Decimalization, high frequency trading, alternative liquidity pools — one by one, the innovations that so disrupted the once-clubby world of stock brokerage have been transforming the trading of foreign exchange. Ever wonder where the infamous stock market day traders of the 1990s have gone? “We’ve even got those now,” sighs Daniel Torrey, head of North American sales at EBS, the electronic currency market operated by ICAP Electronic Broking.
But although the foreign exchange market has welcomed vast numbers of new participants and electronic trading technologies continue to supplant the telephone-based dealing of old, one feature has endured: the primacy of a relatively small coterie of global banks. Last year the Bank for International Settlements’ triennial survey of global currency trading found that the top market makers’ collective share of orders had grown in all but a handful of the world’s trading centers, continuing a long-term trend. In the U.K., by far the world’s busiest currency-trading hub, accounting for 37 percent of all transactions, the combined share of the top ten market makers rose to 77 percent last year from 70 percent in 2007, the BIS says. Over the past decade the number of banks accounting for 75 percent or more of turnover has fallen roughly by half in the U.K. (to nine from 17), the U.S. (to seven from 13) and Japan (to eight from 17).
“The big banks are getting bigger,” observes Peter D’Amario, London-based consultant for Greenwich Associates, which studies foreign exchange market trends based on its annual survey of corporate and institutional participants. Considering the past decade’s dramatic changes, D’Amario adds, “the traditional FX dealers have done a very good job of hanging on to old players.” And not just the old ones. In part to capture the business of new participants, such as hedge funds and even online sites catering to retail speculators, the top banks have invested heavily in electronic trading technology and adjusted their own business models over the past decade, adding prime brokerage and various forms of agency trading to their traditional market-making activities.
The stakes for the banks are large. Foreign exchange trading brings in hundreds of millions of dollars in annual profits — in a good year more than $1 billion — for perennial market leaders such as Barclays, Citigroup, Deutsche Bank, Goldman Sachs Group, JPMorgan Chase & Co., Morgan Stanley, Royal Bank of Scotland Group and UBS. In 2004, the first year in which Barclays broke out foreign exchange earnings in its annual report, the business generated £213 million ($340 million) in pretax profits, or about 5 percent of the group’s total that year. From 2004 to 2010 currency trading contributed a total of £4.3 billion, or 11 percent of the bank’s overall pretax profits during that period.
Such a lucrative source of earnings is more important than ever now that bank profits are under pressure from a sluggish economy and regulatory changes. Crucially, currency profits have proved to be both steady and uncorrelated with results from banks’ other capital markets businesses. Since 2000, RBS has earned almost exactly the same amounts from its foreign exchange dealings (£7.26 billion) as it has from all the rest of its trading activities combined (£7.25 billion). But although the bank’s currency earnings have bobbed along an upward-sloping curve during that time, the results from RBS’s other trading operations have ranged from multibillion-pound gains to a £6.29 billion loss in 2008 (which prompted RBS’s effective nationalization). Similarly, in that credit crisis year of 2008, Barclays’ foreign exchange profits doubled year-on-year, to £1.27 billion; the figure represented fully 98 percent of the pretax profits of Barclays Capital, the investment banking subsidiary that houses the currency operation, and nearly a quarter of overall group profits.
The reasons for trading currencies include facilitating commercial trade and cross-border capital markets activities, and treating foreign exchange as an investable asset class in its own right, notes James Sinclair, who used to head research and strategy for EBS and now runs MarketFactory, a forex-trading technology vendor based in New York. “FX is a reliable business that fulfills an essential customer need,” he says.
As foreign exchange has become more important to the big banks, there has been a profound change in the way currencies are traded. The biggest innovation is the growth of electronic foreign exchange trading, or eFX in industry parlance. Economists at the BIS cite electronic trading as a primary driver of the postcrisis recovery in currency-trading volume, which at an estimated $3.98 trillion daily in 2010 was some 20 percent above 2007 levels. (Another key driver is online trading by retail speculators; see story, right.)
“We could never do the volumes we’re doing without electronics,” says Jeff Feig, London-based head of Group of Ten forex operations at Citigroup. Like all the large banks, Citi offers its market-making services through a variety of electronic channels, ranging from its own custom-built trading platforms to systems run by third-party operators such as Currenex, EBS, FX Alliance and Reuters that connect customers with prices provided by multiple banks.
It’s a testament to the market’s robust growth that these multidealer platforms are thriving even as the banks, their chief rivals, continue to control the bulk of trading volume. (The banks, after all, supply a good part of the volume on the multidealer systems.) The competition between these two camps is intense, though. Multibank trading venues have made it easier for the banks’ traditional customers — corporate treasurers, pension funds, institutional investors and other so-called real-money accounts — to compare currency prices and shop for the best one without calling a bank’s dealing desk. The wiring of foreign exchange has also attracted new participants, including high frequency traders and others who have adapted their machine trading techniques to play in the world’s largest over-the-counter market.
The result of these developments has been nothing less than a technology arms race among the banks and the multidealer platforms to provide faster, easier and cheaper trading services. For the big banks such a race can require spending $100 million or more a year on technology, analysts and industry executives say.
A decade ago prices of the most actively traded currency pairs were updated every three to five seconds on the largest eFX trading platforms, EBS and Reuters. Today prices can change in a matter of microseconds, a measurement that’s meaningful only to high frequency traders and to the banks themselves. To keep up with the market’s accelerated pace, the banks have found it necessary to constantly upgrade and refine their own eFX infrastructure, ranging from the superfast pricing engines they use to supply prices to multidealer platforms and other eFX channels to their own client-facing systems — known as single-dealer platforms, or SDPs — which compete against those channels.
This heightened competition has been a boon for investors, corporations and other currency traders. “The transparency of information is so great now,” muses Greenwich’s D’Amario. “FX is becoming a poster boy for the democratization of a market.”
Transparency has its limits, however. Like all assets that are traded over the counter, currencies are exchanged in many different venues, some of them rather opaque. Over the past year authorities in California, Florida, Massachusetts and New York, as well as the U.S. Attorney’s Office in Manhattan, filed lawsuits alleging that Bank of New York Mellon Corp. overcharged public pension funds for foreign exchange trading in their portfolios. Similar suits have been filed against State Street Corp. Both banks have vowed to fight the suits. BNY Mellon took out a full-page ad in the Wall Street Journal last month to deny the allegation that its customers were in the dark about how it priced its currency services.
THE TRANSFORMATION OF THE FOREIGN exchange market from a bank-controlled world where most transactions were conducted over the phone to today’s electronic free-for-all began about two decades ago. Seeking to broaden institutional participation in the market and to develop a substantial fee-generating business in the process, a handful of banks, led by UBS, began offering prime brokerage services to currency-trading clients like hedge funds and commodities-trading advisers. By offering credit, one-stop trade netting and other services, the banks enabled such clients to take larger positions and trade currencies more actively. By 2005 at least 20 banks were offering such prime brokerage services to as many as 600 institutions, most of them hedge funds, according to the New York Federal Reserve.
An even more significant development came in 1996, when Deutsche Bank launched its pioneering electronic single-dealer platform. The service, dubbed Autobahn, gave Deutsche’s customers what was then a novelty: screen-based access to a top-tier dealing desk, with some of the best pricing in the market. Its impact was dramatic. In 2000, Deutsche was voted the top bank in foreign exchange market share in Euromoney magazine’s annual poll, knocking Citi off a perch that it had held for more than 20 consecutive years. Other big banks soon followed Deutsche’s lead — or found themselves declining in the market-share rankings. UBS introduced its SDP, called FX Trader, to industry acclaim early in the past decade, briefly displacing Deutsche at the top of the league table in 2003.
While the banks were going electronic, a number of new players entered the scene. Currenex, a Silicon Valley start-up now owned by State Street, launched an electronic currency-trading service aimed at corporations and institutional investors in 1999. The following year a consortium of ten banks launched the electronic platform FXall, and another electronic upstart, Hotspot FX Holdings (now owned by Knight Capital Group), opened for business. These companies grew rapidly by targeting nontraditional currency traders, such as the wave of high frequency trading firms, like Jump Trading and Getco, that burst on to the scene around the turn of the century. Trading volumes for the three platforms have grown to between $50 billion and $80 billion a day currently. With business buoyant, FXall has decided that the time is right to go public, filing its initial public offering registration with the Securities and Exchange Commission in September, a deal that is expected to raise about $100 million.
Competition intensified further in 2004 when EBS, which had been an interdealer brokerage, opened its trading system up to nonbanks such as asset managers and hedge funds, a move that Reuters quickly matched. With their origins in the interdealer market, where large banks traded exclusively with one another through a brokerage to preserve anonymity, EBS and Reuters offer exactly what machine traders seek: some of the best liquidity available. The two firms boast average daily volumes of $125 billion to $140 billion apiece, or about a quarter of the overall eFX market each. Although the two companies are fierce rivals, they have thrived in part by specializing in separate instruments: EBS is regarded by professionals as the deepest market for the euro-U.S. dollar trade, for example, while Reuters boasts the most activity on British pound crosses.
The rise of multiple electronic dealing platforms set the stage for the first major skirmish in the foreign exchange arms race, over latency arbitrage. Seeking to take advantage of momentary pricing disparities among various eFX channels, high frequency traders invested in speed-enhancing techniques like colocation, positioning their computers near those of the electronic platforms to shorten the physical paths their orders must travel. The electronic platforms were only too happy to oblige because their revenues are based on commissions and therefore increase with trading volume regardless of price, unlike the banks, whose dealing profits vary with the amount of spread they can capture in each trade.
The rise of high frequency trading has not only helped narrow spreads — now $100 or less on a standard $1 million deal in the most widely traded currency pairs — it has also turned some of these alpha-seeking traders into de facto market makers. “We always used to think, ‘We’re never going to beat those guys, with their colocation schemes,’?” Citi’s Feig says. “Until all of a sudden we realized they are our competition.”
To meet the challenge of the rival platforms and the latency arbitrage they facilitated, the big banks ramped up their technology spending, even through the financial crisis that began in 2007. Each of the top dealers today boasts its own “low-latency” infrastructure: a complex, custom-built collection of superfast pricing engines, trade-matching and other market-making computers, and related network plumbing that represents some of the most advanced hardware and software in use on Wall Street. As a result, the banks are able to participate actively on venues like EBS and Reuters as well as on their own proprietary platforms. “We’re in a world where the banks mingle with their clients in many venues,” says Ian O’Flaherty, London-based head of eFX at Deutsche.
With this build-out, says analyst Howard Tai, a Kansas City, Missouri–based analyst at Aite Group, a Boston consulting firm that focuses on Wall Street’s information technology spending, the trading strategy once preferred by forex high frequency traders has been pretty much turned off. “The HFTs and others that used to be latency arbs have had to change their stripes,” adopting methods such as momentum-based trading strategies, says Tai.
The banks’ response to the latency arb threat underscores the way electronics have transformed the economics of the business. What was once a big-ticket, relatively high-margin activity for the banks has become one based on low margins and ever-higher volumes. More than ever, the industry favors the biggest banks at the top of the forex food chain, the so-called flow monsters that can process the highest volumes of trades at the lowest cost. “Every one of the big banks wants to be Costco,” observes one regulator, who spoke on condition of anonymity.
Notwithstanding the impact of high frequency traders and other new market participants, business from traditional corporate customers and institutional investors continues to rise and remains the foundation of the currency market. That’s another reason the big banks are still so central to the foreign exchange market. After all, they are the main providers of credit and payment services to global corporations and real-money accounts. “If you take the end users out of the market, there would be no HFTs,” says Mike Bagguley, head of forex trading at Barclays Capital in London.
The key for Barclays and other banks is to channel as much of their trading as possible through their proprietary, client-facing systems. These single-dealer platforms allow banks to match some customer orders with others to minimize market impact, which is just what customers prefer. “The banks have looked to internalize their flow more than they have in the past,” says Alan Schwarz, president and COO of trading systems vendor Trading Cross Connects US and a principal of a fund that backs proprietary trading outfits specializing in high frequency trading. Some big banks can meet as much as 80 percent of their customer flow through their internal matching systems, sources say.
The banks also use their proprietary platforms to differentiate themselves, promoting their strengths in research or algorithmic trading, for example, or tailoring products to appeal to particular customer segments. Above all, single-dealer platforms combined with old-fashioned phone traders allow banks to offer customers so-called dedicated pricing — deals that are better than those they post to multidealer systems, where they can get picked off by machines.
It’s not surprising, then, that banks are spending heavily to develop their single-dealer platforms. Aite Group estimates that banks’ spending on such proprietary systems reached an all-time high of $1.5 billion in 2010, double the amount spent just four years earlier. And there’s every indication the trend will continue.
Credit Suisse developed a new line of platforms in the middle of the past decade, including PrimeTrade FX for cash deals and Merlin FX for trading currency options. The investment was part of a broad strategy of building a “customer-led flow business,” says Martin Wiedmann, head of forex sales and distribution in Zurich. “It became very obvious we needed to be in e-trading in a big way,” he says. Today the bank handles the majority of its foreign exchange volume over its proprietary eFX channels.
Goldman Sachs began to get serious about eFX around 2005, says Rick Schonberg, who heads the bank’s eFX distribution efforts. The investment bank launched its single-dealer platform, Redi FX, in 2007. Goldman’s New York–based eFX unit has about 20 people, compared with a North American sales and trading desk of about 130, but it has doubled in the past year alone. “With electronics we get more business than ever before,” says Schonberg.
Citi, JPMorgan Chase, Morgan Stanley and UBS have also introduced new client trading platforms in recent years. Smaller players looking to move up the ranks, including BNP Paribas, Nomura Securities Holdings, Société Générale and Standard Chartered, have launched their own rival systems. All of these platforms employ the latest web-presentation frameworks, using price tiles to display the latest bid and ask prices for each currency pair. The systems enable traders to customize their work spaces and toggle through stored screen configurations with a few mouse clicks.
The more significant innovations in the latest-generation platforms include enhanced trading tools and the addition of other asset classes, such as currency derivatives. “We can innovate more on an SDP than we can on other platforms,” explains Holden Sibley, New York–based head of electronic trading sales at Barclays Capital. In 2005, Barclays used its platform, called BARX FX, to become the first dealer to extend pricing out to a fifth decimal place for certain actively traded currency pairs. That innovation has since been adopted by other large dealers and this year by EBS. (Reuters has so far resisted the move, saying its customers haven’t shown interest in the smaller tick size.) Such advances help explain why Barclays nearly doubled its global market share between 2005 and 2010, rising to No. 3 in the Euromoney ranking. BARX FX now claims one of the industry’s biggest footprints, with more than 2,500 institutional clients.
Barclays can also take credit for being a pioneer in what has become the latest fad in currency trading: offering customers algorithmic execution services. Algos allow customers to automate the execution of their orders in a market-savvy way, slicing a trade into smaller orders that can be dripped into markets to lessen impact, for example.
Citi’s algo offerings stem from the bank’s work on forex market microstructure, says Andrew Coyne, the bank’s London-based head of forex prime brokerage and G-10 e-commerce. Akin to transaction cost analysis, algo offerings are “important to real-money investors,” he adds. Credit Suisse, Deutsche, Goldman Sachs, Morgan Stanley and others have stepped up their offerings.
The efforts are gaining traction. It’s a measure of the market’s competitiveness that many corporate customers and even less active currency traders are installing multiple bank platforms on their trading desks. “They’re not choosing one or the other; they’re choosing all,” reports Jim Daley of SunGard Data Systems, which helps buy-siders link front- and back-end trading systems. Customers that a couple of years ago had electronic links to one or two bank platforms now have three to five, he says.
Of course, every bank knows that installing its platform on a customer’s trading desk doesn’t guarantee it will be used. The busier trading desks, such as those at currency funds and regional banks, may have monitors or feeds from a dozen different banks and still send most of their trades to the multidealer systems that sit alongside them. “You only have so much real estate on a trading desk,” explains Bob Tull, head of the forex and commodities group at Fifth Third Corp., a Cincinnati-based regional bank. “Besides, no one wants to log in to all those separate systems.”
For banks, that means there’s no single solution. To maintain their dominance, they have to offer keen pricing on multilateral platforms and constantly refine their in-house systems. That is costly, but it’s a reality the banks are resigned to. As Goldman’s Schonberg puts it, “We’re in a constant battle for relevance.” • •
