In December 2005, Euromoney published an article entitled “Do the big FX banks need a new platform?” It told the story of how, behind closed doors, banks were planning to set up a new bank-only trading system, in an attempt to re-establish the old model of interbank dealing. At the time, though, no one would openly admit that there was such a proposal. The idea was in response to concerns about liquidity being damaged because of a multitude of trading venues, clever traders taking advantage of gaps in technology at the expense of the big banks, and the presence of anonymous trading on EBS, the main external exchange that banks use to clear their risk. In the end nothing came of it. Six years on little seems to have changed. Now the idea is being mooted again in response to the alleged scalping of banks from high-frequency trading that occurs on external FX exchanges such as EBS and Reuters, and more and more on platforms such as Hotspot, Lava and Currenex, dealers say. Although FX bankers remain coy about the exact detail of their proposed dark pool, code-named PureFX, they say their motivation is to promote responsible behaviour in the market and a level playing field for all.
The continued rise in volumes and the proliferation of high-frequency trading mirrors what has happened in the equity markets over the past decade, and indeed many see the two markets coming close together in the way they work. High-frequency trading in equities has increased transparency but as a result it has made it difficult for clients to execute large trades. So banks have teamed up to create their own dark pools through which clients are now executing. FX seems to be heading the same way. Nonetheless, the two markets are quite different animals, because equities is an agency model traded on regulated exchanges and foreign exchange is a principal-based model traded over the counter, which because of issues around clearing and credit facilities has allowed flow to remain captive for the banks.
However, the business faces challenges as high-frequency traders look to evolve their business models away from speed-oriented strategies that pick off the banks to becoming legitimate market makers themselves. They claim that they can take on the banks at their own game, by going to secondary exchanges, such as Hotspot, with mutual clients, and creating an isolated stream that has segregated flow with desirable characteristics. Usually this involves several weeks of pricing to their entire client base and reporting "problematic" trades. Through an iterative process, those counterparties with toxic flow are gradually removed from the stream. This is standard practice among banks and has gained momentum in the high-frequency community, meaning clients can then bypass the banks.
High-frequency trading fund managers claim that the successful business model is yet to be determined in FX. In the equities market, it was legislation, via the central limit order book, that took that flow away from the banks, and once that happened high-frequency traders were able to generate good liquidity transfer models whereby they were able to facilitate people trading with each other better than the banks had done, or at least more transparently. HFTs won that race and the banks ended up building all the dark pools we see today.
It could be argued that there was no clear winner. Banks lost revenue from trading but made up for it with increased volumes. Could the same happen in FX?
Banks admit that there is a behavioural shift from clients towards the type of client-dealer relationship witnessed in equities, which became commission-based, highly commoditized with a focus on providing the differentiating service. In equities, the most important attributes are a deal pipeline, market access, and research.
FX banks say their clients are looking more and more at their content offering, service provision, and capital for large trades and specialist kinds of transactions. That will be the differentiating factor, they claim, and high-frequency trading can only provide a subset of those requirements.
Ultimately FX players would like to take the best qualities of the equities market and blend it with the best of the FX market. How successfully new entrants can sever the credit connection holds the key to who will dominate the foreign exchange markets of the future. Technology has changed the game forever.