• New FX Venues Emerge

  
  
  Challenging the establishment – new FX venues emerge. David Mercer, LMAX Exchange CEO, shares insights.

  The first generation of FX electronic trading venues initially emerged in the interbank market in the early 1990s. Both Reuters and EBS have remained traditional powerhouses in the electronic FX market since their launches, supported by the dealing banks that relied on the two venues to manage their risk in a timely manner.

  The second wave of significant changes in the electronic FX market occurred during the late 1990s, when numerous electronic platforms surfaced to address trading issues in the client-to-dealer market. While most of those venues, such as Atriax, Lava, and FXMarketspace, ultimately ceased operations due to lack of market adoption, the few that survived, including Currenex, Hotspot FX, and FXall, form the backbone of today’s established FX ECN players.

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• Banks are no longer the largest counterparty in the FX market

  One of the most significant changes that the FX market is currently undergoing is the substantial increase in trading activities from “other financial institutions” —included in this group are retail aggregators, high frequency trading firms, and smaller (Tier-2, Tier-3) banks. Banks with an FX expertise (dealers, reporting dealers) accounted for 64% of all trading in 1995, but that figure declined to less than 40% by 2010. Non-financial customers (primarily corporate clients) as a group have more or less kept pace with growth in the FX market and held on to a 13%-to-18% share of FX volume. Trading from non-bank financial institutions (such as high frequency firms, smaller banks, and retail aggregators) increased from 20% in 1995 to 48% in 2010, thereby becoming the largest counterparty in the FX market. Principal reasons for this large jump in activity follow:

  • The growth and popularity of electronic trading platforms that started in equities markets two decades ago has gravitated to the FX market.
  • The lack of steady, profitable returns from traditional asset classes such as equities and fixed income have propelled FX and commodities as the new alternative asset classes, thereby attracting fresh investor money flow into the FX market itself.
  Volume by Market Participant Type

  

  Source: Aite Group ‘Global FX Market Update 2013: Increased Market Transparency, More Competition’, June 2013
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• The rise of “prime of prime” brokerage firms

  In the institutional market, credit lines or credit limits are the lifeblood that enables two parties to engage in the principal-to-principal, bilateral nature of FX trading in the OTC marketplace. When credit was easy to obtain and credit limits were generous, such as seen in the early part of this new millennium up to the global credit crisis of 2008 and 2009, large banks and their customers were both quite content to trade liberally both directly with each other and also via ECNs (the latter for those that are technologically advanced for electronic FX trading), backed by generous credit limits granted by these same banks’ prime brokerage units.

  Then came the global credit crisis, the ensuing bankruptcy of Lehman Brothers, and the near collapse of AIG and many other large banks and global financial institutions that were all thought “too big to fail.” If it were not for the government-engineered rescues of these venerable institutions, many of them would not be around to conduct their business today. What did result from this dramatic event, however, was a dramatic tightening of credit conditions around the world—gone are the generous credit lines and limits that allowed FX market participants, banks and their clients alike, to trade freely with each other.

  Although the economies of many nations around the globe have recovered a fair amount since then and a “business-as-usual” mentality has returned to Wall Street and global financial centers elsewhere, one direct consequence of the credit crisis is that the two parties entering a given bilateral dealing (e.g., an FX transaction) are now much more cognizant of the potential credit risk that each side brings to the table. This cautious approach toward credit stems from banks and clients; hence, each bank or client has potentially reduced the total number of counterparties that it is willing to deal with as well as the amount of FX exposure per transaction (with each counterparty) that it is willing to bear until the trade is settled.

  Although large banks and prime brokerage units may still grant the largest multinational corporations, asset managers, ultra-high-net-worth individuals, or hedge funds generous credit limits to do FX trades, the same cannot be said of small to midsize banks, proprietary trading firms, asset managers or hedge funds, CTAs/CPOs, or active retail traders. Our conversations with industry veterans in the FX prime brokerage community indicate that in today’s environment, FX credit limits and terms have tightened by as much as one-third from the pre-crisis days of more than five years ago.

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• 4 key fundamentals to consider when choosing an FX venue

  While FX as an asset class might be straight forward, customers that play in the FX market have different needs and requirements.

  For those corporations and traditional asset managers that view FX transactions as a byproduct of their core business (e.g., cross-border transactions), for example, overall costs associated with execution might be less of an issue; these customer segments would also view access to large size as important, leading them to trade on RFQ-based MDPs and SDPs. On the other hand, statistical arbitrage and actively trading hedge funds and HFT firms might care more about cost of execution since they deal with smaller-sized but more frequent transactions, leading them to use ECN/MFT-type execution venues.

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• David Mercer looks further afield…

  David Mercer looks further afield and beyond the regularly discussed topics of geography, greater transparency and growing regulation. In the context of the current challenges in the FX market, David offers views on how the market may be transformed in the very near future. Video Transcript David Mercer looks further afield… David Mercer: Ok, so […]

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