FX Broadens Appeal (Part 2)

Terry Flanagan

(Part 2 of a 2-part series)

As the fundamental appeal of foreign exchange has improved vis-à-vis equity and debt markets, so has the ease of trading currencies and the attendant liquidity.

“The ‘electronification’ of the market continues,” said Sang Lee of consultancy Aite Group. “The market itself is over-the-counter, but it has the structure in place that allows firms to trade in an exchange-like manner.”

While electronic trading is the preferred method for trading currencies, the days of picking up the phone are not over. Electronic trading is more pronounced in the interbank market, where it currently makes up an estimated 72% of volume, according to industry data; in the client-to-dealer market, voice-driven orders account for 53% of the market.

Traders of currencies include large private and public banks, institutional investors, currency speculators, corporations, governments, hedge funds, and retail investors. The multiple deep-pocketed constituencies comprise deep liquidity.

“From a user perspective, foreign exchange is very diverse; that explains the extremely large average daily volumes,” said Lee. “The beauty of FX is, there is always a corporation that needs to make an FX transaction because it has a global presence. There is always a traditional asset manager that needs to hedge risk because it traded a foreign stock.”

In a sense, the fundamental and technical sides of the FX market feed off one another; a better value proposition brings in more traders, which create a more liquid market and an even-better value proposition.

“The trend for FX volumes is up which is a function of diversification needs along with the investing world’s hunger for return and yield in a low-interest-rate environment,” said Bob Near, head of foreign exchange sales at BNY Mellon. “Investors are looking at markets where they can possibly get a better return than their home market, and also looking to go into what have been the traditional safe haven markets.”

For institutional buyers and sellers of FX, the ability to execute jumbo-sized trades is of paramount importance.

FX markets have come under the scrutiny of regulators along with their equity and debt counterparts, with the broad thrust entailing a move to more trading on lit venues plus more robust reporting and transparency. The new rules project to affect handlers and routers of FX trades more than the end-user buyers and sellers.

“We’ve been getting regulatory updates from banks,” said Philip Simotas, president and director of investment management at FX Concepts, a $4.5 billion hedge fund that specializes in trading currencies. “As far as I can tell, because we’ve already been dealing with central clearing with banks via prime brokerages, the brunt of the burden will be on the banks themselves in terms of how they handle credit and how collateral is managed. They may have to rip up what they have and replace a system which I thought was working quite well, with one that is a centrally cleared system. It will clearly impact banks more than fund managers.”

Much of FX’s growth can be credited to electronic trading, which now accounts for more than 60% of all trading done in the global FX market, according to Aite. While the currency market was one of the first markets to utilize electronic trading, at the start it was mainly in the interbank market. Other factors coming into play include the growing presence of hedge funds and proprietary trading firms in the space, more retail participation, as well as the proliferation of FX prime brokerage offerings from the big banks.

Trading electronically also satisfies the increasing need to prove best execution to clients, as it becomes easier to establish audit trails through the electronic footprint on transactions.

High-frequency trading strategies have also had a strong presence in the growth of FX volume, accounting for close to 40% of all spot FX trading, according to Aite. With algorithmic trading comes a larger amount of trades and smaller trade sizes: since 2007, the average number of trades per day has gone from about 650,000 to nearly 1.6 million, while average trade size has fallen from $2.5 million to $1.2 million.

“The major difference between foreign exchange and equities is that FX is still not exchange traded, so there is no such thing as a consolidated tape,” said Lee. “Price discovery is not as transparent as in an exchange-traded market.”

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