FX: an exchange-traded future?
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FX: an exchange-traded future?

The development of FX trading venues has been idiosyncratic, but can it follow other asset classes toward an exchange-traded future?

Originally a market driven by voice execution, more than 60% of the $5 trillion a day traded on the world’s foreign exchange market is now moved electronically, up from around 30% a decade ago.

The first generation of electronic FX trading venues emerged in the interbank market in the early 1990s, with the launch of Reuters and EBS's platforms. Both have remained as a backbone of the electronic FX market, supported by dealing banks that rely on the two venues to manage their risk.

A second wave of multi-dealer FX platforms emerged in the late 1990s to provide connectivity between banks and clients. While many venues failed to gain traction, the survivors, such as FXall, Currenex and Hotspot FX, remain big trading venues.

There has been, however, a fresh wave of new FX venues launched over the last couple of years. Venues such as Gain GTX and LMAX Exchange came on stream in 2010-2011. Meanwhile over the summer of 2012, Euromoney counted seven new FX trading venues launched in six weeks, including Par FX, FXSpotStream, FastMatch, and Molten Markets.

Javier Paz, senior analyst, Aite Group

Javier Paz, senior analyst at the Aite Group consultancy, says there are a number of reasons for the surge in new FX venues into a competitive landscape that was fairly stable until recently.

First, he says, bank liquidity providers have become increasingly dissatisfied with the current group of FX venues because of what they perceive as practices that favour automated trading firms, and a sense that the trading infrastructure of existing platforms is outdated.

“Both of these may lead to potential opportunities for new venues,” says Paz.

Furthermore, the emergence of FX as an asset class has been a driving force behind a flood of new FX execution venues.

Both commodities and FX markets have benefitted from the lack of steady, profitable returns from traditional asset classes such as equities and fixed income.

This has driven fresh investor money into FX from market participants that demand greater execution speed and expect a greater degree of transparency than previously on offer in the currency market. They also have higher requirements for best execution.

Indeed, that can be seen in the increased uptake in transaction cost analysis in the FX market.

“New participants from non-FX markets have entered the space looking for faster, more streamlined, transparent FX trading venues similar to what they are used to in equities and futures markets,” says Paz.

The question is what the electronic trading venue of the future will look like.

Paz says while many new FX venues have emerged over the last few years – most of them touting increased transparency and describing themselves as next-generation trading platforms – only one, LMAX Exchange, has taken the concept of transparency seriously enough to register with the UK’s Financial Conduct Authority as a multilateral trading facility.

MTF status gives LMAX characteristics similar to an exchange, requiring pre-trade transparency with public distribution of price information and without discrimination against any market participants.

Indeed, LMAX Exchange has an open order book and does not give liquidity providers a 'last look' at prices they stream. This last look is common practice at some FX trading venues; it allows liquidity providers to reject the prices they quote, which can result in customers not executing deals at the price they see on their trading screens, particularly in fast, volatile markets.

David Mercer, chief executive at LMAX, says the idea of last look is an anathema to equities and futures traders.

David Mercer, chief executive, LMAX

“They see prices on an exchange at which they can buy or sell,” he says. “They can’t imagine a situation where a price is rejected. Why would that happen in any product?”

That is not to say that there is still not discretionary pricing and discretionary liquidity pools for different clients at LMAX. It operates one venue in which liquidity providers quote prices to money managers, retail brokers and proprietary traders, and another venue where banks trade with each other in larger amounts.

As Mercer puts it, the firm has to maintain a pragmatic approach – banks after all still want to know broadly whom they are pricing.

“But what we are trying to do is level the playing field as much as we can within the existing ecosystem. It will keep evolving, and you could end up with an open order book, like in equities, for FX,” he says.

“If you are looking for Nirvana, if you want to know what I really think, FX should be one open book for everyone from the bureau de change to the guy trading $100 million,” Mercer adds.

In other words, FX could eventually be like equities where, say, the price quoted for Vodafone shares on the London Stock Exchange is the same for a hedge fund manager and a retail client.

Of course that is not to say that LMAX, or any of the other recent entrants into the FX trading venue sector, necessarily have a magic formula.

As Paz explains, just because new venues are built does not guarantee their success. He notes the history of electronic trading is, after all, littered with failed initiatives. FX is no exception.

“The evolutionary process within the global FX market is not a linear one,” says Paz.

Still, he adds: “Exchange-style trading, highlighted by increased transparency and no last look, is certainly a unique way to attract participation to the electronic FX market.”

Of course, the concept may not be universally welcomed, and might face initial scepticism from liquidity providers, but FX need only look to the equity market for proof of its viability.

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