FX Poll 1997: Taken aback by a leap forward


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The foreign exchange business is entering a period of rapid change. The lack of volatility in the market over the past 12 months has forced the big commercial banks, which have long dominated the business, to close offices and cut staff. In their place, our annual poll reveals, investment banks are winning a larger share of the business. The biggest surprise: Merrill Lynch, which jumps into the top 10 at number three. Antony Currie explains why.

OverallWho's best where
Currency pairsBest dealers
Emerging market currenciesForwards
OptionsAdvice and Expertise
How London rates interbank players How New York rates interbank players

FX Poll 1997: Methodology

Bankers have varying explanations why the HSBC group closed its New York foreign exchange trading operation for G7 currencies last September. Some blame management conflicts; others suggest losses on proprietary trades. Rob Loewy, HSBC Midland's head of foreign exchange, says that over 80% of trading took place when both the London and New York offices were open, and that it made more sense to house all the traders under one roof where risk mandates and liquidity were more favourable.

In the end most bankers' comments boil down to this: that it was an admission that the bank couldn't make money

in the US - although Loewy disputes this - and that the move was another indication of the consolidation of the forex business.

But if consolidation is the name of the game, what is Merrill Lynch doing in third place in this year's foreign exchange survey? Its rise of 23 places easily eclipses last year's star climber, Deutsche Morgan Grenfell, which had moved to ninth from 22nd. And Merrill's rise was also a lot less expected. There was no poaching of high-profile staff from other banks, and no statement of intent to capture a certain share of the market. Wayne Grigull, managing director, foreign exchange, at Merrill's New York headquarters, expressed surprise: "We knew from our feedback from clients that our name was out there, and we fully expected to go up. But not that far."

The market was surprised by Merrill's extraordinary performance, too. One head of foreign exchange, on hearing that Merrill had taken third spot, comments: "It's like being a top competitor in athletics, training and racing against your rivals. Then you turn up at the Olympics and there's a newcomer no-one's heard of in the final race."

But what on first sight appears surprising, on reflection is perhaps less so. Merrill Lynch is not the only investment bank to improve its ranking this year. Goldman Sachs jumps six places to eighth, and Morgan Stanley comes back in to the top 30 at 21st. "Both Goldman and Morgan Stanley are niche players, and very good ones, too," comments the head of foreign exchange at one of the top 10 banks. "The way they run their business makes sense for them and is very profitable." The big European banks, such as SBC Warburg and Deutsche Morgan Grenfell, which have been transforming themselves into investment banks, also performed noticeably well in this year's poll.

And Merrill - quietly and without much publicity - has been working hard in the past year to build up its forex business. John Wareham, global head of forex marketing, explains its strategy: "We've spent the last year or so concentrating on providing liquidity, both in the interbank market and to our clients. It's a virtuous circle: the more we increase our flow, the quicker we can price transactions. The quicker we do that, the more flow we can generate. And it's not just a theory - we can feel and see our success: we're getting many more calls than we used to."

Beefing up their teams

Merrill has been expanding its sales and spot teams. It now employs about 40 people in London - 30% more than at the beginning of 1996. Goldman Sachs has doubled its sales staff in the past 18 months, partly through hirings and partly by transferring staff from other departments. It openly admits that the firm had neglected forex over the previous few years.

The big commercial banks are dismissive of the investment banks' efforts; they say they've seen it all before: "The bulge-bracket investment banks have been blowing hot and cold about the forex business for the last decade," says one bank's head of sales. "They probably could have made it by now if they'd stuck at it, but in the past they would stay for a couple of years and then leave just as customers were beginning to take them seriously."

But Lloyd Blankfein, co-head of fixed income, currency and commodities at Goldman Sachs, says that the bank now regards forex as one of its core competences "We aim to be major players in all businesses we're involved in, not niche players. As a result we increased our number of core forex clients to about 250 globally." Merrill's Grigull is equally adamant that, this time, his bank is here to stay: "We've invested a lot of money and resources in foreign exchange, and now view it as a core business. We'll be a thorn in the side of the competition for years to come."

Foreign exchange was one of the few areas of finance that Merrill had no major presence in. "We're a dominant force in fixed income and equity markets worldwide," says John Kay, managing director of global foreign exchange. "So it's difficult to increase our presence there. And we have a high return-on-equity target of 15% to meet." But why move now? Grigull explains that it is a response to the consolidation of the business, both actual and expected: "We've based our strategy around a belief that there will soon be far fewer major players in the forex business, in part a response to costs, in part because clients are cutting back to a handful the number of financial advisers they use. And the increasing importance to the forex business of capital rather than trade flows plays to our overall strengths."

Pondering interbank business

The implication of the rise of the investment banks cuts right to the heart of the foreign exchange business. Despite Wareham's claim that Merrill is an active liquidity provider, the investment bank does not appear in our interbank rankings. Yet its third place in the poll of customers suggests that it is providing liquidity to its non-banking clients. Competitors such as Deutsche Morgan Grenfell and SBC Warburg stress that providing liquidity to clients is critical, but they have the luxury of also being recognized interbank players. Once the big banks that dominate the interbank market realize that more players are taking liquidity and not providing it, they might reconsider their position. "We have to ask the question how long banks are prepared to be a major liquidity provider for other banks," says David Barnett, vice-president, trading, Europe and Asia at the Royal Bank of Canada. "Why keep that market going when you're providing liquidity to non-reciprocal players? All you're doing is giving them the benefit of your experience so that they can go out and take your clients."

This has been especially true in the past 12 months, when gaining access to liquidity has at times been extremely difficult. The convergence of interest rates worldwide and the drop in volatility have been contributing factors. The most obvious example of this is in Europe, where the move towards monetary union has made trading some currency pairs unprofitable. At many banks the Deutschmark-Paris pair is used to train new traders. The Deutschmark-guilder is effectively one currency as far as dealers are concerned. Other currencies have been affected as well: the yen is now very illiquid in London, and the liquidity of the Swiss franc dropped markedly last year as the ratio of price-takers to market-makers increased, both in Deutschmark-Swiss and dollar-Swiss.

The effect of these changes has been two-fold: first, traders - and speculators - are looking further afield for more generous spreads. The main targets are the emerging market currencies. But with banks arriving in droves to trade them, bid-offer spreads on them are quickly tightening. "It took years for G7 and European currency spreads to tighten this far," says Simon Jagot, managing director, foreign exchange, at SBC Warburg. "In new markets and products the competition is so intense that spreads are tightening more quickly."

Second, spread tightening has led some banks either to withdraw, or to scale back, their commitment to the forex business, leaving a larger share for the top banks - commercial or otherwise. But the problem remains, even for the big banks: "Liquidity is becoming a scarce resource, and must be treated as such," says Jagot. The message would seem to be clear: spot trading and providing liquidity is no longer the way to make money. Richard Moore, head of foreign exchange UK at Citibank, disagrees, and insists that being a liquidity provider is still one of their main sources of income, although he admits that even his bank has had to adapt: "We've been consolidating our business over the last few years, centralizing pricing, but keeping marketing localized. And in response to the drop in volatility, we now only have one EMS [European monetary system] desk now - we had two last year."

Others are not convinced, believing that to quote two-way prices for other banks makes little sense. "Interbank is only good for reciprocal arrangements, otherwise it's crazy," comments one head of foreign exchange. "Big, profitable businesses have been built around providing liquidity, and maybe Citi and Chase with their huge books can make volume count for something. But what's the point of playing if you can't make any money? - don't be proud, be rich. If I see us going down in interbank polls I say 'well done boys'."

According to SBC Warburg's Jagot this is a trend which will continue: "Liquidity will reach a finite level and flatten out, and being a market maker will be less of a selling point as long as you provide liquidity for your key clients." This is an obvious cause for concern for the old guard of foreign exchange, the commercial banks, and this year's survey will not give them much comfort: Citibank's share of the market has fallen by nearly one percentage point, while Chase, so close to the top spot last year after the Chase-Chemical merger, has dropped to fifth. HSBC Midland only just remains in the top 10, although comes top in both London and Hong Kong.

HSBC's fall is in part due to the closing of its G7 currency trading division in New York, which forex head Loewy admits was not carried out as effectively as he had hoped: "It was certainly a psychological shock to many of our clients. And for the first few months we were overly focusing on our internal restructuring so that we were actually slowing down price delivery. But since the start of this year we've seen a marked pick-up in customer activity as these issues have been addressed." HSBC still prices and trades emerging markets currencies out of New York, maintains a marketing team there for the G7 currencies, and has invested in technology to try to integrate the US staff with the London office. Cameras in each office allow the teams to see each other, and there are also four atmosphere lines - essentially microphones - in London which are meant to enable those in New York to feel as if they are in an office which is 3,000 miles away. Alan Clarke, head of corporate and institutional sales, is convinced that others will follow: "It's an effective way of integrating the two offices, and we know that there are more banks interested in following our lead. We thought more might have switched their operations out of New York by now, but the increased volatility in the market has probably persuaded them to delay for now."

The attitude at other banks is mixed. Said at JP Morgan calls HSBC's decision brave; others are astounded: "If you don't have a New York office, then you've got no foreign exchange business. Not to be trading in the country which drives monetary and fiscal policy decisions around the world is not common sense," says Howard Kurz, managing director, global foreign exchange at NatWest Markets.

One bank rumoured to be considering the same strategy is BZW. But according to Paul Thrush, managing director and global head of foreign exchange, it has no such plans: "A number of competitors were speculating that we were going to close down our New York office forex operations. But we have reviewed our strategy, making management changes where necessary, and are committed to maintaining our New York operations in the short, medium and long term. It's imperative to have a strong presence in New York if you want to pursue a global forex strategy."

At other forex houses there is a distinct feeling that the commercial banks are starting to lose their way. "I always used to regard Citi as the epitome of what we should strive for," says one head of trading. "Now I'm not so sure - they've really lost their way over the last 12 months."

All the commercial banks reject these criticisms, but they are aware that the biggest change in forex is the one that affects them most. As Citibank's Moore puts it: "Price discovery is no longer the domain of the top few market makers. Pricing is more visible, volatility is lower, and so there is less value in providing it." One of the main reasons for the growth in electronic dealing systems - both that of Reuters and the electronic broking system (EBS) developed by Citibank and several other banks - is that they offer quicker and tighter pricing than humans, and are catching on fast. "I can count several large deals done on EBS recently where no calls were made," says JP Morgan's Said. "Even trades as big as $200 million can be done on it now, although maybe not when the market's really hectic." For this the major liquidity providers are still needed, but for how much longer?

So does this herald the demise of the commercial banks' forex operations? Dave Eddy, senior chief dealer, treasury department, at Sumitomo Bank certainly thinks they should be concerned: "They don't have the power they used to. Ten years ago one dealer could move the market; now it's the hedge funds and pension funds which are setting the pace." But nor are they likely simply to surrender the advantage they have enjoyed for the past 20 years. "They're bound to take a few knocks," says Albert Maasland, global head of forex marketing at DMG. "But don't write them off - they'll fix it." Another quipped that Citi would soon be making more money from its share in EBS than from its own spot desks. (Users pay $25 each time they use EBS for a transaction, regardless of its size.)

Commercial bank clout

One factor commercial banks have in their favour is their sheer size and reach - Citi, for example, has offices in nearly 100 locations around the globe. It can also boast a much larger customer base than the investment banks. "We offer a treasury service for all our clients, whether they're large multinational firms or a small company in the manufacturing industry," says HSBC Midland's Loewy. "Investment banks tend to cherry-pick clients." Lacking the factory to dominate the business, cherry-picking is an effective means of getting good returns.

With cash spot trading no longer making the same money, few doubt where the new revenue is to be found - FX derivatives. An advocate of this approach is former Citibanker Michael DeSa, who left after 17 years to become global head of foreign exchange at DMG in 1994. "We've shifted radically towards derivatives," he says. "One of the clear trends we've identified is to have our derivatives operation as the main engine of our spot desk. More than half the flows going through the desk now are from internally generated derivatives trades." Maasland adds that last year DMG added more than 500 options dealing relationships to its books.

The commercial banks are not blind to this development: our poll shows that both Chase and Citibank rank highly in options. But they are not seen as the banks that are leading developments. Nor, conversely, are the investment banks. "I don't think investment banks will be the main force," says DMG's DeSa. "The prime movers are the blended banks - the universal banks if you prefer. They occupy the middle ground, shifting up their investments and remaining consistent. Look at last year's revenue figures and you'll see that it's banks such as us, SBC Warburg and JP Morgan which are moving up."

Such banks appear to be able to offer the best of both worlds: the global reach and deep pockets of a commercial bank combined with the broad financial product range and risk appetite of an investment bank. Not that all such banks are destined to succeed. The general perception of banks such as UBS and BZW, both universal banks, is that they are slipping; one executive likens their situations to the aftermath of a palace coup: "Both suffer from a distinct lack of strategy, and as a consequence we've seen a lot of blood-letting, and frequent changes at the top." BZW's Thrush admits that there have been some problems, but is more positive about the future: "It's true that the turnover in senior management might have led to us losing some ground to the competition because clients might not have been convinced that we were fully committed to the business. But the changes we've brought in - across the board, not just in forex - should set us up well for the future."

So which class of bank will be the victor - the investment banks, with their appetite for risk; the commercial banks, with their decades-long dominance and deep customer franchise; or the universal banks, whose duality can occasionally blur strategy? Some commercial banks will tell you that there is nothing that the investment banks can offer which isn't already there. Investment banks talk of an inverted snobbery at the commercial banks: "There seems to be a premium put on limiting yourself to two-syllable words," says on investment banker. "We make sure that our sales team can communicate with the clients."

Such jibes, regardless of how much truth might lie behind them, mask the reality of where the market is heading. While name-calling is a well-trodden path in the financial markets, it won't go much beyond that. "I doubt there'll be a fist-fight between the commercial banks and the investment banks," says JP Morgan's Said. "There's room for both to grow, but it will be at the expense of the second- and third-tier banks." This group would encompass those banks that only offer a limited range of currencies, or only concentrate on their own geographic region. Since 1990 the share of the market controlled by the top 10 banks in our survey has increased from 31.2% to 47.5%. And the upward trend is set to continue; some estimate that the top 15 banks will control as much as 75% of the market within two years. Some US banks with a largely domestic focus have already farmed out their foreign exchange requirements to the big guns, and with EMU less than two years away, small and medium-size European banks are bound to be among the next wave.

"The forex industry now is similar to debt securities a while back," says Stephan Harris, head of global financial markets at NatWest Markets. "We'll see the gap between the commercial and investment banks narrow over time, and without doubt the former will offer high-quality hedging advice. The latter can add value, especially in cross-product transactions, but they can only widen their franchise to a certain extent - Citi's huge branch network works in their favour. The big challenge for banks is how to provide clients - especially the big institutional investors - with the economic return on their investment without their having to shoulder the burden of providing the infrastructure for managing the cashflows."

Little wonder that Merrill Lynch wants a piece of the action.

FX Poll 1997: OverallFX Poll 1997: Who's best where
FX Poll 1997: Currency pairsFX Poll 1997: Best dealers
FX Poll 1997: Emerging market currenciesFX Poll 1997: Forwards
FX Poll 1997: OptionsFX Poll 1997: Advice and Expertise
FX Poll 1997: How London rates interbank players FX Poll 1997: Taken aback by a leap forward
FX Poll 1997: Taken aback by a leap forward FX Poll 1997: Methodology