Trading In the Ether

Tepid worldwide equity markets and expansion of international trade have spurred growth in all forms of financial exchange. That growth, in turn, has fueled greater need for and development of electronic trading technologies for financial services companies offering foreign exchange (FX) services, according to Octavio Marenzi, CEO of New York-based consultancy Celent Communications.

"In the past couple of years, the equities markets have moved sideways, so the [profit] opportunities have been more limited," Marenzi says. "So companies are starting to look at other asset classes and they're seeing opportunities to make money in the foreign exchange market."

According to Marenzi, the continuing growth in international trade means not only that traditional multinational firms will be involved in exchanging payments with customers, suppliers and employees in different currencies, but so too will a larger number of smaller companies that are becoming part of the global marketplace and need the same foreign exchange capabilities as larger enterprises.

FX has trailed other financial services in terms of technology deployment, says Dushyant Shahrawat, senior analyst in the securities and capital markets practice at TowerGroup (Needham, Mass.). "New ECN and alternative trading systems ... have changed the nature of the equity markets," he says. "Now, that same trend is starting to play out in foreign exchange."

As automation spreads to foreign exchange, TowerGroup expects to see the same kind of bifurcation of order flow witnessed in equities - where self-service functions are separated from high-value services. For example, small orders or highly liquid securities tend to go electronic, while large orders, those matched internally and illiquid securities continue to be traded through traditional channels, such as open outcry.

There are two distinct FX markets: the interdealer market, in which large international dealers (e.g., Citigroup, Deutsche Bank, etc.) primarily deal with one another; and the dealer-to-client market, which includes other banks, non-bank financial services firms and large corporations.

Interdealer Trades Dominate Market

The interdealer spot market trades $301 billion each day and has higher adoption rates of electronic trading than the dealer-to-client market, and EBS and Reuters are the dominant trading technology solutions providers in the international dealer market, according to Celent's Marenzi. London-based EBS, which is more established, has 2,000 traders on 750 floors globally using its platform to trade an average of $110 billion, while Reuters, also based in London, runs a little more than half of that volume. EBS's partnership, since December 2004, with Bloomberg (New York), the leading provider of market data, opens up the EBS system to non-banks, Marenzi notes.

Celent estimates that 60 percent of interdealer trading was conducted electronically in 2004 and will grow to 90 percent by 2007. The efficiencies offered by electronic trading are making it difficult for traditional interdealer voice brokers, such as Tullett Liberty and ICAP, both based in London, to remain viable, according to Marenzi.

Even EBS and Reuters aren't relying on their market dominance and are continuing to add to their product offerings. At the end of May, EBS unveiled two enhancements to EBS Live, which was launched in February and provides live data feeds to FX customers. The new enhancements to EBS Live enable customers to capture the highest and lowest rates traded for the day and the highest and lowest rates within any 10-second interval that conforms to certain volume and other requirements.

Reuters added mergers and acquisition data and meta stock charts to its Reuters 3000 Xtra application (part of the Reuters 3000 suite) in March. While EBS dominates in terms of total volume, Reuters 3000 offers trading in more currencies, according to Bryan Hunter, director, foreign exchange, for the Chicago Mercantile Exchange. The exchange partnered with Reuters in March to offer CME FX on Reuters, the first major linkage between sell-side traders in the interbank FX market and electronic CME FX future markets. "The product has been very well received," Hunter says.

That should fuel further growth of the CME's FX business, which has seen a three-year compound annual growth rate of 112 percent on its Globex electronic trading platform. CME FX now accounts for about 5 percent of the overall FX market.

Dealer-to-Client Transactions Also Growing

The dealer-to-client side of foreign exchange is more fragmented and is seeing a larger array of new platforms and technology upgrades, which Celent's Marenzi attributes to increases in the number of corporate clients. He estimates that 43 percent of dealer-to-client volume was traded electronically in 2004, a figure that he expects to grow to 70 percent by 2007.

Although a recent Greenwich Associates (Greenwich, Conn.) report says that half of financial institutions using foreign exchange have no interest in electronic trading, Marenzi disputes this finding. Automation enables banks to trade as cheaply and easily as possible, he argues. Once customers begin using an electronic platform, they start using it for a majority of their trading activity, Marenzi asserts, citing results reported by Currenex and FXAlliance (FXAll), two foreign exchange trading platforms typically used by the client-to-dealer market.

New York-based FXAll is owned by 17 banks and management. Average daily trading volume was $25 billion as of December 2004, double the volume of a year earlier, according to Celent. In November, FXAll added 20 new features to its platform, Altair, including continuous streaming of data from all FXAll banks, anonymous trading and order management capabilities. The buy-side portion of the technology still is being rolled out.

Independently owned Currenex (London) handles $12 billion to $15 billion in daily trading volume. In May, Currenex launched ESP 7.0, the next generation of its trading platform, delivering a number of enhanced features, including one-click executable streaming prices and rapid two-way request-for-stream trading.

Proprietary Platforms Questioned

While large banks with significant FX businesses, such as Pittsburgh-based Mellon Financial, have developed their own proprietary technologies (see related article, page 34), these systems enable customers to see only one financial services company's FX pricing, rather than several, notes Celent's Marenzi. He questions the validity of such technologies going forward because, he says, customers want to see multiple-bank pricing so they can choose the best deal.

Celent's research, however, indicates that the reality is more complex. FX Connect, launched by Boston-based State Street Corp. in 1996, was a single-dealer platform until 2000, when it began accepting prices from other banks. Even though the platform now has established multibank capability, only 5 percent of FX Connect's transaction flow stems from quotes requested from multiple banks, according to Celent. Celent further reports that State Street says most customers don't seek multidealer quotes due to the difficulties in netting orders at a single asset management firm when trading with multiple banks.

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Small Effect From EU 'No' Vote

The FX market won't be directly affected as a result of the recent rejection of the European Union constitution by the Netherlands and France, predicts TowerGroup analyst Ralph Silva. For the most part, the financial services rules lie outside of the constitution, he explains.

However, the rejection of the constitution could affect where any new FX participants set up trading operations within Europe. If the constitution had passed, then the operations could have been set up anywhere without any differences. Until the constitution becomes a reality, though, any newly established foreign exchange trading operation must abide by not only European Union rules, but also by some country-specific rules and regulations, Silva says. -P.B.