The Fx Market Ere And

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A foreign exchange dealer who had fallen into a very deep sleep at his desk in 1993 and awoken today would find the dealing floor and the market as a whole changed considerably, if not unrecognizably. The main change on the floor would be the significant reduction in the amount of noise generated (a possible explanation of why he slept for so long!). Today's trading room is undoubtedly a far calmer, less frenetic place to work.

As with so many other markets, the key driver of change in foreign exchange over the past ten years has been new technology. At the start of 1993 the majority of foreign exchange spot activity took place 'interbank' (between pairs of banks). Business was mainly conducted through voice brokers, who acted as intermediaries to match buyers and sellers anonymously (you did not know who you had dealt with until the deal was done) or directly between banks over the telephone or Reuters direct dealing products.

Voice brokers operate by quoting or responding to prices transmitted through a telephone line, with, typically, a loudspeaker at each end. At any time up to 1993 a dealer might have had three, four or more 'lines' to different brokers on his desk, all calling out prices, often at the same time. With prices spewing out from loudspeakers and spot dealers barking orders at the brokers and their colleagues, noise was clearly a key feature of the typical trading floor in 1993 and especially the larger ones that might have upwards of 50 traders.

So what happened? Technology, as previously mentioned, played a major part. So too did the impact of bank consolidation (banks merging with each other or rationalizing their own activities). Another more recent factor for change has been the introduction of the euro in 2000.

In respect of technology, there is no doubt that the introduction of electronic matching systems, known by most dealers as the 'machine' or 'the box', has had the most influence on today's spot markets. Now, instead of hordes of dealers screaming at each other and a cacophony of noise emanating from brokers' speaker boxes, one is more likely to see traders staring intently at an array of computer screens. Instead of having numerous dealers trading many different currencies, electronic matching has allowed banks to use fewer dealers to trade more currencies.

Electronic matching has also enabled many smaller banks, which were formerly treated as customers by the larger banks, to access liquidity directly (subject to credit availability).

This utilization of technology should not have come as a surprise. The FX market has always been quick to utilize technology to make trading more efficient. For instance, the advent of the Reuters' Monitor Dealing Service (RMDS) in 1981 effectively made dealing over a telex machine redundant and in many cases was more efficient than using the telephone, not least because it generated a hard copy audit trail — the forerunner of straight-through processing (STP).

To paraphrase another ACI motto, a dealer's 'word was his bond'.

RMDS introduced for the first time the ability to produce an independent record of a trader's activities, obviously a significant improvement on relying on their word and more importantly, their memory, to identify the trades they had done. It also led to the production of deal tickets, the automated entry of trades into risk management systems and to the back office and as such, straight-through processing (STP) of deals.

The popularity of automated direct dealing cannot be overstated. In addition to Reuters' RMDS, Telerate, then the second largest information vendor, launched The Trading System (TTS). In concert with Minex (a consortium of Japanese banks, brokers and corporates) this system had some success in Japan. Quotron, a Citigroup subsidiary, also launched a competing direct dealing product, called FX/Trader. Despite the competitive challenge, however, it was estimated in 1991 that Reuters' direct FX dealing systems had captured around 50% of all FX transactions, worldwide.

Not surprisingly, many banks were uncomfortable that Reuters — a supplier to the market and not a contributor or participant — seemed close to achieving a dominant FX share and, with their announcement of the launch of a new automated matching system (Dealing 2-2), potential hegemony in the provision of automated trading tools to that market. Many banks felt, with some justification, that since they were the providers of liquidity to the market they should have a greater influence on how the market operated.

Their response was to establish a consortium — The EBS Partnership, comprising, initially, representatives of eleven of the world's largest market-making banks — to develop the EBS Spot™ dealing system, an anonymous electronic matching system (Figure 5.1). (Coincidentally, EBS selected Quotron as its technology provider and built EBS Spot on the foundations of its existing FX/Trader dealing system.)

Since its launch in May 1993, EBS Spot has captured a significant share of the interbank spot market globally and added three new partners — The Minex Corporation of Japan, Commerzbank in Germany and the Scandinavian SE Banken. EBS accounts today for the majority of brokered business in EUR/USD and USD/JPY, the world's two most actively traded currency pairs. Everyday, an average of around USD 80 billion of business is transacted over the EBS dealing system.

Electronic matching systems like EBS Spot have promoted an unprecedented degree of price transparency in the market — making the market rate visible to a much broader audience than might previously have had access to it. In 1993, banks had access only to prices from brokers and from one another. Customers knew only what banks told them. Often the rates quoted to customers were very different from 'the market' and especially for amounts larger than what was considered regular.

Figure 5.1

Electronic FX matching - EBS Spot™ dealing screen

Source: EBS™

As the Bank of England said in 2001:

Electronic trading systems increase the transparency of market prices ... Deals traditionally executed by phone to facilitate price discovery are no longer necessary, leading to a more efficient market, less opportunities for arbitrage, and an overall fall in turnover.

Sarah Wharmby (2001) Foreign Exchange and Over-the-Counter Derivatives Markets in the United Kingdom

For many market participants increased price transparency is considered a healthy, positive development. For others, most noticeably the voice brokers, the move to a more 'efficient' market has proved less welcome. According to another central bank report:

... most voice brokers have been forced into retirement since the mid-1990s, reportedly in great part due to the cost advantage of the electronic systems.

Alain Chaboud and Steven Weinberg Foreign Exchange Markets in the 1990s: Intraday

Market Volatility and the Growth of Electronic Trading

While this may be a slight exaggeration, one trader stated in October 2002 that spot voice brokers were 'getting a few crumbs off a rich man's table'.

This greater transparency has filtered down to corporates and smaller banks, often to the chagrin of the banks providing FX services to them. Other banks, recognizing the logical extension of automated trading services to customers, have embraced the 'new way' and have established their own bank-to-customer electronic pricing and trading systems. Some banks — adopting the maxim of 'if you can't beat them, join them' — are also participants in multi-bank dealing portals like FXAll and FX Connect. The net effect of all of this activity is that customers know, with a much greater degree of accuracy, where the market really is and, as a result, are less readily inclined to accept quotes that are significantly away from 'the market'.

The narrowing of spreads and a more efficient, more transparent trading environment is something of a double-edged sword for FX banks. On the one hand, electronic trading has engendered far greater trading efficiency, resulting in lower operating costs (fewer dealers and less back office resources are required) and potentially greater profit margins. On the other, spreads have narrowed considerably, not least as a result of a huge increase in 'matched' prices. As noted earlier, bank customers are much more aware of where the market price is and what the spreads really are. The opportunity to make significant revenues from charging very wide spreads (subject to credit availability) is therefore reduced greatly.

In today's trading environment, the secret of competitive success for foreign exchange banks is order flow, and, more precisely ownership of order flow. Order flows are 'owned' by customers. In an increasingly level playing field, banks are looking at different ways of enhancing customer value and maintaining customer loyalty. Adding value can range from providing free research to 'bundling' foreign exchange in with other services, e.g. custody for a basis point/percentage commission. Consequently, not all banks compete equally for foreign exchange business.

Another significant change that has occurred in the last ten years is bank consolidation and the associated concentration of business into the hands of a smaller number of banks.

According to BIS, just 17 banks in the UK account for 75% of the total FX business (compared with 20 in 1995). This concentration is even more pronounced in the US. There, just 13 banks account for 75% of the total daily business, compared with 20 in 1995. This aggressive consolidation has led to the disappearance of many well-known US 'names' including Manufacturers Hanover Trust and Chemical Bank, subsumed into US giant, Chase, which in turn has merged with J P Morgan.

The third profound change to the FX markets has been the advent of the euro. Much of the activity in the 12 legacy currencies that now make up the euro consisted of cross trading. Often, a deal would be 'unwound' by trading the two respective currencies against the US dollar. So, someone buying 20 million Deutschmarks (DEM) against the lira at 990 might have traded out of the position by selling DEM 20 million against US dollars and then buying Italian lira against the dollar. By doing it this way, volumes would have been increased by at least a third, probably by more.

Not surprisingly, the integration of so many trading houses and the elimination of so many active currencies has led to a fall in the total daily turnover in the market. The impact on volume levels as a result of unwinding cross trades can be illustrated as follows:


Bank buys DEM 20 million at 990, sells ITL 19.8 billion.

Bank sells DEM 20 million, buys (approx.) USD 10.25 million.

Bank sells USD 10.25 million, buys ITL 19.8 billion.

Positions all square, profit (or loss) booked: total turnover DEM 60 million.

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