The US$5 trillion-a-day foreign exchange market has found a new paradigm as it matures, already visible as the leading players hunt better customers instead of chasing more business. Their formulas are reshaping the rules for all participants and starting a scramble to adapt. In this latest report, Opimas will show the lay of the land and highlight winning ways of side-stepping risks and benefitting from new opportunities.
FX veterans should not have been surprised by the contraction of trading volume noted by the BIS last year in its triennial survey of the markets, as they in fact started to grow more slowly a decade ago across all instruments. Under the new paradigm, Opimas does not expect the FX spot market to rebound significantly in the future as riskier directional trading in spot declines. For other reasons, we expect some small growth of volume in forwards and swaps. Overall, we estimate that in 2019 the average daily volume executed in the FX market will be in line with 2016 levels at around US$5.1 trillion.
Regulations, scandals and a fall in global trade and capital flows have all dented the market, although most of the recent rules were designed with a light touch. Regulators recognise a complex market that is relatively efficient and poses less risk to the world’s financial system than other markets.
FIGURE 1. FX TRADING BY INSTRUMENTS
Currently, only non-deliverable forwards (NDF) have shifted significantly to central clearing. The move was massive: LCH’s subsidiary, ForexClear, recorded a 723% increase in cleared volume in April, compared to the same period last year. It remains to be seen if the new rule for posting variation margins for FX OTC derivatives will have a similar impact on the FX swap market, if no initial margin is required.
While recent regulations overall have had a limited impact on FX markets, some rules had enough force to create the new paradigm for FX Markets. Higher capital adequacy ratios did push numerous dealing banks to become more selective market makers and cut back their prime brokerage services, notably in the wake of the Swiss National Bank’s abandonment on the peg in January 2015. Moving from quantity to quality business, sell-side institutions as we said have evolved from acting as volume magnets, and are now pursuing counterparties with a good credit profile.
In the past, the strong growth in FX trading was partially driven by increasingly active high-frequency traders (HFTs) and commodity-trading advisors (CTAs). HFTs’ growth in this market is slowing as banks retrench from prime brokerage, even if prime of prime players are partially filling the gap. Other factors in the slowdown are an extended period of tight spreads, the commoditisation of HFT strategies, and the use of trading safeguards such as “speed” bump. Now, the attention-getting players in FX are specialised liquidity providers such as Citadel Securities and XTX Markets that are using sophisticated quant technologies to win significant market share. In fact, we expect that by 2019, three of these principal trading firms (PTFs) will be amongst the top ten FX liquidity providers.
Responding to the changing market, exchanges have recently made some significant acquisitions of FX trading venues. Bats bought HotSpot FX, Deutsche Börse took over 360T and Euronext added FastMatch. While acquirors traditionally paid around US$7mn per US$bn of ADV, Bats and Deutsche Börse forked out a material premium, spending US$14mn and US$12mn per US$bn of ADV respectively. While this expansion into new asset classes is strategic for these exchanges, a failure to grasp the essence of these trading venues could quickly lead to a disaster.
The FX market is neither fully OTC nor totally exchange-like, even for spot FX. Recognising that, the acquirors must now try to keep the people and the FX “know how” of their targets by retaining existing incentives and not imposing their own equity structures on them. At the same time, the exchanges must impart their own knowledge. The central limit order book (CLOB) side of the acquired FX platforms could certainly benefit from the exchanges’ experience in operating this type of venue and the innovation required. Deutsche Börse, in buying 360T, also has a significant opportunity to offer a complete gamut of post-trade services, particularly by clearing OTC derivatives through its Eurex Clearing subsidiary.
Real synergy is valuable. Amongst trading venues, Thomson Reuters clearly dominates the FX market with around US$350 billion of trading a day. The company’s current FX offering is a combination of its historical FX Matching Engine (originally developed as a pure inter-dealer platform), and its 2012 acquisition of FXall; all is under one umbrella called Thomson Reuters FX Trading that can be accessed either directly or via a Thomson Reuters Terminal. No other company occupies such a dominant position among FX trading venues. EBS (now part of NEX group), which used to vie with Thomson Reuters on the interdealer side, has suffered from declining volumes for a number of years, and the combined volume of EBS Market and EBS Direct is estimated to be just above US$100 billion a day.
Most FX trading venues provide a variety of execution models from traditional request-for-quote (RFQ) to CLOB. The range is necessary to gather liquidity from a heterogeneous pool of customers. This is especially true as trading venues are competing with single-dealer platforms that have been recapturing ground as of late by leveraging their client relationships and offering better prices. At the same time, these trading venues must avoid open warfare by assuring the banks that they respect their ties with clients. The banks may be relying more on electronic trading solutions, but they need more than ever to maintain their relationships with quality clients, as we have said.
More acquisitions may be in the cards, as winning business and volume in FX markets requires more than offering a variety of ways to complete a trade. A trading platform must offer a clear operating framework from pre-trade to post-trade and reporting. While most trading venues have expanded their offerings to include Trade Cost Analysis (TCA), regulatory reporting services and so on, we expect more FX participants to go the partnership route with FinTech start-ups. We could see banks partnering with technology-driven liquidity providers and suppliers of innovative post-trade solutions--or trading venues might decide to share their offerings with outside suppliers of analytical solutions and trading tools.