Electronic platforms are testing customer-to-customer market

Electronic trading in the spot FX market appears to have bedded down at last. After the disappearance of some high profile initiatives, those left standing – from broker systems to multi-dealer platforms – report that volumes are increasing. However, there still seems to be a gap in the market: customer-to-customer trading. While some firms are jockeying for a position in this area, others suggest that there is no real market to be cornered.

In the past, customer-to-customer trading initiatives have not met with much success. In the pre-electronic early 1990s, AIG set up a trading operation in an attempt to become the first major buy-side organisation to distribute spot FX to other customers. The move had limited success; other buy-side institutions preferred to stay with their credit supported bank relationships.

Little sign of interest

FXall has the facility for customer-to-customer trading but it has not been requested so far

According to Mark Warms, general manager for Europe at multi-dealer platform FXall, the situation has not changed despite the advent of the electronic era. He says that while FXall has the facility for customer-to-customer trading, no customer has requested it so far. He suggests that the processing side of the transaction will largely prevent clients from seeking other counterparties.

“We regularly talk to our client base of more than 500 institutions and the feedback is clear: customers are happy with the pricing and level of service they receive from their banks,” says Mr Warms. “In addition, settlement is such an important aspect of the trade that corporates and asset managers will trade with either their custodian or their credit banking counterparty just because they know that there will be no issues with settlement, instructions will go through as planned and if there is a problem, they know who to go to. The presence of different market models potentially adds another layer of risk and complexity that many firms won’t feel is worthwhile, whatever savings they may or may not get.”

Mr Warms acknowledges that there is a segment of the market that is interested in customer-to-customer trading but he says it represents only a small percentage of the overall market. As a result, FXall will investigate alternative market models but only when the demand arises from the market.

Some believe that such a demand already exists. Hotspot Fxi was founded three years ago and began trading last year. It now has five market making banks (which are undisclosed to maintain the fundamental anonymity of the platform) and eight prime brokerage banks signed up: AIG, RBS, Dresdner, Deutsche, Bear Stearns, FIMAT, UBS and ABN.

Customer-to-customer trading, although important, is not the bulk of Hotspot FXi’s business

The firm’s president and CEO, John Eley, says the idea was to bring the features of an electronic communication network to the FX space. Live continuous prices are provided by the bank market makers, leaving it open to the buy-side clients supported by prime brokers either to act against those live prices (click and trade) or to provide their own bids and offers.

“When we say live, we mean live, unlike the other multi-dealer platforms which have quasi-live quotes,” says David Ogg, founder and senior managing director of Hotspot Fxi. “The match occurs on our servers, not a glorified fast request-for-quote [RFQ] system, as is the case with the other platforms. This enables any other bank or client in the system to make markets through the prime broker mechanism. It is done anonymously, so true client-to-client trading does occur.”

However, Mr Eley concedes that customer-to-customer trading, while important, is not the bulk of Hotspot FXi’s business. “Our customers want best price execution. And, while Hotspot FXi has customer-to-customer matches, the fact is that our partner banks provide us with such great pricing that the lion’s share of the business is still bank-to-customer.”

A new platform is scheduled to appear in this space in June: Forexster. Forexster’s patent-pending technology, its creators argue, will take FX trading to the final step in its evolution.

Forexster aims to bring together all natural sellers and buyers, improving pricing

Order book integrity

Forexster allows firms on its system, whether they are banks, corporates, fund managers or any other FX market participant, to trade or make markets either through its RFQ or reverse auction facilities, but only in accordance with its credit limits. “Forexster’s custom deal-able order book architecture keeps the order book integrity between different parties, so that people can see only the orders on which they are allowed to deal, up to the amount on which they are allowed to deal,” says Arman Glodjo, founder and chairman of Forexster. “Forexster takes your existing credit relationships and, by the virtue of a network dealing architecture, allows you to take advantage of pools of liquidity throughout the network.”

That network will, Mr Glodjo believes, become self-expanding. The entry of one prime brokerage to the system (Bear Stearns has been the first firm to sign up to the platform) provides access to all of the firms that have credit lines with it. Those firms will have credit lines with other banks and/or customers, which also may join Forexster; they, in turn, will have relationships with other firms and so on. The end result, in theory, is that Forexster will bring all natural sellers and buyers together, improving both pricing, depth and market efficiency. For the major FX banks, the downside is that they might lose out on spread income.

Mr Glodjo says Forexster wants to preserve customer relationships and roll out prime brokerage services that are custom-tailored to their needs – they will still be the ones inserting credit limits. “If you can still make some spread as a market maker, that’s great; however, if you are allowing your clients to trade with others on our system, you are now acting as a credit bridge, so you will earn fees from that anyway. Because Forexster is a facility towards which the buy-side will naturally gravitate, participating banks have a real opportunity to grow their market share by offering access to the facility.”

Finding demand

To date, Bear Stearns is the only bank that has joined both the Hotspot FXi and Forexster platforms. David Schoenthal, global head of FX at Bear Stearns, explains his firm’s thinking: “It is something that we see as inevitable for the future of foreign exchange markets. Many of our customers want this kind of service, so we need to provide it because if we don’t, the competition will.”

Mr Schoenthal believes both platforms have their own specific advantages but argues that they could see further competition in the future. “If either of these platforms shows any signs of success, EBS and Reuters will have to look at their systems and ask whether they should open them up to certain customers.”

As for who those customers would be, Justyn Trenner, principal and CEO of research analysis firm ClientKnowledge, argues that there is a specific market for position-taking capability. “Hedge funds, for example, not only want to take prices but make prices as well, but the vast majority of customers don’t.”

However, Hotspot FXi is gaining real traction, according to Mr Trenner. “Our estimate is that it is doing somewhere between $1.5bn and $2bn a day, which is a credible volume. It’s happened among the hedge fund community, which I imagine is Forexster’s market as well, but hasn’t taken off materially among any other group of users. Although I think there is enough space in the market for one platform, I’m sceptical about whether there will be room for both,” he says.

However, he does not believe that the successful platform will be a significant threat to the role that FX banks play. “It will not affect corporate or real money volumes but it might threaten the margin for a small part of their business.”

That said, Mr Trenner says that banks would be much happier if there were fewer systems in the running. “Everything else apart, the more systems that gain traction, the more places they have to consider connecting to, which obviously costs them. Take-up of these systems tends to narrow spreads, so they are not necessarily welcoming.”

Banks are unenthusiastic

This lack of welcome was perhaps demonstrated by many of the leading FX banks’ unwillingness to comment for this article. One banker, who asked not to be named, says: “Within any organisation, there is always debate over electronic trading. This increases in the case of customer-to-customer trading because the more business is done electronically, the less trading revenues banks are able to make. They only make a transaction fee instead of trading profit, and fees are always less than trading profits. From my own perspective, I don’t want it simply because I run a trading desk.”

While bankers may not want it, yet another initiative aimed at attracting customer business is scheduled to be launched soon by online currency exchange Currenex. Rob Fisher, managing director, EMEA at Currenex, says the notion of customer-to-customer trading, where people have credit approved through a central party or through a prime brokerage facility, sounds more appealing in theory than in practice. “Traditional buy-side members are not in the business of managing counterparty risk nor are they in a position to provide the level of liquidity required of true price makers. Although we don’t prohibit buy-side members from trading with each other, we have no new initiatives targeted for buy-side-to-buy-side trading. Instead, what we will be offering in the near future is executable streamed pricing,” he says.

Prices will be pushed out by the banks to credit approved counterparties that are executable (rather than the RFQ model), says Mr Fisher. “They will also be able to establish the amounts and have a view into the depth of liquidity available. We think that is much more in line with current market appetite and that it will appeal to banks, corporates and funds.”