The flows of yen, Euro, dollars traded in currency pairs against each other represent a pure market of natural interest, and maintains the flow of international business. Open 24 hours a day, seven days a week, turnover in this fascinating market has rocketed in recent years.
Put simply, there has been a seismic increase in turnover in traditional FX markets, with average daily volumes rising to USD 3.2 trillion in April 2007, up 71 percent since the last study in 2004 by the Bank For International Settlements.*
This year has seen record volumes on the spot electronic brokers, EBS and Reuters, which both posted records for trading volumes amid highly volatile global markets.
Daily volumes on the Icap-owned EBS mirror this growth, reaching $456bn on Thursday August 16, breaking the previous record of $311bn on July 27. This was followed by a new second-highest trading day on Friday, August 17, when $411.38bn was traded. Average daily volumes on EBS have remained at about $250bn.
As a breakdown of the BIS volumes, spot FX – the core OTC trading rose 62 percent, from $621bn in April 2004 to $1,005bn in 2007, according to the BIS report. This means that spot FX trading now accounts for 33 percent of FX market turnover. The core interbank spot market also remains strong, with volumes rising to $427bn.
Yet the main evolution of the market has been the increase in FX turnover between banks and non-bank financial customers, including commodity trading advisors and hedge funds.
This sector’s volumes rose 85 percent, from $213bn in 2004 to $394bn in 2007, so while electronic FX trading is still dominated by the large dealing banks, the market has also absorbed hundreds of new participants from both emerging and developed markets and non-banks all seeing great opportunity in FX.
This variety is excellent news for liquidity, as the more volume and diversity of participants, the more trading opportunities for all, as organisations can get the price in the currency pair at the time they need to play.
If there has been a single trend over the past three years, it has been one of evolution and diversification. Many more counterparties have joined the core and downstream markets, using both the traditional interbank markets and the downstream retail offerings.
In part, this has been the increasing participation by hedge funds treating foreign exchange as an asset class in its own right which have contributed to driving this explosion in volumes.
But often overlooked is the growth in overall counterparty numbers from across so-called emerging markets. Banks and non-banks which may have previously not had access to the market have been enabled by technology and are adding unique liquidity and diversity to the benefit of all.
Over the past three years, the currency composition of turnover has changed only slightly. The greenback was on one side of 86 percent of all transactions, followed by the euro at 37 percent, yen at 17 percent and sterling at 15 percent.
Some currencies, notably the Australian, New Zealand and Canadian dollars have seen growth, driven by their use in carry trades, while growth in other currencies, such as the Hong Kong dollar reflects the growing importance of regional markets (i.e. links to China)
London remains the dominant foreign exchange trading centre and has consolidated that position over the past three years through a combination of favourable business operating conditions. The City increased its share of the FX market from 31 percent in 2004 to 34 percent in 2007.
Across the Atlantic, the US share of the FX market went the other way by roughly the same amount, declining from 19.2 percent in 2004 to 16.6 percent in 2007.
In 1997, fewer than ten organisations in the global marketplace used a foreign exchange prime broker, and the market was dominated by four banks, according to a report from the New York Fed.
Now analysts estimate that over 600 clients use prime brokers and at least 20 banks offer the service as a core foreign exchange product.
There will be continued growth of both banks and funds trading FX through prime brokerage relationships as the FX market appears to have adopted prime brokerage as a successful way to generate additional liquidity and bring new and diverse participants to the market as it preserves the role of banks as natural clearers.
Yet hedge funds are not the only prime brokerage clients. Commodity trading advisers, small banks, asset managers and pension funds use the service.
Five years ago, less than one percent of daily dealer-to-client volume was FX prime brokerage, a figure that has risen to 25 percent according to Traiana, the prime brokerage software provider.
Prime brokers typically charge clients a fee on a volume basis for trades conducted so this growth has produced a welcome income for banks that offer prime brokerage services.
And according to the New York Fed, prime brokerage provides efficiency of scale with respect to transaction processing and technology investment, allowing banks to leverage their technology and operating infrastructure.
It says that as foreign exchange execution continues to migrate to electronic platforms, prime brokerage presents an opportunity to build a fee business into an institution’s electronic foreign exchange platform to extract investment costs.
Improved technology has had significant impact on the ability of prime brokers to detect early warnings of problems within client portfolios. The technology is there for real-time risk assessment, but it remains up to the investors in hedge funds to ensure that managers have good risk controls.
Automated FX trading is opening up the field to a wide variety of market participants, reflected in growing FX market volumes, particularly from non-traditional players.
Trading FX used to be a game stacked heavily in favour of the high rollers of the major FX banks. Volume was everything, meaning not only high revenues and customer poll leadership, but also pricing power when trading with the lesser mortals of the market.
The well-known FX players continue to gain customer support thanks to their extensive reach and the quality of their services. Yet in some respects it is in the fast-growing arena of automated FX trading that the playing field finally levels out for all market participants irrespective of size or type.
Automated trading – whereby financial instrument prices are requested and trades are executed by computer – is in one form or another as old as computers themselves. However, it has only been since the automation of markets themselves that genuine automated trading has been possible.
Automated trading began to make its presence felt in stock markets and then derivatives exchanges as increasing numbers of banks, hedge funds and trading arcades traded on a high frequency basis first the stand-alone instruments, and then cash instruments versus derivatives as well.
The London Stock Exchange reported that around 40 percent of its total volumes were generated from algorithmic trading in equities in 2006, a staggering figure. Now the attention has turned to applying the same technology to FX, with auto-traded volumes on the increase on the core e-trading platforms.
The principles for automated trading are to design a model, test it using the purest and most representative historical market data and, if it works, switch it on and watch with interest.
The onus on the FX platform providers and the market is to facilitate a market where these new technologies can bid and offer in an orderly fashion, adding liquidity and pricing to the benefit of the whole market.
Algorithmic trading in various forms has become more common, particularly among the hedge funds as a complementary method of trading, particularly for yet integral part of the FX markets now and for the future, complementing both voice desks and the keypad traders.
The resilience of the foreign exchange markets were tested in the fall-out from the sub-prime crisis, putting front and back office systems to the test and passed with colours. Banks and customers alike reported that pricing in the core markets could still be sourced and trades executed and settled.
In the future, developments in technology will continue to drive growth and the challenge for many professional trading organisations will be to ensure they make the business case for investment in both transactional tools and the source market data to inform their trading decisions.
Those who fail to do so will find their margins eroded rapidly in a profitable, yet ultimately highly competitive and sophisticated global market.
Godfried De Vidts
Director of European Affairs
ICAP plc And President of Euribor ACI