Financial Journalist

FT Mandate December 2006

Electronic communications networks are increasingly used to handle forex deals – but their rise in popularity has been so dramatic that the market remains a mystery to some. Gerry O’Kane talks to the major players and lifts the lid on this technology revolution.

For an industry that likes to dot the ‘i’s and cross the ‘t’s, the fact that no one seems to know how many electronic communications networks (ECNs) handling forex deals are out there is a tribute to their dramatic proliferation.

And the effect of this proliferation over the past few years has been equally dramatic, being attributed to increased turnover in the spot markets and bid/offer spreads sliced wafer-thin.

An ECN brings together multiple market makers, matching buyer and seller together for a small fee and displaying the bids and offers from all market makers and traders on the platform. Orders are matched to the best available price.

eFX, as the techies like to say, has arrived, whether trading takes place over smaller private networks, or networks provided (often under licensing agreements or white-labelling deals) through brokers.

“The biggest change to the traditional FX prime broking landscape, apart from the huge growth in hedge fund strategies, is electronic trading and the growth in networks,” says Stephen Li, head of derivative prime brokerage sales at Barclays Capital.

Volume increases

A study by financial research firm Greenwich Associates found that of foreign exchange traders, 53 per cent traded electronically in 2005, up from 32 per cent only three years
earlier. Currently the average share of total forex trading volume captured by e-trading systems, regardless of size, is about 50 per cent. And it is the UK that tops the league with about 64 per cent of forex volume traded online, compared with 60 per cent traded that way in the US.

“The typical user of e-trading systems executes slightly more than half of its overall FX trading volume electronically, but e-traders tell us that they expect electronic trading to account for a full 57 per cent of their FX volume in 12 months’ time,” says Greenwich Associates consultant Robert Statius-Muller. “These expectations suggest that e-trading volumes will continue to grow for the foreseeable future.”

But Greenwich also warned that growth could be tempered by the fact that eFX platforms would have a harder time attracting new institutional customers.

Even so, size is no discriminator. Greenwich’s research shows that 51 per cent of players who handle more than $10bn per year in the FX market do so electronically.

This electronic market has long been dominated by EBS and Reuters, who in particular cater for interbank trading and who have seen their own trading activity quadruple over the past 18 months. But even these big boys are taking note of the changes in the FX trading environment.

Reuters and Chicago Mercantile Exchange (CME) announced plans in June last year to
create FXMarketSpace, the world’s first centrally-cleared, global foreign exchange marketplace, through a new 50/50 joint venture company. How it will affect the forex trading world is yet to be seen.

The recent acquisition of EBS by ICAP, the world’s largest interdealer broker, shows those in the know do not believe it is a contracting market. But both these deals further blur the clear divisions between regulated markets such as stock exchanges and the unregulated market dominated by OTC FX deals.

Nevertheless, other ECNs are unlikely to go away. There are newer platforms such as multi-dealer firms FXall, Currenenx and State Street’s FXConnect, while Hotspot is a multibank prime credit system. These companies are also experiencing serious growth, with many of them finding success in niche markets that produce enough trade volume to support their business.

“Our revenue growth was 23000 per cent in the past four years and although we’re only seven years old, our monthly volume turnover is hitting $100bn,” reveals Glenn Stevens, managing director of GAIN Capital.

“What we’re able to do is offer the more ‘downmarket’ sector an opportunity to trade – banks can’t service the $500,000 to $5m deals.”

The effects of these new dealing channels has been profound. The affordability of eFX
trading technology allows start-up investor groups to access the markets. It has allowed the smallest sorts of players to access the forex market – the micro hedge funds, the high-net worth individual or the retail speculator.

“The advent of e-commerce has lowered the barrier of entry to the FX market,” observes David Aldrich, head of Bank of New York’s hedge and broker business in Europe.

They have also allowed existing players to adopt strategies they would have found both
difficult and expensive to follow previously and with the cover of anonymity. All benefit from workflow efficiencies and integration into other systems.

Alpha opportunities

Many of these new participants reflect the growing trend of hedge fund and investment managers recognising that the foreign exchange market can produce alpha for their portfolios (although the hedging use of forex remains the dominant strategy).

“To a large extent the increased growth has been because of the recognition of forex as an alternative asset class and an alpha opportunity,” says Mr Stevens.

But for the banks that provide liquidity to the forex market, the emergence of these trading networks has been one of the critical factors in the plummeting bid/offer spreads in the spot market. Both the recognition of alpha opportunities and the price transparency now available across dozens of independent online markets, have pushed spreads dramatically downwards.

This search for alpha has seen technologies active in the equity and fixed income-markets, and algorithmic systems, enter the FX markets. Algorithmic trading is a way of timing entry and exit into a market, exploiting pricing opportunities and pushing up trade volumes.

According to Deutsche Bank, 15-25 per cent of all FX activity is due to algorithmic trading, and these liquidity suppliers have no way to cope with the speed of some of these systems.

Many of them have become unhappy with the growth in these ECNs. Blame has even been heaped upon the opening of EBS Prime to buy-side institutions like hedge funds for starting this trend. While the banks want to regain more control over the market and dream of pushing spreads towards historical highs, the opportunity for influencing dealing patterns remains distant.

“Even between Reuters and EBS, each trading platform is more suited to certain FX players than others for either strategy or product requirements, and while there have been attempts and discussions by certain parties for a central marketplace, the market simply doesn’t want a monopoly,” warns Roger Allen, director of FX prime broking at Dresdner Kleinwort.

He believes that past reactions to players trying to capture parts of the market had shown it was a strategy unlikely to succeed. In his view reactions included direct and outspoken resistance to anyone trying to control the FX marketplace and an organic movement of business. This flow of business also reflected the idea that the FX market is not suited to an overly structured environment.

Indeed GAIN finds its own niche comfortable for avoiding larger deals, but even so there are indications of a certain amount of convergence between some of the ECNs and dominant players such as EBS.

“While a $50m trade would be big for us, EBS is designed to handle such trades,” explains Mr Stevens. “While the smallest trade on it is $1m, its average trade size is about $1.3m, while ours has risen from $250,000 to $700,000 converging towards their levels.”

Whatever the grumbling about falling spreads from the liquidity banks, they still participate on the ECNs. The trading platforms connect in an automated fashion to banks and act as a message hub that can translate the messages of any customer and bank so they can each talk to each other.

“We’re complementary to the banks who find our liquidity useful, and we’re a member of EBS Prime and have access to 10 top banks and remain in the sector because we’re acting like a prime broker,” says Mr Stevens. He views staying ahead of the technology is vital for any ECN’s long-term survival.

“We’re not wanting to re-invent the wheel. We have to keep up with demand for example enabling application program interfaces (APIs) with our system for things like algorithmic or auto-execution trading. We need to be able to provide real-time margining, for example,” says Mr Stevens.

An advantage of these sorts of systems is that they do allow clients to carry out transaction cost analysis, something that organisations with a fiduciary responsibility for best execution need and something that future regulatory changes may require.

One criticism of the way the market is developing is that there are so many ECNs, which, in theory, create market inefficiencies and boost costs to interface with them. But the industry argues these are marginal costs, not linear, and being able to both access the business and see developing trends makes viable whatever extra costs there are.

Additionally, the ease with which clients can get onto this web-based systems attracts both established forex players and the individual speculator. “You sign up in the online environment get a technical demonstration and then await our due diligence activities. After about three days you can start trading,” explains Mr Stevens.

For the ECNs, signing anyone up is good news, since research by Greenwich shows that once a party starts trading electronically, the volume of trades executed that way increases.

As for the future of the sector those involved show boundless optimism. However with so many players in the market few disagree that there will be some consolidation. Acquisitions are likely to be based on both profitability of the companies and also their technical expertise. Buying technology for this sector can be cheaper than developing it – and to stay in the forex business, having enabling technology is crucial.

Electronic communications networks, forex, FX, foreign exchange, trading, growth market, liquidity

FT Mandate December 2006

The future might look rosy for foreign exchange prime brokerage, but those who refuse to provide a broader service through new technology may find themselves left behind. Gerry O’Kane discusses this and other issues facing FX prime brokers in the next few years.

There is little doubt that the industry sees the future of prime brokerage in the foreign exchange market as healthy. Trade volumes may not be growing at the rates of a year ago but they show no signs of declining either.

“In a nutshell, future developments will include many more clients attracted to the prime brokerage model not just for leveraging credit but also to avail themselves of the sort of outsourcing models the prime brokers have,” says Roger Allen, director of FX prime broking at Dresdner Kleinwort.

However, there are likely to be changes as the industry develops and adjusts itself to the ever-increasing demands of existing clients and new entrants.

“I’d expect FX prime brokers will continue to focus on client problems, including efficient pricing or risk management, in order to give them some edge over competitors. They’re pushing to bundle more products” says David Aldrich, head of the Bank of New York’s hedge and broker business in Europe.

At the back end of the process, integration will continue, he believes, making it easier to move data through to custodians and fund administrators.

While technology solutions are seen to be the main driver of change over the immediate future, one area that may get a shake-up are those prime brokers who only specialise in foreign exchange. “I think that FX prime brokerage is a subset of the business and when you’ve got hedge funds only dealing in forex that’s fine but when they want broader market access then capabilities will be important” warns Ted Platt, head of prime brokerage in EMEA at Merrill Lynch.

For these smaller FX-only operations finding the money to invest in the technology required by this broader service demand will not be easy. As a result there is likely to be an increase in white labelling systems and one ECN, GAIN Capital already generates half of its revenues from that business.

But it is unlikely to be an immediate disappearance of the specialist players since it seems that about half the players in forex continue to use non-electronic trading.

“It’s fair to say that technology will move to make the process more automated and reduce the reliance on phone deals and not to be able to go with that growth could cause problems,” says Mr Platt. “I’d never write off a specialist but I do expect broader prime broker players,” he adds.

Elsewhere some expect to see consolidation in the number of ECNs. “There are a wide variety of these systems now and while its likely that both EBS and Reuters will remain the main players, more are likely to come in,” says Mr Allen. “But I’m certain we’ll see a consolidation process in that sector too and it’s starting already.” In June 2006, ICAP, the world’s largest interdealer broker acquired EBS.

“For the future I’d see ECNs offering more tools such as cross-collateral trade to pick up margins and certainly an improvement in real-time servicing,” says Glenn Stevens, managing director of the GAIN Capital Group, an electronic communication network (ECN).

He also notes that as the ECN market develops, players may look for technologies that allow them to disaggregate large trades, something only the more sophisticated FX prime brokers currently offer. This means executing deals in smaller pieces over time concentrating on market impact rather than pure price.

The use of technology to create further operational efficiencies and lower risk will continue to develop, as will an ever-increasing use of electronic trading. The development of more workflow solutions for clients is likely to continue.

As algorithmic trading has left the equities world and moved into forex, some expect more sophisticated models to emerge. The one caveat with it, however, is that it functions better in low-volatility environments, as the forex market-place has been for some time. Should this change there may be a fall-off in some of the volumes coming from the less-sophisticated players, leaving the advantage to those with models that spread risk.

According to Mr Stevens, modelling systems are likely to become more sophisticated. Post trade data-mining is one area tipped for growth. While some of the bigger banks already do this, it is not yet a common but could tighten spreads still further as the systems extrapolate the effects of certain deals in the market.

Already algorithmic trading has highlighted issues of pricing across ECNs, as banks complain that they are being hit by sniping. They argue that some players are putting in bids and offers to EBS and Reuters and then hitting ECNs at the same time for larger amounts. It creates a ‘liquidity mirage’ and hurts the liquidity providers, the big banks, and because the speed of using algorithmic techniques it is hard to respond.

“Sniping does happen but the counterparty banks figure it out after a while and refuse to do business for a time,” says Nick Jones, head of European sales and marketing of FX at Bear Stearns.

The effects of this are two-fold. Firstly few see future bid/ask spreads widening any time soon and secondly, it will push the banks to reassess how they will provide liquidity. The critics of the banks’ complaints on sniping is that it highlights an inefficiency in their pricing methodology and their own systems will have to improve – boosting data mining technologies, for example.

prime broker, foreign exchange, FX, technology, ECNs, Gain Capital

FT Mandate: November 2006

At a time when China is lurching from one financial scandal to another, writes Gerry O’Kane, both Northern Trust and Citigroup have won the first global custody mandates from a Chinese pension fund.

The National Council for Social Security Fund (NCSSF) was established in 2000 to act as a fund of last resort and is the only scheme allowed to invest overseas. “They recognised that only global custodians rather than local institutions, have the qualifications to provide the services they want,” said Lawrence Au, regional manager, Asia-Pacific for Northern Trust.

For Northern Trust, the mandate includes global custody, compliance monitoring and performance measurement. It followed this deal by winning a mandate to act as overseas custodial agent and provide similar services to qualified domestic institutional investors (QDII) in China for the Bank of Communications.

The NCSSF mandate was won in an open RFP with five competing global players and Mercer acting as a consultant.

What makes the deal more significant is that it is the first step in looking outside China for investment opportunities and a number of international investment RFPs are expected in the coming months.

So far, the NCSSF has only invested part of its underlying assets of $30bn (expected to increase by 20 per cent per year) in domestic products, but its initial foray into international securities is expected to be up to $1bn using fund managers who do not have to hold the qualified investment licences issued by the Chinese authorities.

More importantly, the performance of the NCSSF in investment terms and transparency is seen as the first step towards future liberalisation of the national pension system. “The importance of the NCSSF cannot be underestimated. It enjoys a special status with the Chinese government recognising the serious issues facing it,” observes Mr Au. “All eyes are watching how well the NCSSF manages the fund.”

China, like so many nations in Europe, is facing a pensions funding crisis and the NCSSF was set up to report directly to central government’s State Council to provide future funds to failing pensions. The patchwork of provincial, city and company schemes face huge deficits as a result of a mixture of poor investment decisions, rampant corruption and an aging population.

According to World Bank figures, the current system has obligations for one pensioner to every three workers. As a result of the one-child policy that will be one-to-two by 2010. While liability deficits are not published, Mercer Investment Consulting estimates it will be $27bn by 2010.

Also the scale of corruption was highlighted with the recent arrests of the former director of the Shanghai pension fund, Zhu Junyi, and the city’s most senior communist official, Chen Liangyu. They were accused of misappropriating funds in the region of $1.25bn for illegal loans and investments in real estate and other infrastructure deals.

Currently, these local and company pension schemes are only allowed to invest in cash and national bonds.

Initially, opportunities for fund managers with NCSSF will be limited. “There are certain restrictions on what sort of overseas assets can be used, for example only investing in developed markets,” says Mr Au. Other limitations include forbidding investment in derivative products and disallowing securities lending.

“Everyone anticipates that all the Chinese pension funds will invest overseas but it’ll take time. The NSSF is a role model on how to do it using the cream of Chinese investment managers,” concludes Mr Au.

Northern Trust, Citigroup, NCSSF, China pensions, corruption