Special FX: The Evolution of e-FX Trading

The foreign exchange (FX) market is the most liquid in the world. Aside from pure dealing in currency, it is used to support equity transactions, as underlying for certain derivatives products and for hedging risk, among many other functions. The creation of the euro enhanced its profile greatly with the birth of a new super-currency, but what has altered it almost beyond recognition has been the emergence of electronic trading and the overwhelming communicative power of the internet.

The growth of FX as a tradeable asset class has been spectacular. From daily volumes of $1.5 trillion to $2 trillion at the end of the 1990s, today’s level is closer to $4 trillion. Along with lowering transaction costs, spreads have, according to estimates from Citi, quartered in that time, creating a highly liquid, cheap and efficient market. And the emerging supremacy of trading in technology has driven both of these factors.

“The cost has been driven down by the fact that machines do things that people used to do,” says Tim Carrington, global head of FX at Royal Bank of Scotland global banking and markets. “Operationally, with volumes through the roof, we probably have 25 percent of the number of people in operations today that we had 10 years ago.  So certainly, the big driver in terms of the reduction of costs has been automation.”

Chris Peters, head of electronic trading for spot FX, also at RBS, agrees. “The interbank market has morphed into an electronic one, with the creation of multiple application programming interfaces (APIs) between banks and between clients, and with the explosion of the retail business, it’s all come together at once in the last few years,” he says. “The efficiency with which volumes can be moved relative to the late 1990s is completely different. The ability of banks to make markets at much faster speeds has certainly been a driving force.”

Mitigating Risk
The accepted consensus is that, although movement was slow at the turn of the century in terms of adjustment to this brave new world of electronic trading, it quickly picked up momentum. For the interbank market in particular, though, it wasn’t just electronic trading that they had to adapt to.

“You don’t just use limit orders any more—you also use algorithms to transact. In a sideways market, the algorithms are very efficient. These algorithmic tools have absolutely taken off, and it’s one of the big changes in the market.” —Anil Prasad, Citi

Following a number of high-profile bank collapses over the previous 30 years, such as that of Herstatt Bank in 1974, and Barings in the mid-1990s, settlement risk became a hot topic within FX. Under pressure from regulators and governmental institutions to either fix the problem or have it fixed for them, the major banks effectively overhauled the way in which they transacted FX with each other through the concept of continuous-linked settlement (CLS).

The idea was simple—to eliminate this so-called Herstatt risk to an enormous degree, a central body, owned by a consortium of the banks, would match the trades with simultaneous settlement at an agreed date. The mechanics were more complex, however, when internal processes of the counterparties were taken into account.

“The challenge when CLS went live was that the service requires people to make payments at specific points in time, whereas previously the industry made payments almost as and when they chose on the day of value,” says Jonathan Butterfield, director of communications at CLS Group. “But in order to be able to execute the simultaneous debits and credits of the currencies that have been traded, we need to have the payment systems for those currencies open and available, and we need the cash in the account to effect the transaction. That requires them to get their money in on time.”

Mark Warms, general manager for EMEA at FXall also highlights the changes that have taken place in the management of risk within FX. “The focus on risk hastened the need for increased compliance and operational controls,” he says. “We regularly support straight-through processing and automated workflows that allow flexible trading. Custodians, for example, used to do all the FX for asset managers who were unwilling to go elsewhere because of the potential of equity or bond settlements to fail. With enhanced post-trade settlement through CLS and straight-through processing to [banking cooperative] Swift, this has been virtually eliminated.”

Open Doors
Outside of the banks, one of the major structural changes has been the opening of access to the market. Hedge funds and proprietary trading shops entered, causing a large growth in the retail segment of the market. Moreover, the advent of the prime brokerage model brought technology and new tools to FX, including something that had become prevalent in the equities trading landscape—the use of algorithms.

“The other feature that has grown, and grown very quickly with a large share of the market, and made it a lot more efficient to transact, is that you don’t just use limit orders any more—you also use algorithms to transact,” says Anil Prasad, global head of FX and local markets at Citi. “In a sideways market, the algorithms are very efficient. These algorithmic tools have absolutely taken off, and it’s one of the big changes in the market.”

Algorithmic trading, although commonly associated with technologically sophisticated hedge funds, isn’t just restricted to them. Observing an opening in the market, the banks stepped in with their own offerings to clients in the form of platforms that have evolved to offer algorithmic strategies. Credit Suisse is a famous example of one bank that went public with its technology, but others exist and have developed enormously, such as RBS Agile, and Citi’s Velocity 2.0 high-frequency trading platform.

“Clients are demanding more, touching on the resurgence of the single-bank portals,” says Ed Mount, managing director and head of technology-based trading at RBS. “They’re demanding pre-trade analytics, sophisticated order management, and algorithmic execution all the way to post-trade services. So, much of our investment is spent on those technological pieces, drawing them together so that we can stay engaged with the client from start to finish.”

The Big Squeeze
With these developments, spreads tightened to a fraction of what they once were, aided by the introduction of a fifth decimal place for percentage-in-points (pips). The value of individual trades has shortened inversely as a natural evolution of the emergence of more players and the chase for ever-shortening price opportunities, while the volume of trades has increased exponentially.

“One of the more substantial changes has been the growth in lower-value trades. These are not all necessarily algorithmic, but do tend to be platform-based,” says CLS Group’s Butterfield. “So, whether the platform is making the buy or sell decision independently of any human intervention, or whether somebody is reviewing prices and pressing an execute or request-for-quote key, pretty much everybody accepts that what happened in equities is largely happening, or indeed, has happened in FX. This has led to much higher volumes but not necessarily much higher value.”

As CLS Group opened its doors in 2002, it has been well-placed to observe FX from a post-trade perspective over the last decade. Over the last few years, according to Butterfield, trades of $1 million or less have come to represent over 80 percent of its settlement flow. Some of this is due to a hesitance to move the market with large trades, given FX’s sensitivity, but decreasing value versus increasing volume is a common trait of markets with an influence of algorithmic or high-frequency trading activity.

“It’s a very significant change in the composition of the market,” he adds. “The general perception is that this growth is driven by hedge funds, but I think this is a little simplistic. Yes, hedge funds identified FX as a trading opportunity, but equally, so did the banks. I think you’ve had a significant change in trading strategy by both clients and banks. Everybody assumes that the banks are market-makers; that is not the case. The vast majority of banks are effectively buy-side firms in that they’re buying to execute something either for themselves or on behalf of clients.”

Looking Ahead
The FX market has huge potential for growth but the transformation of structure and practice through technology hasn’t finished. Along with the growth in algorithmic trading, which many still consider to be in its relative infancy compared to equities, there has also been a renewed focus on transaction-cost analysis (TCA).

“Historically, TCA reporting has done a good job of characterizing inefficiencies and costs related to ‘fuzzy’ instructions and inefficient workflows,” says John Fatica, head of analytics at TradingScreen. “The demand for FX TCA is making it clear that FX executions will no longer be considered an afterthought of investment implementations. And, with the rapid increase in algorithmic execution, TCA measurement provides the feedback mechanism to refine trading tactics.”

Indeed, the use of algorithms shows no signs of abating any time soon. The universal opinion is that it will continue to claim an increasing share of electronic order flow moving forward. “The margins are so thin, and very much like the equities markets with a few basis points for commissions, you can’t rely on a human to do every transaction,” says Fatica. “There’s a move more toward collapsing the time horizon between the settlement of an equity or cash fixed-income instrument, so a lot of that is tending toward real-time netting of positions and then executing on an algorithmic and electronic basis.”

Paolo Gilardi, head of US FX sales at TradingScreen, says that although the equities market trades a lot with algorithms, the FX market is still lagging behind, despite an exponential increase in interest.

“The margins are still a bit bigger, which is why everyone, particularly on the market-making side, is interest in it,” Gilardi says. “Going forward, that’s where the value is, but it’s going to shrink quickly, and banks are looking to take advantage there.”

From the perspective of the banks, too, algorithmic market share is on the rise. “More and more of the flow will go to the algorithmic platforms, whether they’re high-frequency market-making or taking some of the emotional decision-making out of the hands of the clients and using platforms like Agile,” says RBS’ Mount, with Carrington adding that they see more FX transacted in a day now than they did during the whole of 2000. Growth, it seems, is inevitable.