FXMS - Space 2007: an FX market odyssey?
Although adoption of an exchange-like structure has been predicted for years, foreign exchange has predominantly been traded over the counter. Could a new initiative by the CME and Reuters finally force the transition through? Lee Oliver reports.
IT’S FAR TOO early to say categorically what its ultimate impact will be but the launch of FXMarketSpace by the CME and Reuters might ultimately prove to be one of the most significant events in the foreign exchange market’s long history.
The two companies themselves were not shy about heralding the potential impact of their joint venture, hatched under the codename “Project Anonymous”. It marked, they said, “the next phase in the evolution of the global FX market space”.
FXMarketSpace will be headquartered in London and regulated by the Financial Services Authority. Its board will consist of the CME’s chief executive, Craig Donohue; its chairman, Terry Duffy; and its chairman emeritus, market legend Leo Melamed, who is credited with the creation of currency futures while chairman of the CME in 1972. Joining them will be Reuters chief executive Tom Glocer and Devin Wenig, who is the company’s executive director and president of the business division.
FXMarketSpace’s day-to-day management team will comprise Mark Robson, who will join from Reuters and act as its chief executive, and the CME’s Rick Sears and Bryan Hunter. The platform will enter beta testing later this year and is expected to launch in early 2007.
The CME’s intention to target FX as a lucrative growth area should come as no surprise. In April, Donohue told Euromoney: “We think we’re seeing some real underlying shifts in the foreign exchange market that are very favourable to the CME and the exchange model.”
He made similar comments during a press conference announcing the launch of FXMarketSpace. “This is obviously a very big idea and we think it takes advantage of the natural evolution of the trend we are all observing in the forex markets over the past few years,” he said. He described the joint venture as “an innovative market solution that has potential to truly revolutionize the $2 trillion-a-day marketplace. We’re expanding our expertise away from futures into the world’s largest cash market.”
For Reuters, the benefits are not at first so apparent. However, a research note published by Goldman Sachs shortly after the joint venture’s announcement highlighted the near inevitability of the adoption of an exchange-like structure in FX and praised Reuters’ pre-emptive move.
“In the past we were concerned that a rival player could have launched spot forex on an exchange-traded model. This would have potentially damaged Reuters’ OTC forex franchise. It is therefore a positive that Reuters is carrying out the move itself, even if it must share the upside with its JV,” wrote Goldman.
An obvious issue is whether or not the new platform, which will initially trade spot and then later forwards and perhaps options, will act as a drain on Reuters’ existing liquidity. “The issue of splitting liquidity is fundamentally important,” says Robson. “The best way is not to mess with what’s working well. There’s substantial new FX flow to come into the market. FX as an asset class is becoming more than just a tag. FXMarketSpace is targeted at doing a job for these [newcomers].”
|Who moves the money|
|Average daily FX volume by client segment|
|Source: Bank of International Settlements|
There is no doubt that hedge funds and other non-bank participants are playing an increasingly active role in the FX market – the total volume of trading by leveraged funds recorded in Euromoney’s FX survey rose from $12 trillion in 2005 to $31 trillion in 2006 (see Investment is crucial to the volume game, Euromoney May 2006). The CME cites data from the Bank for International Settlements showing that one-third of FX activity stemmed from hedge funds, commodity trading advisers and professional money advisers in 2004. The anecdotal evidence is that this proportion has continued to grow, driven to a large extent by the increased use of algorithmic or automated trading programmes. However, the lack of a centralized marketplace and the provision of a central counterparty (CCP) have restricted these participants’ role in the market. Although few would admit it, many of the larger sell-side institutions are clinging to a market model under which they believe that they can to some extent control participation through credit. Whether or not these FX powerhouses will actually sign up for the concept and provide it with its initial liquidity remains a very big if.
CME and Reuters insist that FXMarketSpace will operate alongside their existing electronic platforms. It is entirely feasible that all of these platforms, as well as those of their rivals, will thrive. According to Nick Barker, FX e-commerce programme manager at UBS, there is no reason why multiple market models cannot exist in some kind of harmony.
“The impact on FX will be positive if additional demand for the FX asset class is created,” Barker says. “The adoption will depend on whether the market model that is implemented adds value as an avenue of liquidity provision.”
CME will provide FXMarketSpace’s matching engine, as well as clearing services. Reuters will provide trading access via its global network as well as its heritage, which is a less tangible asset. Neither the CME nor Reuters appear to have any illusions that the FX market is suddenly going to flock to the new platform. Both companies appear to be thinking about the longer rather than the shorter term.
The cost of getting the project off the ground appears modest, given the potential rewards. The CME and Reuters will each contribute $45 million; start-up losses are predicted to be in the region of $20 million to $25 million. The FXMarketSpace venture is expected to become profitable in 2008, based on its capturing an extremely modest 2% share of the spot market.
The fact that the fastest-growing segment of FX, the hedge fund/CTA community, is likely to welcome access to a technologically advanced platform with a CCP behind it could help underpin its success. However, to some degree, many from this community can already access the brokers that are effectively at the hub of the market through the use of prime brokerage, so they might well not rush to trade on FXMarketSpace. Those sell-side houses with strong prime brokerage offerings might well prefer to see their clients trading on existing venues, even if they are, as is likely, already general clearing members of the CME and so can provide an almost identical fee-based service.
For FXMarketSpace to prove successful, it might have to cut through the silos that exist in many sell-side institutions. And those running their separate empires might not embrace the new model that willingly. Robson admits that getting the prime brokers to accept the new model might prove tough.
“We’ve got a good sense of the likely reaction from the sell side,” he says. “Generally, it’s been pretty favourable. Naturally in the large banks, there’s a range of different constituencies – futures, prime brokerage and prop trading, as well as market making functions. The general picture is one of considerable enthusiasm in the futures and clearing departments, where the two groups already work closely together. There’s good feedback.”
The use of a CCP to mitigate credit risk obviously has appeals, including for regulators. However, some users will be wary of how much margin and collateral they will have to post at the CME, even if they do obtain sizeable capital efficiencies. Furthermore, it is inevitable that the regulators will seek reassurance on how CME Clearing will manage the vast amount of risk that might result from its use as the CCP in FX.
European Central Bank executive board member Gertrude Tumpel-Gugerell said at a recent conference on the use of central clearers organized by the ECB and the Federal Reserve Bank of Chicago: “Although a CCP has the potential to reduce the risk exposures of market participants, it also concentrates risks and the responsibility for risk management.”
She added: “Many of the benefits of central counterparty clearing can be attributed to multilateral netting. Multilateral netting allows for a substantial reduction in the number of settlements and, therefore, in operation costs, including settlement fees.”
This ability to net trades has possible ramifications for CLS, which handles the settlement for a growing proportion of FX transactions. In theory, there is no netting in CLS, which charges a fee on each ticket it settles. Some banks do net bilaterally to reduce their CLS charges, which one market source described as a bad tax. If the FX market does embrace the use of a clearing house, it will be interesting to see what impact it will have on CLS’s revenue. CLS declined to comment.
The ultimate impact of the launch of FXMarketSpace remains uncertain. A major issue will undoubtedly be just how much support the current dominant liquidity providers give it. There is a sense that they are always prepared to back every horse in any race, just to be sure they get on the right one. But they will also no doubt be asking themselves if there is a danger that the new venture will disintermediate them.
Whether FXMarketSpace does signal the advent of a new market paradigm, or whether it is a solution looking for a problem, it still looks like a bold move. If the figures are to be believed, it will not have to garner too much volume to be viable. It is far too early to even attempt to assess its ultimate impact, but as Melamed said of its launch: “On a personal note, to say I’m extremely pleased is an understatement. It’s a lifetime dream come true. I think it will change the FX market for ever.” Coming from the recognized founder of financial futures, this statement is very much worth noting.