Australian Foreign Exchange Committee
REVOLUTIONARY TRANSFORMATION AND EXTRAORDINARY OPPORTUNINTY – TODAY'S ELECTRONIC FX MARKET IS CHANGING EVERYTHING*
Ian Martin, State Street Global Markets
The global foreign exchange market is undergoing revolutionary transformation at a rate unlike any I’ve ever seen. It’s difficult to assign a single driver of this dynamic situation – rather, what we are seeing is a mutually-reinforcing combination of new technologies, diverse new market participants, a stunning flood of multi-sourced capital market liquidity and a new belief in currencies as an asset class. And of course electronic foreign exchange trading systems make it all possible – this near zero-latency network is the digital nervous system that is both allowing the transformation and accelerating its impact.
The worldwide market in foreign exchange is a remarkable capital markets success story. Over the past four years daily volume has tripled-depending on how one measures it, daily turnover may already top $3 trillion. Liquidity is deep and competition is vigorous. Margins are razor thin and all market participants – from the largest central bank to the smallest commercial enterprise – can easily enter the FX market to execute their business.
But it is precisely this diversity of market participants – from mega-banks and hedge funds to retail investors – that makes the contemporary marketplace so challenging. If the forex market used to be clubby, conversational, geographically confined and relationship-based, it is today a wide-open digital ecosystem. And while this diversity is a hallmark of a healthy market – it also makes it difficult to map the terrain.
Who’s Who in the Global Marketplace?
Electronic trading has come to define the size, shape and rules of the game for the new forex market. In decades past, the currency arena was one of the earliest adopters of electronic messaging and today it is arguably the most digital capital market of all. Much of the wholesale interbank market is entirely electronic, and both dealer to client and retail trading are aggressively migrating online – either to bilateral standalone platforms or to multi-party networks of various types.
While this is certainly a good thing – and clearly the kind of growth we’re seeing would be impossible offline – the speed, efficiency, flexibility and scalability that define the contemporary market make it difficult to keep up with exactly who is who and what they are doing – and where risk resides. We love our digital networks, our streaming prices, our low latency and our smart algorithms. And we clearly love leaving much of the operational drudge work, from routine price making to post-trade communications, to machines. But this convenience comes at a price.
For example, the introduction of autodealing techniques into the FX interbank market and other electronic trading venues, together with the rise of prime brokerage services, has introduced an element of anonymity into the market. Autodealing has for the most part had a positive impact on overall market liquidity and pricing – indeed, one can make the case that these practices have given rise to a newly heterogeneous market with increasing numbers of counterparties, large numbers of individual quotes and expanding volume and trades at every price point and in almost all market conditions.
But these new practices, in large measure taking place under the umbrella of prime brokerage services, have brought into question the precise identity of market participants. Is that market player – that digital market player – from the buy side? The sell side? Are they offering meaningful liquidity or are they merely dancing through a bit of price-point arbitrage? Are they a global bank, a hedge fund or a retail trader experimenting with leveraged speculation? In traditional prime brokerage, clients trade in the name of the prime broker but execute their transactions directly with the dealer. In the electronic prime broker model by contrast, there is often no clear identification of the trade as being prime brokered at the time of execution – so the end user is able to trade anonymously.
This new flexibility being demonstrated by the FX market has thrown many notions of market structure out the window. In recent years, aggressive traders from what we used to think of as the buy side have seen an opportunity to profit from being liquidity providers – a role formerly played by bankers who all knew each other. At the same time, many banks have seen fit to invest in currency funds – effectively becoming customers in the market.
Electronic trading has been a primary factor in this scrambling of traditional roles. When new market participants, working through prime brokers, were effectively given access to the inter-bank space a lot changed. There was a bit of rough stuff at the outset – some hedge funds had good technology and aggressive instincts and not all their initial forays into this area of the market were entirely appropriate or professional. Liquidity providers have been forced to adjust to new market practices.
Clearly, the FX market has been thrown open and new players are here to stay. And so the FX market, through bodies such as the FX Committee in New York, the FX Joint Standing Committee in London and through regional sister bodies including the Australian Foreign Exchange Committee (AFXC), for which I’ve served as Chairman for the last eighteen months, are scrambling to receive these new participants with new best-practice, risk management and self-regulatory initiatives, all aimed at identifying and accurately quantifying risk within the context of a self-regulatory framework. Only last October we were part of the first meeting of global FX Committees hosted by the Foreign Exchange Committee in New York, with representation from:
- Foreign Exchange Joint Standing Committee (UK) - JSC
- Singapore Foreign Exchange Market Committee - SFEMC
- Canadian Foreign Exchange Committee - CFEC
- Tokyo Foreign Exchange Market Committee - TFEMC
- Australian Foreign Exchange Committee - AFEC
- Treasury Markets Forum of Hong Kong - TMFHK
- Foreign Exchange Contact Group (Euro Area) – FECG
This was the first meeting of its kind and we were able to share our perspectives on critical issues, developments and trends underway in the global foreign exchange market, discuss key Committee initiatives and projects and begin to determine appropriate ways the global Committees can enhance their collaboration.
FX as an Asset Class
New participants in the FX market – investors dedicated to FX as an asset class – may prove to be the greatest single driver of today’s soaring FX volumes. Hedge funds and other leveraged investors have introduced new dynamics into the market, not the least of which is the aggressive compression of pricing latency to near-zero. In recent years, as global macro-economic policies have converged, equity market performance has grown more correlated, as the proportion of investor assets moving across borders has boomed, and as quant-driven strategies have mushroomed, sophisticated investors have woken up to the potential of currency investment as a driver of portfolio alpha.
While it’s arguably true that there can be no inherent return in currency, or that it is a ‘zero sum game’ , it is also true that a high proportion of currency market volume – driven by central banks, energy traders, multinational corporations and investors using currency markets only to facilitate cross-border investment in equities, fixed-income securities or funds – are non-return seeking. These market participants are merely using the FX market as a conduit to get from one place to another, leaving many investors to conclude that currency investment may be a reliable source of non-correlated returns.
However, only a few years into the present love affair with currency alpha, there are already signs that there may be more traders chasing a limited number of ideas and thereby canceling out their opportunities for arbitrage. Yes, currency investment offers some alternative to highly transparent and correlated equity markets, but as evidenced by the Parker Index, three years of close to zero returns for the median currency manager demonstrates that the market is certainly not offering anyone a free lunch.
The view from Asia-Pacific
Nothing gets the FX market more excited than a currency rebalancing by a central bank with deep pockets. And from our perspective in the Asia Pacific region, the long, hard look being given by Asian governments at their voluminous U.S. dollar holdings is expected to significantly impact the global FX market. In recent years, new pools of liquidity have risen – in China, other Asian countries are among energy and commodity exporters. And these new liquidity pools are often outsized in comparison to the investability of their local markets. So we expect much of this liquidity to be allocated around the world.
This may prove challenging, as FX markets and market-related technology in the Asia Pacific region are somewhat immature when compared to traditional market centers like New York and London. What’s more, the regional market is physically dispersed with different financial centers – in Tokyo, Singapore, Hong Kong, Sydney, Shanghai and others – all competing for liquidity, talent and technology. This fragmentation has historically impeded Asia when it came time to forge global financial policy. But there’s no question that Asian capital markets are evolving at a terrific rate and that any perceived lag in expertise, technology and market practice will be fleeting.
A big question facing capital markets, notably the FX market, in Asia will be the role of central banks and financial ministries in fostering the evolution of market practice. In Asia, many markets are highly regulated and closely controlled. And so any financial firm seeking to operate in the region faces the daunting challenge of navigating ten or twelve different sets of rules, regulations and market practice (on top of laborious air miles chalked up servicing a physical area as large as North America and Europe combined).Regulatory and business practice standardisation has been a primary challenge for the European Union for decades, after all. And Asian financial market standardisation is at an early stage.
Still, the potential of Asian capital market development is so massive that any and all financial players in the region seem committed to bearing whatever burden it might require. There is nowhere else in the world with the kind of massive concentration of foreign currency reserves – $1 trillion in China, $800 billion in Japan, $400 billion in Korea – that can be found in just a few East Asian economies. And as the stated goal of these central banks is to diversify away from the U.S. dollar holdings that account for some two-thirds of these reserves, there will be great potential for a well-managed distribution of these assets through regional foreign exchange markets.
Given the speed with which technology-driven change is moving through the FX market, we may find that the perceived ‘lag’ between industry best practice and the way of doing business in Asian capital markets may disappear faster than we think. For example, the advent of the China Foreign Exchange Trade System (CFETS), multi-bank FX portal under the auspices of the People’s Bank of China, has facilitated the growth of FX trading in China through the use of real-time, internet-based trading, and streaming executable FX prices contributed by global price-making institutions.
Clearly, Asian governments are going to open their FX markets – both in terms of regulation and in terms of electronic trading – at their own deliberate pace. And, given the fact that the Asian financial upheaval of ten years ago began in large measure in the currency markets, this is perhaps understandable. But I expect momentous things in the Asia Pacific FX markets in coming years, as the benefits of electronic trading and state-of-the art risk management practice imported from other regions does much to mitigate the physical, monetary and regulatory fragmentation that has thus far impeded the growth of the region’s financial markets.
Where are we Going?
The foreign exchange market is one of the least-regulated on earth. And there are good reasons that this is so – because for all practical purposes it may be impossible to regulate the transnational FX market. But as global finance grows more interdependent and unitary in structure, common best practices and standards are rapidly emerging. After many years of technological and practice evolution, we are still debating whether the over-the-counter foreign exchange market is aggregating into something resembling a quasi-exchange, into a constellation of competing multi-counterparty digital trading venues or into something more exotic – P2P networks matching price makers and price takers? Why not?
It’s ironic that the FX market is wondering whether a single exchange model will emerge even as centralised national equity exchanges around the world are losing control of previously captive liquidity in the face of foreign competitors and alternative digital trading venues. What this tells us, perhaps, is that none of us can know with certainty how, when or where the technological changes sweeping our industry are taking us.
What seems clear though – with the advent of new kinds of market participants, new technologies and the strategic rise of massive new liquidity pools and financial institutions in Asia – is that the FX market is growing larger, more varied, more transnational, more digital and more efficient than at any time in its history.
Footnote
* This article was first published in the April edition of e-FOREX magazine. (back to text)