Oanda’s Michael Stumm and Richard Olsen on Retail FX: the triumph of hope over experience
Richard Olsen and Michael Stumm point to the reasons for the remarkably rapid rise of the retail foreign exchange market.
Lee Oliver, Euromoney's FX correspondent, is taking a well-deserved summer break. While he enjoys the clean air of the Alps, over the next three weeks The weeklyFiX will be contributed by guest writers from the industry. Our first guest contributors are Richard Olsen and Michael Stumm of Oanda, who look at the potential of the retail FX market.
The explosion of retail currency trading in Japan1 recently attracted attention to retail foreign exchange on radar screens worldwide.
Although some banks and institutional investors are dismissing the Japanese experience as a localized anomaly, the conditions that enabled it illustrate the potential of retail FX2 as a force to be reckoned with.
In less than 10 years, a relatively small number of online currency brokers and market makers have had a massive effect: by efficiently exploiting technology, by driving a five-fold decrease in the cost of trading, and by presenting banks and institutional traders with an insurmountable challenge. This article examines the new economies of retail currency trading and considers why some big players will find it impossible to catch up.
Rapidly emerging and disappearing investment niches and products are taken for granted in the financial services industry. But how does one explain the sudden evolution of an entire market that did not even exist 10 years ago?
Moreover, it is not just an isolated niche market but a global engine of trade with profound effects on the flow of capital, national interest rates and the public perception of risk, efficiency and value.
A better mousetrap
We are always eager to recite the virtues of online FX trading, but this phenomenon didn’t come out of nowhere. Retail currency trading got started just as three favourable conditions were becoming fact:
the existence of a globally wired economy ready to communicate – easily and cheaply – through the internet;
the need for more efficient cross-currency transactions required by truly global and ever-increasing trade;
a spirit of innovation that rode the coat-tails of technology but had a higher purpose: doing more with less, and making opportunity available to the many instead of the privileged few.
In 1996 FX trading was done by banks, a few investment managers, and those corporations that were big enough to have to worry about it. These big players predicted that small-time market makers and brokers wouldn’t have a chance. There was too much risk, too much capital required, and no reliable platform to attract a clientele that, in any event, was too busy chasing equity returns and couldn’t understand currencies (or stomach their volatility).
The global-finance oligarchy could not imagine a business model capable of opening the private club of currency to the average investor. For a while, they were right: a few banks adopted new technology and trading costs went down, but not for the banks’ big retail customers. Spreads began to narrow and volatility slacked somewhat, but costs were still high. Even though the core market became relatively more efficient, volatility relative to cost (spread) was not favourable. And this might have fuelled the early pessimism that technology alone would not change business as usual.
And it did take more than technology to change FX. This is where the retail start-ups saw an opportunity:
in an unregulated industry...
...with low barriers to entry...
...and an unboundaried, ready-made distribution channel – the internet – that demanded results to build awareness and loyalty, with dramatically reduced dependence on sales and expensive relationship-building.
What’s the big deal? (why you should care)
The big deal is that the retail FX start-ups made it happen, succeeding beyond anyone’s expectations (including their own):
today there are well over 100 internet FX brokers worldwide;
some are market makers, some are clearing houses, some are fully automated – there is a spectrum of business models;
we estimate daily volume for internet-only FX market volume at between $40 billion and $50 billion, or about 8% to 10% of total daily FX volume;3
Greenwich Associates reported that global retail currency trading rose by 54% in 2006 (an 80% increase in Europe, up 55% in Asia/Pacific, and up 30% in the Americas).4
So retail FX is a growth business. But what are its real effects, and what values does it offer?
1. Most important, the cost of trading currencies has come down dramatically – for everyone. Most online brokers charge only the spread (the difference between bid and ask for a currency pair). Spreads vary with currencies, the time of day, the day of the week, and the market maker’s desire to move product. But over the past five years the typical spread on a euro/dollar trade declined from five-plus pips to one pip.5
A five-fold decrease in cost is big news for any industry. For retail FX this has meant more – and more diverse – market participants, increased market liquidity, and a competitive position to challenge the larger, slower-moving players.
2. More than just a low-cost alternative, online platforms rival institutional trading platforms as reliable sources of pricing. (Banks sometimes give incorrect prices or “spikes”; at OANDA we filter close to a hundred spikes a week, and while we don’t claim to be perfect, we’ll pit our information against anybody’s.)
3. Because of their low cost and reliability, Internet brokers invite the participation of thousands of investors whose trades make a difference. Far from embracing the lunatic fringe of global finance, retail FX serves every possible interest. We think this is part of a larger, internet-enabled move toward consumers taking greater control over their own needs and desires. (Consider the travel industry, among many other examples.) Instead of deferring to a limited institutional offering with a privileged and dictatorial pricing schedule, retail currency traders have created their own market – and have insisted on lower prices and higher standards.
What has retail FX done right?
Retail forex is a unique form of investing. It depends on the simultaneously flawless performance and interaction of a number of different and very complex systems. It is an egomaniac’s game: I want to trade precisely when I want under the precise conditions I stipulate.
Some would claim the start-ups got lucky, entering the market before regulators began to block easy access – that they happened to appear at the right time and the right place. But the story is not that simple.
The smarter players in retail FX exploited their medium, mounting platform interfaces that were easy to use, readily available on the desktop of every personal computer, and ready to trade around the clock. They also exploited the speed of the internet to enable users to track prices in real time and execute trades instantaneously, immersing investors in the trading environment but without the unnecessary baggage.
Equally important, retail providers succeeded where big institutions – despite their rich IT budgets and R&D capacities – could not, at deploying technology in precisely the right ways. (Witness the recent partnerships between three large banks and much smaller retail FX shops.) Success here came through the simplification of tracking the market and obtaining other relevant information at the lowest possible cost, and making a few basic processes easy to understand and efficient to execute.
Finally, retail FX makes it easy to do business: minimum trade sizes are low (one broker allows trades as small as $1.00), and trading on margin allows individuals to leverage their positions to create serious investments.
Less than perfect
If we have given the impression that retail FX is a land of unlimited opportunity and easy success, let us correct that. There is the usual ratio of unscrupulous providers in this space, with regulatory intervention only starting to keep them on the straight and narrow. (If anything, regulatory action is working to limit inflows of new ideas and processes and the always necessary increased efficiencies.)
The good news, and the bad news, is that individual currency traders are a demanding lot. This diverse clientele has irrationally high expectations of technology; no one standard of service seems capable of satisfying the universe of trading objectives, risk tolerances, and plain old customer-service expectations these people have of an inherently low-margin business.
Equally good and bad is the fact that the global community of retail FX customers is wired in a tight and communicative group: they talk to each other – obsessively and with authority, keeping a running scorecard on every nuance of market makers’ performance. While it’s good to know what your customers are thinking and saying to each other, it’s frustrating to be praised one minute for your “transparency” and user-friendliness and then damned because your platform hiccupped just as a hundred customers wanted to sell.
Of course, this connectedness does present an unprecedented marketing opportunity. Intense competitiveness means that while small mistakes always hurt, big successes quickly attach to who you are and what you are capable of ... most of the time.
The clear lessons
1. Sustaining a retail product that has to be fast on its feet is more demanding than mounting a monolithic “professional product”.” Relationships are built on a live ability to deliver results in the marketplace. Instantaneously, with no excuses.
2. Price points are so competitively driven that there is no margin for error.
3. Alternative providers are readily available, and the cost of switching is negligible.
4. Success depends on the intrinsic quality of the product and its continued instantaneous delivery, day in and day out.
5. Loyalty is built on a handful of criteria that – although not unique to FX – have been prioritized quite differently by large and small players:
Is my money safe?
Is this the absolute lowest cost?
Is this the absolute highest quality?
Is somebody else offering these same benefits, but through a platform that it easier to use and more efficient?
Financial products tend to stay proprietary, local and stodgy. Global retail FX has broken through those constraints, proving that commoditization doesn’t have to blunt the creation of efficiency and value.
Richard Olsen and Michael Stumm work at OANDA, a noted instigator in the evolution of retail FX. For a concise and objective analysis of the make-or-break factors at work in this market, see The Forex Trader’s Bill of Rights (available at www.oanda.com). This quick read outlines what’s wrong with forex and encourages individual currency traders to make it better.
1 See Kosuke Goto, “Housewives outmaneuver UBS, Deutsche Bank trading yen (Update 4),” June 18 2007, www.bloomberg.com. And Shu-Ching Jean Chen, “A yen for currency trading,” June 24 2007, www.forbes.com.
2 “Retail FX” in general refers to currency trading not done by large corporations, investment banks/asset managers/fund companies, or large banks. In terms of volume of spot currency transactions, most retail FX occurs through online brokers and market makers.
3 Much of the often-cited figure of $2 trillion daily FX volume includes swaps. We estimate pure spot trading to be about $600 billion per day. For perspective, note too that Japanese individuals now trade approximately $11 billion per day – a 300% increase over 2006. Cited in Goto.
4 Cited in Goto.
5 Most major currency pairs are priced to four decimal places; the smallest change an exchange rate can make is that last decimal place, usually 1/100th of 1%, or one basis point.