates that. From an engineering perspective, if you like, a more disintermediated FX market has more routes for capital to find different homes than going through only one point.

SB, Euromoney Put it another way, you are OK with the idea of many CCPs; you’re not happy with just one.

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HE, UBS Obviously a CCP is a point of concentration risk because you can’t get rid of counterparty risk; you can shovel it around, or you can put it all in one place and that is what a CCP is. It concentrates counterparty risk and mutualizes it. Almost all the CCPs at the moment are for-profit companies and their business is to bring more volume onto the CCP. There is now beginning to be more talk about what happens if a CCP blows up. Clearly, the market that is using that CCP will blow up with it.

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MW, Credit Suisse Aren’t the current prime brokers in FX mini-CCPs? We have 15 FX prime brokers around the world; in a way they act as a central counterparty.

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HE, UBS It is a network.


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VC, HSBC In essence it is already there, but there is no multilateral netting. It is a mini CCP, but it doesn’t really get the same kind of risk mitigation that you would get in a CCP.

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HE, UBS Everyone assumes that if a major CCP came close to the brink the governments would step in and bail it out (although this could be a dangerous assumption). Why did the regulators start getting excited by CCPs? Because when AIG and others were on the point of failure, no one knew who had exposure to whom and what the knock on consequences would be. So the new theory is that at least with a CCP we would know all the exposures and would know that if we save the CCP we should save the wider community.

SB, Euromoney What does the buy side have to say about all this?

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SF, Threadneedle In some respects we don’t have a voice at that table. It comes down to what the regulators want to do to the banks. As far as I am aware we are not asked. It is important because ultimately it could impinge on our business and how we go about doing it. My view is that the FX market functioned very well even in the eye of the storm. You could get a price, you could trade and you could deal and I don’t recall any problems in that respect for us at all. That is the ultimate test and there are other areas that need to be fixed, like the credit market, not foreign exchange.

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FJ, SG A number of end-users have been vocal about CCPs, not specifically in FX, but in other markets, for example commodities. A number of non-financial corporations responded to the consultation from the European Union and pointed out that any move to CCPs is simply the transformation of counterparty risk to liquidity risk. How does an institution fund margin calls in the hundreds of millions of dollars or even in billions when you have the price of oil going from $30 to $150 and back to $30? In those kinds of markets the mark-to-market swings are huge and when you are hedging that risk and you have a bank counterparty that is not asking for collateral payment for margin, you can survive. With a CCP you have to pay and you can go bankrupt.

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PD, Shell Corporates are most concerned with the CCP creating a liquidity strain from exchange margin calls as a by-product of their normal hedging activity. I also doubt many corporates currently have the infrastructure – systems and staff – to handle the continual changes to margining required when dealing over an exchange. If the CCP proposals are introduced to include corporates there will be a big increase in the cost of managing hedge portfolios, which may deter some corporates from hedging – presumably not intended by the CCP proposal. If counterparty risk is a concern there are other ways for corporates to manage this risk, such as adjusting credit limits or using CSAs. On the CLS side, it is interesting you were saying that lots more corporates are signing up to it. We had a look at that over a year ago and we decided not to go with CLS mostly because of operational complexity. It doesn’t deal with same-day cash-book swaps, which for us are extremely large. We would have had two different settlement processes – one process for same-day swaps and another, for example, for spot FX. We decided at that time – that is pre-credit crunch – that CLS wasn’t the way to go. We are going to look at CLS again in 2010.

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DB, Deutsche That is part of Huw’s point too: don’t focus on the CCP, the big elephant is settlement; we should be working on getting that fixed and so you can do same day.

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PD, ShellIf you can do same-day FX, it will greatly simplify the introduction of CLS.


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DB, Deutsche CLS isn’t perfect, we all know that; it is very, very good – it just could be a whole lot better.


SB, Euromoney More generally are there regulatory risks to the market that concern you?

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HE, UBS One of the big risks in the current environment is one of deglobalization, which means that, for various reasons, trades done, for example, in Tokyo stop being completely fungible with trades done in the UK. We will have to start pricing in a basis between the different trades and this will increase the cost of doing business. That will really hurt.

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DB, Deutsche That is a potential issue and one of the things that worries me is that different countries will bring in very different types of regulation. That is a bad thing, as we were saying before, and for a great business that we would all like to see working at least six and a half days – I want Sunday afternoons off! – a week. Our market is open for 126 hours in a row and it is a great, global 24-hour platform that seemed to function very well over the course of the crisis last year. What scares me is some regulatory change, for political reasons.

The more platforms the better

SB, Euromoney What are your views on the existing proliferation of platforms?

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DB, Deutsche This is the question of does the market need more platforms and more trading venues? The answer is yes. I hate to think of everything all in one spot, because then if it does break we are in a lot of trouble. I like the idea of a more electronic, transparent marketplace, but the currency pairs where you have lots of different venues seem to have the best spreads and the currency pairs traded in one spot in one time zone have the widest spreads. As more and more markets move into this transparent, regulated state, we will see people adapt to it. As the FX markets went electronic, a lot of people did lose their jobs, but those that adapted quickly kept theirs and did a better job at it. Those that wanted to stay in the old mindset were the ones who lost their jobs. The environment over the next 24 months is going to be more transparent than at any other time in history.

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FJ, SG In terms of ECNs and e-commerce, this is a 10-year trend that will continue and accelerate. Ten years ago when you spoke to traders and sales people they were very concerned about e-commerce, thinking, "it’s going to take my job away and machines are going to trade and I am not going to speak to my clients; it is all going to go electronic and where is my value added?" What has happened instead is that sales people and traders have become more available for the transactions you can’t do automatically and that require value-added. It has been a fantastic change for the industry, for the users, for the banks and it is going to continue growing and help this market expand.

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JWC, Record On the voice-versus-ECN point, we have been relatively slow adopters of ECNs because of our fear, going back two or three years, that precisely when you need liquidity, in rapidly moving volatile markets, the first place from which banks would pull liquidity would be ECNs and the people who would keep it would be the people who maintained voice-to-voice relationships. We very much felt that served us well, particularly throughout the second half, particularly the last quarter of last year. We will obviously continue to see how that market evolves, but we are very cautious about giving up that voice-to-voice contact and the access that brings.

Derivatives decline

SB, Euromoney Let’s move on to more product-related market changes. Vincent, we’ve seen the disappearance of some types of derivative and some types of longer-dated structures; do you see those structures coming back or do you think there has been a deep-seated change in customers’ mentality?

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VC, HSBC The issue is not necessarily the products themselves, but rather a combination of the sheer size of the move during the crisis and the way some products have been used. Many corporate treasurers would have ended up in the same predicament if they had used simple forwards as opposed to target redemption forwards, for example. Mark-to-market volatility is really the big issue, not the products. Treasurers want to justify what they have done to their boards or to their CFO or CEO, so they are much more prudent in the way they approach things. There is a return to basics to some extent and buying options is more popular than it has ever been, at least in some parts of the world.

Some of the structures that have absolutely no link to the underlying commercial exposure will probably disappear. So there were forwards linked to CMS spreads that really have a very narrow application and I don’t think people will go back to that.

The classic structured forwards – and I include target redemption forwards in that – will come back. The volumes are down this year, but these are very valid hedging strategies, as long as they are explained. If they are leveraged, people need to take into account the leverage and what it means compared with the underlying exposure, particularly in the context of falling economic activity. The mark-to-market volatility of those structures has to be analysed pre-trade as opposed to justifying it post-trade.

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JWC, Record  On the view of simple products and sticking with simple products, as you were saying, that is consistent with how our processes are run today – we are very much spot and forward and even options are a relatively small part of what we do.

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RO, Oanda Which other ones do you think will persist and which ones disappear?


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VC, HSBC Anything that has a legitimate hedging purpose should persist. Take the target redemption forward, which had a bad press last year because of highly publicized cases in some parts of the world; this is quite a simple product. The problems start if you leverage it too much. But you don’t have to leverage it. And we have versions of the target redemption forward where your mark-to-market is capped. There is a future for those trades as well as the most simple foreign exchange structured forwards.

I see less of a future for structures that include elements unrelated to the actual underlying commercial exposure. For example, structures that incorporate a view on one asset class (for example, rates) to achieve an improvement in the FX hedging rate. Likewise, snowballs – which worsen your hedging rate as the market moves against you – are inappropriate for corporate hedging and unlikely to make a comeback.

We have seen a return to basics this past year, but I think structured forwards and structured products will come back as long as they are carefully and suitably tailored.

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FJ, SG I agree with Vincent. We will see far less of some products, such as snowballs, but the others make real sense and we simply need to ensure that people use them correctly and in a way that is matched to underlying exposures. Provided you have the right product for the right exposure and it is properly understood and the risks are disclosed for some users, not for Shell, but for some users, it makes a lot of sense and it brings a lot of value. What is key and again what this crisis has shown is it is essential that the user is told about the risks and understands them.

SB, Euromoney Paul, what’s your view on these types of hedging instruments?

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PD, Shell Banks still offer complex solutions to problems that I don’t have. I can’t see us going down the structured route for foreign exchange. We rarely use options. We see things as outright risk and execute FX positions based on market liquidity. Looking ahead I can see us internalizing more risks and putting better internal risk models in place. We look to maximize FX netting internally, which I can see growing next year to about half our flows.

Future trends

SB, Euromoney Finally, what developments do you predict for the next year or so and what do you think will be most important for you?

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PD, Shell We will definitely take a look at CLS if it can be rolled out to same-day deals. Most of the foreign exchange that we do is really very vanilla. We are a big user of e-trading, with most of our flows traded in this way.

Most of the flows are STP as well, so we don’t have to do much manual intervention. One of the things I personally would like to do more of is to focus on how we measure ourselves; are we doing a good job or not when we do our e-trading? We are looking to introduce a trade-weighted performance measurement rather than a point in time, which has been, historically, how we have done it.

SB, Euromoney What are you trying to get to there – just the cost of transaction?

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PD, Shell We’re looking at value-added from our FX banks and value those banks that give us daily input on market direction.

I also see us trialling different bank trading algorithms. We have been talking to some of the banks about various tools that can do this for us. It’s going to be interesting comparing one with the other; we will do a parallel run and see which bank solution is best.

SB, Euromoney To what end?

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PD, Shell  We don’t really want the bank to take risk when we do our dealing. I want the best prices I can possibly get and I am willing to accept volatility in the rates that we get. I know that over the year I’ll win on average so I am more focused on minimizing spread leakage than transferring risk to the banks.

Breaking FX positions into small trade amounts on e-trading platforms can be very efficient. We have 15 banks streaming FX prices on e-trading which gives us access to very deep liquidity in the FX market.

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JWC, Record On the product side a big development that we are pushing is to change the way that institutional investors look at currency. At the moment many investors see currency as a risk and in many cases it is a long-term, unrewarded risk and that can be removed efficiently. In some cases it is a risk that comes along with other activities and you expect it to be rewarded and you need to think about measuring and managing that. The big area where there has been some traction in the UK, albeit slightly tucked away in alternatives, is in the opportunities for return generation from currency strategies and understanding, as one should in any investment strategy, where that return is fundamentally coming from and who is paying for it and how sustainable is it and how correlated is it to other asset classes. That is something we have done a lot of work on over the last couple of years, both ourselves and with the FTSE Group in terms of currency indices. That is something we are looking to get more and more traction on in the coming years.

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MW, Credit Suisse One thing we haven’t discussed yet is how long will it take for volumes to recover. We have seen 20 years of growth in the global FX volumes measured by the BIS tri-annual survey. This year for the first time we will see a dip but after that growth will go straight back up. Why? Now performance in global equities means the asset base is back up to pre-crisis levels – not quite, but almost. Then global trade flows will normalize again; that is an important factor. Then volatility, which is now at more normal levels again means there will be, on a nominal basis, increased risk taking again from lots of players in the market. There will be more and more STP connections – straight-through processing where clients just hit a button and go straight into their risk management and position-keeping systems, letting traders and customers do more trading. Retail aggregators continue to mushroom in various places around the world, so there are reasons to be optimistic about the underlying industry – it will continue to grow.

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HE, UBS I see two mega-trends: technology and globalization. Technology is the one we have talked about and that technological trend is not going to go away. As people have said, we are still at early stages of the overall evolution of technology into the markets, especially FX, and I am sure we will be here in 10 years’ time, slightly greyer, still talking about FX but from a very different technology and market structure perspective.

Globalization has been the other major driver of the recent growth of the FX market, which means more personal and institutional balance sheets now have access to and are deployed in the FX market in some way. This trend might pause or even temporarily reverse given what is happening in the global economy and especially given what is happening in the regulatory environment, but it will only be a pause. The underlying trend is still going upwards.

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SF, Threadneedle I am quite optimistic about the foreign exchange business and I am positive in a sense that it can only grow, simply because I threw up the example of the Euro when it was first introduced, when a lot of people thought, "the Italian lira has gone, the funds are gone there, the Spanish peseta, etc." But something came along in emerging market currencies and the business has kept growing, so something else will come along too and that will be the Chinese renminbi and liquidity and investment instruments to trade will only improve. It is a curve that is sloping upwards and it will remain so. I am quite optimistic.

SB, Euromoney On the bright side the peseta and the lira will come back! They are there in bond land already – you can trade lira and drachma bonds right now.

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RO, Oanda I think one thing that will change is a reversion to the trend towards simple products. Simple products mean for me three types of products: liquidity, execution and investment products for people who want to invest, but simply. The black box stuff will go out, but what will come in are scientific products which you can open and put on the table – this is it, what it is going to be about.

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JWC, Record  I completely agree with that. As an industry we need to provide that justification for what we do and where the money comes from.

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RO, Oanda One thing where we have to be careful as an industry is if you look at the computer industry. We have completely underestimated the speed of change and the problem with the financial industry is that we are making exactly the same mistake. The mega-trend is technology, globalization and this will happen in a far bigger and stronger way than we would ever think possible. This is how I would like to wrap up: I would argue that instantaneous settlement is essential; second-by-second interest is essential because this introduces transparency which will allow volumes to go through the roof.

SB, Euromoney That is as much time as we have, so thank you all very much.

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