Last month, Joe Kohanik evaluated how the money market industry can thrive these turbulent market conditions with the help of technology. In this month’s column Joe continues his assessment of market trends in his review of the driving factors fuelling the tremendous growth in FX volumes.
Drivers of Increased FX Volumes
The foreign exchange market has seen tremendous growth over the past few years. In fact, according to the Foreign Exchange Committee, an industry group sponsored by the Federal Reserve Bank of New York, average daily FX volumes now total roughly 325,000 trades per day; a 33% annual increase over the past three years.
So what is driving this increase in volumes? The primary drivers are technology advances, investor strategy and the expansion of market participants.
The technology used to connect FX trade counterparties has been further developed over the past few years in ways that mitigate the risks inherent in the OTC market place, thus removing the barriers for entry for market participants.
The automation of deal execution and confirmation processing has provided both buy-side and retail clients with ‘ease-of-use’ trading solutions. Firms such as FXall, Currenex, FX Connect, Globalink and eSpeed provide similar offerings at prices that are affordable to any buy-side firm.
Automated netting functionality through multilateral settlement systems, such as continuously-linked-settlement, is another area that helps firms reduce settlement risk and counterparty exposures. Launched in 2002, CLS eliminates much of the systemic settlement risk associated with foreign exchange.
Investor Strategy…Who is driving these volumes?
Investor strategy and sophistication has become more refined during this boom in FX trading, directly resulting in higher trade volumes.
If we take a closer look at volumes reported by the FX Committee, the statistics indicate that buy-side firms are increasingly “taking back the vig” (2-4 pips per trade) from the market dominators; the large banks and dealers. As tracked by the FX Committee, the flows coming from both traditional asset management firms or hedge funds have increased more rapidly over the past 3 years and they now account for 26% of volumes. On the flip-side, note that interdealer brokering has decreased by around 8% over this same period.
Institutional investors used to give up FX trade execution responsibilities to their prime brokers or custodial banks in return for services. In fact, many banks still do give away services, like fund accounting, as long as they get their clients’ FX trades. Leaving the concept of best execution aside, over the years, institutions have come to realize that a lot of money was being “left on the table” when letting their custodians transact on behalf of them.
Further, with investment strategies such as currency-overlay or global-macro, buy-side firms have brought in the necessary talent to manage the credit and liquidity risks associated with managing foreign exchange. Hence, the resolve of many buy-side participants is to take FX trading back from the custodian and bring it in-house.
Expansion of Market Participants
Whether it is enhancements in technology that eliminate barriers to entry or evolving investment strategies, the main reason that volumes are up is simply because there are many more market participants trading FX today than there were just 3 years ago.
As indicated previously, the number of institutional investment firms with FX desks has and will continue to increase over the coming years.
Forgetting the institutional space for a moment, the retail customer market continues to boom. Not only has FX become an asset class, but along with it, perhaps, comes retail investors who get 20:1 leverage when trading in a relatively unregulated market.
As these new market participants arrive each day, let’s just hope that the industry has learned from its past mistakes in understanding and appropriating risk mitigation techniques across the world.
* Read Joe Kohanik’s previous column – "What’s to Become of the Money Markets Industry?"