Whether this proves to be the case is perhaps debatable – history has repeatedly shown that the more things change in FX, the more they stay the same. But at the same time, the way the market is evolving should not be underestimated. It is clear that FX participants need to give thoughtful consideration to the structure of their business, otherwise they risk losing competitive advantage.
Consolidation and concentration within the industry are the main drivers of the shift currently taking place. This is nothing new – it is a trend that has been taking place for more than a decade. As can be seen in the BIS chart, fewer players are accounting for the majority of the volumes transacted.
In theory, the fallout from the sub-prime crisis could have allowed the emergence of some new FX powerhouses – those banks to have emerged from the turmoil with their balance sheets relatively intact have an opportunity. While that may yet happen, the evidence suggests that it will take more than a strong credit rating to break the dominance of the large FX trading banks. As the Euromoney FX poll showed this year, the market share of the top five banks remains remarkably steady at around 61.5%, even though several of them were high-profile losers from the sub-prime crisis. It is also worth noting that in the past year, the combined share of the top 10 banks rose from 76.3% to 79.7%.
Such figures underscore the role these banks play in the market, and this importance is not decreasing. At the time of the last BIS Triennial central bank survey in April 2007, much was made about the emergence of a new breed of market-maker. In reviewing the turnover, BIS stated: “By counterparty, the expansion in turnover in the inter-bank market was comparable to growth over the previous three years, but was outpaced by the increase recorded in the non-financial customer and non-reporting financial institution segments, which more than doubled in size.”
But BIS makes another key observation: “Consolidation of the banking system was identified in the past as reducing turnover in the inter-bank market through channels such as efficiency gains and the ability to net trades across related parties within an organisation.”
Three years ago, it was anticipated that the emergence of the new players would have the most impact. This, many argued, would lead to an erosion of the banks’ dominance on price making, leading to the long-anticipated move of FX on to a single, or at least fewer, centralised locations. But this has not happened, largely because of the ability of leading FX banks to internalise their order flow – or, as BIS put it, net their “trades across related parties within an organisation.”
Internalisation is a much-talked about concept in other markets; in FX it is a reality. The ability to match-up trades means banks are no longer so reliant on – and perhaps are even independent of – the main external platforms for reference pricing. Banks have rediscovered the true art of market making, albeit with a new, electronic twist. However, they will always have business that they cannot match up and that they need to offset.
But when they seek to do this, they sometimes encounter problems. Naturally, a good deal of thought has gone into how these problems can be overcome. While the spill-out business from the banks may be comparatively small, it can still be of sufficient size to result in quite big losses if it is not transacted smoothly and fairly. A concern is that this flow can be read, which leads to the market being pushed away from the bank as it tries to offset its risk.
When there is a concentration of liquidity, such as on a single exchange, it is easy to make the argument that a trading venue must have equal rules and access for everyone. But the structure of FX, which remains a fragmented market place, means that different venues will have different rules for different participants.
The simple fact is that the banks have remained the true liquidity providers in FX. The new breed of FX participants have played an important role – which is mostly welcome – but it is hard to see the majority of them ever stepping up to the plate and making a price in a $1 billion in competition for a demanding client. Naturally, the banks do not see why they should act as the ultimate suppliers of liquidity, only then to be picked off by someone who will not reciprocate and make a price in any meaningful size back when they come to transact their own flow.
A potential solution is to have a variation on dark pools, but a different approach is required than the one utilised in equities. In FX, the issue is not about moving block trades, but rather it is about transacting smaller packets as efficiently and profitably as possible. Banks want to be able to meet with counterparties of natural interest, which will invariably be other banks.
Older market participants will remember how inter-bank brokers were able to meet many of these needs of the banks; the fact that non-bank players could not access their prices is believed to be a major reason why. On the whole, the brokers were trusted. And trust remains a crucial part of FX, just as it was when a bank used to tell a broker he was on the bid or offer. Electronic trading has not replaced this. Now banks are not only analysing how they price risk and credit, but also how they price trust.
The changes taking place have been given very careful consideration. They will not suit everybody, but as with most of the developments in FX over the past decade, they will almost inevitably result in an even more efficient market. The FX market has shown itself to be very capable of overcoming conflicts when they arise.
Only a wise man or a fool will claim to be able to predict the future, but looking at the market’s history should provide some clues. There is something in FX to satisfy the needs of most participants, and technology should allow different platforms to survive with very different business models. There is no single way to trade: some will prefer ECNs, others will prefer bank-streamed prices and, sometimes, dark pools will be chosen where shared interest can be matched. Some platforms will offer variations on all of these, and this could prove important.
Banks are looking to diversify the venues they trade on as they seek to diffuse their risk, but at the same time, in seeming contradiction, they are looking to consolidate where they place their business to extract efficiencies and savings. Single market-model platforms still have plenty to offer, but there are real opportunities for those that can offer multiple ways of execution. Ultimately, FX will continue to thrive because it offers real choice for its vast array of participants.
The number of banks accounting for 75% of FX turnover
| 1998 |
2001 |
2004 |
2007 |
|
| UK |
24 |
17 |
16 |
12 |
| US |
20 |
13 |
11 |
10 |
| Switzerland |
7 |
6 |
5 |
3 |
| Japan |
19 |
17 |
11 |
10 |
| France |
7 |
6 |
6 |
4 |
| Germany |
9 |
5 |
4 |
5 |
Source: Triennial Central Bank Survey, Bank for International Settlements
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