FX poll 2001: Forex transformed by mergers

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In foreign exchange it's a truism that size matters. Niche players are being squeezed out of the market because they can't compete with the big banks on price, and even the heavyweights are swallowing each other up in a bid to become the most powerful institution. For now, there's one clear leader.

Citigroup has re-emerged in this year's eagerly awaited annual foreign exchange poll as the top dog. Last year, Deutsche Bank moved ahead of it, ending 20 years of dominance. Citibank had won the overall Euromoney poll each year since its inception in 1979 through to 1999. After the setback of 2000, Citigroup hit back with a vengeance. The 2001 poll comprises 71 separate categories: Citigroup is top in 48 of them, nearly 70%. But in the key poll its market-share lead over second place Deutsche Bank is slender. The rise of electronic marketplaces and recent and future bank mergers may alter the structure of the foreign exchange market.

Cover story: Forex transformed by mergersForex ventures beyond the phone
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Look down the list of top foreign exchange institutions over the past five years and one trend is impossible to miss. There are fewer of them. Among the top 30, several names are combined, or disappear altogether into a larger rival, every year. The recent combination of JP Morgan and Chase, for example, creates a formidable force, at least on paper. Simply adding their market shares in Euromoney's most recent poll - in which JP Morgan ranks fourth and Chase fifth - would elevate the new JP Morgan to top position.

Of course, merging banks almost never manage to achieve such simple combinations of market share. And the jury is still out on whether the new institution will be able to convert that potential market position into profits.

In the meantime, an air of expectancy hangs over the marketplace. Consolidation is far from over and forex bankers admit that there are potential partnerships that pose an even greater threat to their business than that of JP Morgan and Chase.

Although size may not be an advantage per se in banking, in forex the biggest players take a disproportionately large share. "This is for the most part a generic high-volume, low-margin business," says Loic Meinnel, global head of foreign exchange at BNP Paribas. "That it's high volume means it's easier for the big players, that it's low margin makes it even more challenging for the niche players."

Because forex was originally designed as a non-commission business, banks made a profit through the spread they charged clients.

However, an important side effect of rampant consolidation - and some leading forex banks have now merged three or four times - is that spreads are down to near zero.

The fact that there are fewer participants means that the market is much more transparent and, with the rise of multi-bank electronic trading platforms, this trend can only increase. "A number of commercial banks are sitting on clients' medium-sized transactions where they're charging spreads that are wider than the top-tier institutional clients. We believe those spreads will have to come in as price transparency increases," says Geoff Grant, co-head of global foreign exchange at Goldman Sachs.

As spreads have tightened, it has become more difficult to make money through straightforward transactions or everyday flow business, other than by dealing huge volumes.

That is bad news for those institutions that don't make it into the top 10. "If you define price as the only differentiating factor then the small players are doomed," says Paul Thrush, global head of foreign exchange at Barclays. Only the very largest banks with weighty balance sheets will be able to compete.

Peter Murray, co-head of global foreign exchange at Morgan Stanley, agrees. "The forex market will be dominated by a small number of global organizations," he says. "I think the barriers to entry in this market are definitely increasing when you look at the human capital you need and the costs of running a global network."

Spot still a money spinner
That's not to say that spot business is not extremely valuable to top-tier institutions. "The bulk of our profitability is still from the day-to-day flow business," says Simon Jagot, global co-head of treasury products at UBS Warburg. And Citigroup, Deutsche Bank and JP Morgan have all managed to retain their big market share through doing the bulk of these deals.

The forex market is huge, with estimated daily turnover of $1 trillion, and so banks can make a tidy profit if they are able to capture a large chunk of these transactions, albeit with low margins on each trade. But to do that they need a global presence, well-developed infrastructure and lots of salespeople. 

Consolidation is the obvious way to gain a competitive advantage. The most talked about deal of 2000 was the merger of JP Morgan and Chase. Shortly after acquiring the UK broker Flemings, Chase demonstrated the extent of its financial muscle by buying JP Morgan. By rights, this combination should be causing forex bankers a few sleepless nights.

As the largest bank in the world in terms of assets, Chase has a forex capability to be reckoned with. JP Morgan too was regarded as a premier forex institution, consistently finishing in the top 10 in the Euromoney poll. Indeed, pro rata, JP Morgan and Chase - finishing fourth and fifth respectively - would between them clinch the largest share of the market.

But, in fact, market participants remain largely ambivalent about the threat this merger presents. "I think they will struggle to make one plus one add up to much more than one and a quarter," says the head of forex at a rival bank. Other observers point out that there is significant overlap between the two institutions' business areas and customer bases and doubt that the merged entity will be able to generate much more business than Chase alone. "I look at mergers on the basis of are they additive or are the two businesses broadly speaking similar," says one. "JP Morgan, in my view, is not particularly additive."

More important, doubts have been raised over how smoothly the integration timetable is progressing. "They will be pretty big together, if in fact they ever manage to get it together," says a former JP Morgan banker.

Staff turnover, inevitable in all mergers, has perhaps been accelerated by the decision to relocate the forex division from New York to London. Robert Standing, head of rates markets Europe at JP Morgan, says that this decision has been very popular with clients.

Maybe it has been less so with some of the bank's staff. Many of Standing's former colleagues who showed an inclination to move on were quickly snapped up by competitors such as Barclays, Bank of America and CSFB. "With the mergers that have occurred recently, there have been considerable redundancy issues and we have been able to recruit some very good people who might not have been available beforehand," says Paul Thrush, head of foreign exchange at Barclays. "There's certainly been a considerable redistribution of talent around the market thanks to JP Morgan," adds another banker.

Among the high-level departures were Klaus Said, former global head of foreign exchange and commodities and David Newman, global head of FX sales. Both joined Credit Suisse First Boston in February, Said to head the considerably smaller forex division there. "CSFB set me a goal to take a foreign exchange business that, over the years, has consistently come in between 7 and 10 in the Euromoney poll and create a force to rival those of the major institutions. We're off to a good start as the results show," he says [this year it ranks sixth]. "We won't try to be the biggest flow shop but we will compete on the basis of our advisory and value added capabilities, our capital commitment and, of course, price."

To this end, Said is hiring aggressively, with the aim of soon increasing CSFB's global sales force by 50%. "The client people here are good, there just aren't enough of them," he admits. His second priority is to ensure that, as far as possible, the forex division pulls in transactional business on the back of client relationships in other parts of the bank. "Our model for success is to add capital in areas like options and to harness the flow-generating power of the firm, its investment banking, private banking and prime brokerage business. This is low-hanging fruit for us."

Said says he was attracted to the position at CSFB because it was the last opportunity to build a major forex business - CSFB is the only remaining top-tier global institution without a significant forex capability, he explains. "They gave me the chance to shape the FX business."

Other former JP Morgan bankers offer an alternative explanation for their departures. They talk of fundamental clashes of culture. "It quickly became apparent that Chase's strategy was radically different to ours," says one. "They focused on price and volume while what mattered to us was value and advice, they organized their forex department on a regional basis and we worked globally and while JP Morgan was always very research driven, Chase is totally muscle-driven."

The scale of the exodus was also much greater than the customary fallout after a merger. Virtually all of JP Morgan's former sales people, along with the bulk of the spot and forward traders and many of the research analysts, walked out. "If you went through the FX department today and drew up a list of the people there who used to work for JP Morgan you'd find there are very few of them left," says one source. "In theory, Chase and JP Morgan could have been very powerful if they had held on to the good people, but they haven't, they're all gone." Says the head of forex sales at a rival bank that recruited several of them: "I really don't know what can be left of the JP Morgan forex team. Clients we speak to say that they don't know anybody there now."

According to the source, Chase management were intent on running the forex their own way, and had very little interest in longstanding practices at JP Morgan before the merger. "The business is being completely led by Chase.

What they wanted to do was completely contrary to everything we had built up over the years.

Their structure, their outlook, their reward scheme was all opposite to what we believed in." In his view, the forex business will survive as a Chase operation incorporating Chase values and priorities while the JP Morgan influence will gradually dwindle away to nothing.

But Standing at JP Morgan is relatively sanguine about the loss of human capital the bank sustained. "Yes, we did lose one or two people," he admits. "There has been some turnover of salespeople and that's sometimes not the easiest thing to handle. But one of the advantages of being a top foreign exchange institution with our depth of talent is the ability to continue to build quality teams where we need to."

Staff turnover can have a major impact on forex business, however. End-users Euromoney spoke to say maintaining a continuous relationship with the client is one of the golden rules of a successful forex department. "We tend to find that if our main sales guy is away, our account isn't very well looked after," says a major institutional investor. "At some houses, when our primary contact is on holiday then we just don't talk to that bank for two weeks." And, he adds, this doesn't just happen at the smaller firms.

Says a large corporate user: "If our main contact leaves, particularly to go to a rival bank, then we'll watch the situation carefully to see if the level of service changes. In some cases we might decide to continue to deal with that person at the new bank because he knows our business."

That mergers are fraught with hazards for a business that requires a high degree of client contact is evident from Royal Bank of Scotland's result this year. In 2000 RBS acquired NatWest Global Financial Markets, the UK commercial bank that came 11th in Euromoney's poll that year, with a market share of 2.71%. However, as a combined institution, RBS managed to reach just 20th place with a meagre 1.32% of the market.

This is a result that David White, head of foreign exchange in UK, Europe and the US at RBS, finds "disappointing". He adds: "I think the problem is that the outside world hasn't realised that we're actually a lot more powerful now than the old Royal Bank of Scotland was," he says. "We've struggled a bit in terms of perception of our counterparts and our peers in the inter-bank market. Clearly, NatWest was a strong foreign exchange house but RBS wasn't. We did a lot of work in the old NatWest ensuring that our name was well known in the market. We're now doing more business, but this result shows that it's taking the market a while to catch up."

At Citigroup, head of FX Richard Moore at least partly attributes his institution's return to the top spot to the fact that those concerns are behind him. "As we bed down merger issues we now have a consistent platform and coverage model that is not suffering from any disruption," he says.

Observers had suggested that Citigroup's third place ranking in 2000 was the result of a shift towards the fusion of investment and commercial banking activities and that Citi suffered because it didn't have a strong reputation in investment banking. The acquisition of Salomon Smith Barney in 1998 changed that though. Despite the assurances of Guy Whittaker, former head of foreign exchange and now treasurer of Citigroup, last year that from a foreign exchange perspective the group was already completely integrated, it seems likely that Citi's improved performance is at least partly a result of progress in this area.

The value of diversity
Moore agrees that cross-selling services to clients across the organization has been a priority. "The diversity of Citigroup is its biggest ally," he says. "If you were to ask me what has really made a difference to us over the past 12 to 18 months, it has been the positive impact of the merger. This has had a direct impact on forex." In particular, Moore says, Citibank now has a prime brokerage business under way, which was set up in October 2000, and is aimed primarily at hedge funds. It provides them with leverage, execution, and other ancillary services related to foreign exchange. That this has been a priority for Citi is no coincidence.

Deutsche's victory last year was due in no small measure to its success with its hedge fund clients. 

Among other initiatives implemented is an internal joint venture involving dedicated salespeople working with investment bankers to ensure that forex business relating to cross-border M&A and the investment banking business is executed by Citibank. "Pre Citigroup, and in the early stages of the merger, we would not have had this business and would be been competing for it second-hand by offering fantastic prices to investment banks who wanted to do that business," says Moore. "We can now do it directly."

Another recent move is the setting up in May of a joint venture with Citigroup's custody business, called AutoFX. This involves providing exchange rates electronically to the custody department, so that when a customer adjusts a portfolio, the system automatically handles the currency transactions that result from those shifts in this underlying portfolio.

Moore says that he is also looking at similar ventures in the consumer banking business. "One of our best opportunities is to make sure we deploy our services effectively internally where the underlying rationale for the trade may not be a foreign exchange trade.

It might be a custody trade, a consumer trade, or part of a corporate finance or investment banking activity." He believes that Citibank's long-standing reputation as the leading forex bank gives it a head start here. If clients are already doing business with other parts of the bank, then why would they go elsewhere for their currency transactions?

But Citi's image as a volume-driven forex operation has also been an impediment. Though the bank has been well known for its execution capabilities for 20 years or more, it has recently been losing out to investment banks on the basis of clients' belief that these organizations are more solution-driven. Moore stresses that the perception of Citi as the place to do flow business but not the more complex transactions is outdated. "Two or three years ago," he says, "we would give presentations to our customers on hedging optimization strategies basically using a lot of analytical tools and giving really quite an in depth analysis of their exposures and their peers' exposures and the reaction we got was 'I didn't expect that from Citibank.'"

Now, Moore says, customers do rely on the bank for high-level problem solving and expect forex bankers to get involved in decision making and risk management. "We were already recognized for our execution capabilities but the other part of what we do is what we've been working on, and the last 12 months has really seen that relationship develop," he says. An important step in this process has been the reorganization of the forex department into industry specializations so that salespeople can keep clients in the loop about what their industry peers are doing and can develop sector specific solutions for them.

Bank of America has also been doing some restructuring this year under the auspices of William Fall, global head of FX, interest rates and structured products. A significant move has been the creation of a global risk management group. This brings together derivatives, foreign exchange, structured credit products and structured securities.

According to Alan Circle, co-head of global FX sales at the bank, this is the first and most important step in providing global coverage across product groups to clients. "Solutions have become a lot more sophisticated," he says. "Ten years ago clients just wanted a simple FX product. Today, sales teams need to integrate FX and structured interest rate products to provide a global value added service to their clients."

This strategy inevitably means more work for the sales team as the onus is on them to develop a complete understanding of four product areas. But, according to Conor Dufficy, head of European FX trading at Bank of America, they will soon be reaping the benefits of adapting their business model to customer needs. He believes that, as opposed to when pricing was a commodity, clients are now directing business towards firms that can provide value-added, cross-product solutions.

Another trend Dufficy points to is the increase in the number of corporates doing forex business with those banks that lend them money. "Clients want to talk about more than one product, they don't just want to deal with forex, and likewise banks want to extend credit for more than one product, they don't just want to lend," he says. "That's been the case for some time but it has definitely taken a step forward in the last year."

Simply extending loans to clients doesn't win banks much revenue and so, in order to step up their return on capital, lenders are looking to add on ancillary investment banking products. "Doing well with the corporates is increasingly going to be a function of those institutions that are able, at the end of the day, to advance credit," says Hal Herron, head of global foreign exchange at Deutsche Bank. "As major conglomerates grow, they want to know that they have a source of funding available." A large corporate user corroborates this view: "We only use the forex business of banks that are supporting our business with syndicated facilities on the lending side. It's you scratch my back and I'll scratch yours."

Though this approach clearly offers basic economic advantages to both the customer and the bank, it also indicates the extent to which an integrated approach to forex has become the norm. "Foreign exchange is no longer going to be seen as something that comes out in the wash," says Tony Norfield, head of FX research at ABN Amro. "It's an important transmission mechanism for the wheels of finance and can have a significant impact on the valuation of the deal that is being done."

Recent developments in the equity markets mean that forex risk is going to be a primary focus for chief financial officers and treasurers looking to improve the efficiency of their business operations. When the cost of capital is relatively low - as it was last year - then exchange rate risks are probably less significant. But as it becomes more expensive, then it is crucial to use the limited capital and liquidity that is available to maximum advantage. In recognition of this approach, several banks, including UBS Warburg, have this year initiated consultancy-type services for their clients with corporate risk, institutional risk and research advisory groups.

Many institutional fund managers are now looking closely at how to better manage their forex risk through forex overlay. Says Alfonso Prat-Gay, head of FX research at JP Morgan: "It's been proven that asset overlay can add some decent alpha to your portfolios and it's worth giving it a try. So we're seeing more clients asking how to do it, what's the optimum hedge ratio, how to trade currencies around that ratio and so on."

As volatility in the forex market increases, this is an area that is likely to attract greater interest from institutional investors and provide profits for banks that can capture this market. Deutsche Bank comes top of the table of key relationship banks based on replies from institutional investors, despite the fact that its market share according to the same set of responses has fallen from 15.97% in 2000 to 8.83% this year.

Herron at Deutsche is adamant that this result does not represent what is actually going on inside the bank. He points to the fact that Deutsche's revenues were up 33% last year, topping e1 billion for the first time while Citigroup's were down 12%. "From our perspective we've had an outstanding year," he says. "We think we've increased our market share and penetration and done more business with clients than in the past." Herron refuses to comment on speculation that Deutsche has been losing hedge fund business over the last year. "Our revenue comes from a combination of servicing our institutions, hedge funds and corporates," was all he would say. He does concede however that, compared with some of the US investment banks, doing forex transactions off the back of M&A activities isn't a major part of Deutsche's business.

An M&A-based spree
M&A-based forex does comprise an important part of Goldman Sachs' business though. Since 1986, the bank has consistently appeared in the top 20 in the Euromoney poll but has never before reached third. It's a result that Zar Amrolia, co-head of global FX, says is the product of several years' consistent focus on client needs. He stresses that there is no single explanation for the meteoric rise in market share - from 4.38% in 2000 to 7.09% this year. It seems likely, however, that a significant part of this is derived from investment banking related business. Amrolia himself says almost as much. "Last year was a bumper year for M&A," he says. "Let's not kid ourselves about that." 

Forex business relating to these transactions can be extremely profitable, depending on a deal's complexity. Companies will need currency initially to complete the acquisition but post transaction there are balance sheet issues to be resolved and accounting decisions to be made. CFOs and treasurers also look to their investment bank to advise them about how to link different types of financing or derivatives and how to hedge credit protection, for example. If it is indeed the case that much of Goldman's additional market share has come from this source then it is unlikely that the bank will be able to sustain this pace of growth. Given the slowdown in activity - cash M&A deals accounted for $50 billion in the first quarter of this year compared with $500 billion in the whole of 2000 - there will be far less of this low-hanging fruit for Amrolia and his team to gather in 2001.

But Amrolia dismisses these concerns. Goldman apparently has another secret weapon up its sleeve - its proprietary electronic execution system. M&A might have slowed this year, "but we're on-boarding clients to our e-trading platform faster than ever," he says. If the clients want the advice and research side of the business then those services will always be available to them via traditional channels. "Electronic execution of vanilla products allows us to focus on high value added services. E-distribution allows us to deliver these services to a wider client base." In other words, there are clients who are focused on price and straight-through processing and really not that interested in advisory.

So far, though, electronic execution has been slow to take off. Customers aren't particularly enamoured of the idea of single-bank systems and are holding back to see how successful the multi-bank platforms are going to be. "We've viewed a lot of the e-trading platforms including FXall and Atriax but most still have issues to be ironed out," says a large pension fund. Even when e-trading does gain acceptance, corporates and investors say they'll be reluctant to do large trades via the internet. "By this time next year I'd expect to be doing between 50% and 75% of business this way but these will be small transactions. I wouldn't put deals over £25 million through the system," says a UK fund manager.

Another challenge of e-commerce, besides signing up customers is the first place, is the issue of how these platforms will affect liquidity. Though there is no clear consensus among forex bankers as to how e-trading will change their business, some fear that if there is more than one dominant multi-bank system this may divide the already diminishing liquidity in the market.

Volatility effects
Others believe that e-trading has injected volatility into an already unstable market. "You have the rise of electronic broking at the same time as there's been a fall in the level of interbank trading. That has meant that liquidity through these electronic systems generally pools up and at times you can move large amounts of money with very little impact on the price," says Jagot at UBS. "When that liquidity goes, because there's no interbank market-making, you get much bigger gaps." Thrush at Barclays agrees.

Not so long ago, he says, dealers had call-up lists of 30 or 40 banks and knew roughly how much they could move in a set of phone calls. "The ECNs have changed the nature of dealing relationships and trader behaviour. As a consequence of their emergence, the depth of liquidity has become more difficult to determine."

Whatever impact electronic execution eventually has on the industry, those banks that can best harness the potential cost savings and efficiency gains of the internet will win a clear competitive advantage over their peers. Amrolia at Goldman believes his firm is well placed to be the foremost provider of e-execution and the results of Euromoney's poll in this area seem to bear this out with 181 respondents naming WebET as the best platform for trade execution. And he isn't fazed by the impending launch of the multi-bank platforms either. "We don't believe this is a short-lived success," he says "We feel the e-trading is something we understand very well and this will serve us well in future."

The race for e-customers
If Amrolia is right and there is in fact a community of forex users that bases its decisions on best price and speed of execution, then the race is surely on among the banks with e-trading capabilities to enlist these low-maintenance clients. The ability to conduct a large number of plain-vanilla transactions electronically means that investment banks stand a chance of competing with commercial banks on the basis of volume.

The more customers persuaded to transact electronically, instead of calling the sales desk, the more flow business a bank will be able to do, at a minimum cost, and the more time its salespeople can devote to building customized solutions for their clients.

Amrolia boasts that Goldman has come this far even though Deutsche's sales team is two and a half times the size of his and Citibank's twice as big again.

But if this gives Citi's Moore cause for concern, he isn't showing it. "You have to remember that in trying to compete with Citigroup in foreign exchange you are trying to compete with a company that is present in 100 countries," he says. "That's a benefit we have purely in terms of coverage that our competitors don't." Nevertheless, the gap between Citigroup and its peers is closing. Go back just three years and there is clear water between Citi and the second-placed bank.

That's no longer true. Isn't it obvious that Citi is just hanging on by its fingernails, with hungry competitors snapping at its heels? Not so, says Moore. "The market was fragmented, now it has consolidated, de facto the gap between us and our competitors is closer."

And it will get closer still. Though there has been a tremendous amount of merger activity in the recent past, none of the institutions in the poll bags a greater than 10% market share.

Consider almost any other large global industry - airlines, drug companies or car manufacturers - the dominant market share of the leaders is around 20%. That suggests that the forex market is still much too crowded. In the wake of the JP Morgan and Chase merger, foreign exchange bankers are quietly apprehensive. Privately, they admit, what really keeps them awake at night is the combination of an institution with a large global corporate banking franchise, a significant client base and an impressive lending capacity, with a powerful investment bank. "HSBC and Goldman Sachs," says the head of foreign exchange at one top-10 institution. "Now that would be a threat to our business."

It’s all just a drop in the oceanForex ventures beyond the phone
And the winner is...
results tablesmethodology