Market Transformation

New partnerships and better technology will lead to half of all FX trades being done online by 2004

After a gestation period that seems to have taken forever, online foreign exchange trading has been born. Within the past three months, two bank-backed ventures, Atriax and FXall, have gone live with electronic platforms for dealing and booking FX trades. They, along with similar platforms, aim to transform a staggeringly huge market that has withstood technological, economic and regulatory changes.

With $1.5 trillion in daily turnover and around-the-clock operations, the FX market is by far the largest commodity market in the world. Unlike other commodity markets however, the FX market has no physical exchange where buyers and sellers come together. Even in London, where about a third of the world's FX trades are brokered, trading is conducted by telephone or by interbank systems like Electronic Brokerage Systems (EBS) and Reuters, never in person.

With no exchange structure to enforce contracts, FX market participants have had to rely on their own personal knowledge of counterparties to assure creditworthiness. The risk is magnified with forward contracts, where the actual currencies involved are delivered at a future date. "In the FX market, if you go bankrupt, I lose out. So I care who my counterparty is," said Harpal Sandhu, CEO of Integral Development, an e-commerce software firm that built the trading platform now used by Atriax.

With more than 50 of the world's top banks behind it, London-based Atriax has enough liquidity to satisfy the risk needs of most fund managers. Its three founding banks-Citibank, J.P. Morgan Chase and Deutsche Bank-alone control almost a third of the world's FX volume. The venture, whose platform went live in June, is governed by advisory boards from both the buy and sell sides. Buy side participants include some of the world's biggest multinationals, including GE and Microsoft.

"So far, it is performing as expected," said Vikas Srivastava, global head of FX e-commerce at Citibank. "As members get more comfortable with the system, we should see a lot more takeup." He noted that it took six to nine months for similar trading platforms in other asset classes to achieve critical mass. "Atriax probably won't take as much time."

Atriax has chosen to introduce its platform incrementally, adding new functions on a monthly basis. "We wanted to build a flexible system. We'll be able to add other asset classes easily, and plan to do money markets and deposits at the end of the year," said Dan Morehead, president of Atriax.

BUILDING MOMENTUM

Yet even backers of online trading concede that it faces tough challenges. "The traditional way has worked for a long time," said Morehead. "Most accounts are taking a pragmatic approach to such an important issue as switching, at least partially, to doing their business electronically."

Indeed, while global straight-through processing, or STP, has made inroads in other asset classes like equities and fixed income, FX trading remains rooted to the old ways of doing business. In a survey of 2,300 FX traders at corporations and banks conducted last fall by Greenwich Associates, only 13% said they were trading online. More than 90% of those surveyed had Internet access and the ability to gather information online. But for many, the will to trade online is lacking.

"It's more a question of trust and human nature than technological savvy," said Peter D'Amario, a consultant at Greenwich Associates. "Going online to try something new and untested and then having it go wrong has job-ending implications for a lot of these folks. Until there's a higher comfort level, you're not going to see these people piling in."

That could change with the introduction of Atriax and FXall, which allow traders to view online quotes from a number of banks in real-time, along with the times (typically 30 seconds or less) that each quote will remain in effect. "While there may be a ceiling in terms of how widely e-commerce is embraced by FX users, this year will be the wrong time for it to be ignored entirely, especially with the advent of FXall and Atriax," said D'Amario.

Atriax and FXall join established online FX exchanges like State Street's FX Connect and Currenex, an independent (non-bank owned) venture that went live last year. Currenex boasts among its participants some of the largest FX institutions, including ABN AMRO, Barclays and Royal Dutch/Shell.

"We're beginning to see a lot of momentum in the online FX world," said Fritz McCormick, a research analyst at Celent Communications. Efficiency and cost savings will cause half of all FX trades to be conducted online by 2004, he wrote in a report, Online Foreign Exchange: Let The Games Begin.

Approximately one third of FX volume comes from the buy side-corporations and institutional money managers looking to cover currency exposures. The remainder is composed of banks and brokerage firms (the sell side) trading on behalf of their clients or their own accounts. Banks garner profits from the bid-ask spreads on trades and from transaction fees.

On the sell side, banks for years have used electronic systems such as EBS and Reuters to trade between themselves. EBS, formed in 1993 by 12 of the largest market-making banks, provides a platform for interbank spot transaction in all major currency pairs. Reuters' FX dealing system, launched in 1992, handles spot and forward transactions in 33 currency pairs.

Many banks have also invested heavily in proprietary systems for connecting electronically to their buy side customers. The advent of multibank trading systems will spur the adoption of these proprietary systems by customers. "Banks have spent a lot of money developing proprietary customer-facing systems. They're now able to leverage those systems by connecting them to multibank platforms," said Roddy Boulton, managing director of European operations at Currenex.

ROOTING OUT INEFFICIENCIES

Despite the availability of multibank trading solutions, most corporations and money managers are still wedded to the traditional method, wherein they call dealers on the phone to receive quotes on an FX trade. When a satisfactory rate is found, the trader "hits," or accepts, the ask price, executing the trade. At the end of the day, the trade is sent to the bank's back office, where settlement arrangements are made for a specific date, depending on whether the trade is a spot or forward transaction.

This process is fraught with inefficiencies, noted the Celent report. Corporate treasuries must utilize several people in order to query different banks and receive comparable pricing on a timely basis. Another call may be needed to execute the trade and provide proper settlement instructions. And because the transaction is conducted over the phone, there is no way to keep an accurate record of prices, making it hard for auditors to determine whether transactions have been conducted with propriety.

The problem is magnified for institutional investors, who engage in the heaviest trading volumes. State Street Bank created FX Connect, an online trading portal, five years ago specifically to meet the needs of its institutional clients. "Before FX Connect we had a lot of institutions doing hundreds if not thousands of deals a day, usually by telephone and fax," said Morris Heffernan, senior vice president, product development and technology at Global Link, an e-commerce subsidiary of Boston-based State Street.

"You'd call in a block amount and fax over the details to be manually entered," he explained. "That might be 500 deals. It required you to calculate the block amount before you could call and negotiate a price. There's a lot of paper work and the potential for data entry error."

"One of the portfolio capabilities of FX Connect," he continued, "is the ability to load in hundreds of trades and have it calculate the block amount."

Although FX Connect began as a proprietary trading site, State Street has since opened it up to multiple counterparties. More than 20 banks have committed to participate, the latest being Bank of America. "A lot of State Street's customers are also FX customers of Bank of America. They asked Bank of America if they could trade with them using FX Connect," Heffernan said.

But competitive pricing is a mixed blessing for institutional investors. "Reverse auction-simultaneous competitive pricing-is in vogue with certain segments, but it also has the potential to be counterproductive in terms of optimizing price and liquidity," said Heffernan.

When an institutional money manager asks a number of banks to quote a price on a large volume of FX trades, "information leakage" can occur, Heffernan explained. "Institutional investors are going to be careful about information leakage."

Aside from being the first to launch an online FX portal, State Street is unique in its focus on the institutional buy side. For example, to alleviate large money manager concerns, State Street eschewed the Internet in favor of a private network, although it does provide an Internet connection for smaller customers. "Our primary focus has always been a private network. Institutional investors are looking for reliability, performance, high availability and security," said Heffernan.

Still, in building a robust trading infrastructure, dealing firms have been constrained by more than just the choice of whether to connect over the Internet or a private network. More challenging has been creating a virtual marketplace where no physical one existed. "The FX market has never had an exchange," said Integral's Sandhu. "There was never the technology to allow everyone to be connected until the Internet and exchange technology."

SCALING UP

The main technical challenge is scalability. "You need to build something that can scale to thousands of users conducting millions of transactions simultaneously," Sandhu said.

To meet this goal, Atriax uses hardware and software from Sun Microsystems to run its platform. "The whole thing is implemented in Java 2 Enterprise Edition," said Sandhu. "It runs across multiple Sun servers running in parallel. It's highly scalable and completely fault tolerant." Other technology suppliers include Integral (price quoting system), TIBCO (market data feeds) and Radianz (IP connectivity).

Currenex also selected Sun as its platform of choice. Two Sun Solaris servers (one in hot standby mode in case the other fails) run the trading application. The two Sun servers are connected to an enterprise-class Oracle database server. A Netscape enterprise server manages static Web content. "You can increase scalability by adding more processors, more memory, more disk," said Jim Kleckner, vice president, products and development at Currenex. "The architecture is capable of handling every FX trade on the planet."

Other Currenex technology partners include Cognotec (trading software), Integrity Treasury Solutions (treasury software), SAP (straight-through processing) and Wall Street Systems (treasury software).

Not to be undone, FXall-a New York-based venture that's owned by 14 capital markets institutions-has put together a team of technology firms including AVT Technologies (trade routing software), Cognotec (e-commerce software), Trema (treasury and risk management) and Wall Street Systems (confirmation and settlement). Andersen Consulting (now Accenture) was the lead integrator.

The aim of all this technology integration is to automate trade processing on both the buy and sell sides. "Salespeople at banks spend up to 20% of their day booking tickets," said Currenex's Boulton.

PROFIT PERSPECTIVE

Still, the growth of online FX exchanges raises the question of what impact, if any, there will be on dealer spreads, a major source of bank profits.

In theory, online trading should make markets more transparent, but the FX market is already among the most transparent in the world. "It is a pretty transparent market. Most of the gains will come from process rather than pricing efficiencies," said Citibank's Srivastava.

"The market's the most efficient asset class in the world," said Atriax's Morehead. "We're not sure if the market will end up with people quoting extremely tight prices that they have to change every three seconds, or whether they're going to quote slightly wider prices but hold the price fixed for 30 seconds."

To get to a fully transparent market, corporations and institutions would need to gain access to the same electronic brokering systems (EBS and Reuters) that the banks use to trade among themselves. Nobody expects that to happen anytime soon.

"It seems unlikely," said the Celent report, "that the major FX dealers will want to allow clients to usurp the bank's position by providing the ability to trade directly with other corporates."

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A Twisted Standard

TWIST (Treasury Workstation Integration Standards Team), a group formed by Royal Dutch/Shell and Currenex, is focused on creating standards for an open FX marketplace. Its goal is to achieve interoperability between corporate treasury operations and their banks.

Both banks and their clients have an interest in providing an efficient FX marketplace, noted Tom Buschman, treasury development manager at Shell Treasury. "This initiative allows for the rapid proliferation of best practices."

TWIST has issued a document describing the FX transaction flow based on FpML (Financial Products Markup Language), a standard for exchanging information for trading of financial products. The TWIST proposal will be submitted to a working group responsible for extending the current FpML standard to cover FX instruments.