The future for foreign exchange

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THE ISSUES:

• Introduction of new technology

• Impact of the credit crunch

• Efficiency of fx processing ­systems

• Success of the ­vendor/service provider ­community

• Industry-owned and operated ­utility model

THE KEY ISSUE:

CHALLENGES FOR THE FX MARKET

Before the turn of the century, many commentators predicted that the introduction of the euro would bring with it the death of foreign exchange (FX). In fact, the FX market has never been stronger, entering a period of rapid growth in 2002. Now, organisations such as Wall Street Systems, a specialist in treasury, trading and settlement systems, are seeing daily FX transaction volumes hitting the $4000bn mark. But booming volumes have taken their toll on organisations’ FX processing operations, and have left many smaller players unable to keep up.

• WHAT HAS DRIVEN THE EXPLOSION IN FX VOLUMES IN RECEBT YEARS?

A lot of it has been down to the introduction of technology. The original FX business was a broker-led, phone-dealt business, but during the past five or six years we’ve seen a lot of ­technology introduced into the sector. We’ve got a lot of transparency in prices, we’ve got the main bank portals, we’ve got the currency venues themselves, and we’ve got a lot of other institutions that provide FX. Now, we have real price transparency, and technology has made that accessible to other people. In the early days, it was only available to the inter-dealer brokers and to the main participants in the market. Now it is available to everybody and there is a huge number of new participants.

• WHAT KIND OF EFFECT HAS THE CREDIT CRUNCH HAD ON THE VOLUMES IN THE FX SPACE?

It is twofold: one is that there’s been a flight away from exotic to more traditional cash-based assets. But there has also been a lot of movement in cash, from one currency to another, as people look for safer havens and better returns on interest rates. But our ­prediction is that we’re going to see more and more return to traditional FX in cash ­products.

• HOW DO THE PROJECTED VOLUMES COMPARE TO HISTORICAL VOLUMES?

There are two factors [driving the] growing market: one is the daily volume, but the more interesting thing [to note] is that the number of tickets we’ve written has increased dramatically because, like the equities markets, we’ve taken our lead from this sector. A lot of black box and algorithmic trading has been introduced. The profile of algorithmic trading is primarily a larger number of small-ticket items, so not only does the dollar volume increase but the actual number of tickets dramatically increases.

• SO TECHNOLOGY HAS BEEN A FACILITATOR AND HAS HELPED PUSH UP VOLUMES: WHAT CHALLENGES HAS THE EXPLOSION IN FX VOLUMES CREATED FOR ORGANISATIONS' IT OPERATIONS?

For the past couple of years, the main focus of technology has been on getting latency out of the price distribution execution; the IT teams have done a really good job on that. The distribution of rates is basically on a par with what we see in the equities business. What this means is that, with the additional capacity that’s been created by the technology, we’ve moved the latency problem from pre-trade to post-trade. So the situation we’re in now is that the guys can execute a large number of transactions, but the traditional back-end systems have been put under a lot of stress and we’ve seen a number of stress points.

• HOW COST-EFFICIENT ARE THE PREVAILING FX PROCESSING SYSTEMS?

The key thing, like any industry, is that those who have scale and volume have the best cost model. Because they’ve got that volume and they’ve got big infrastructure behind it, their cost per trade is generally low and it is very effective. But that’s the top of the top-tier organisations. As you move down that tier, and move into second tier and third tier, the gap between processing for the top players and the smaller ones becomes huge.

• HOW DO THESE ISSUES COMPARE WITH OTHER ASSET CLASSES?

The processing efficiency for FX and cash is fairly high. It is actually not as good as equities, but it is probably second only to equities. So generally, in our view of the world, equities is the most efficient, and FX is ­probably second, and there’s been a lot of industry-wide initiatives during the past few years. For example, the introduction of CLS (Continuous Linked Settlement), affirmation and confirmation. All the same stuff that’s been introduced on the equities side, we’ve taken a lead from that, but we’ve still a long way to go.

• HOW SUCCESSFUL HAS THE VENDOR/SERVICE PROVIDER COMMUNITY BEEN IN SERVICING THIS MARKETPLACE?

I think they’ve done a good job. One of the problems with the vendor community is that they want to do everything. I think they get carried away with their exuberance; they want to be all things to all banks but actually what you really want, in this business, is focus because the big guys need systems to do specific jobs, to do them well and do them cost-effectively. The big guys will have big infrastructures – some that they’ve built themselves, some that they’ve bought from vendors. The problem is, as you go down tier, these banks are obviously in the same business but they don’t have the same volume. So, they have to buy a lot of infrastructure and traditionally this stuff has been expensive: it has been a capital project with a lot of cost associated with it, a lot of people on the project, and it is a burden for these organisations. While times were good, people were happy to deal with that. Now people are taking a look at the capital projects they want to do, and cost is an important issue.

• IN THE MARKETPLACES THERE ARE LOT OF EXAMPLES OF INDUSTRY-OWNED AND OPERATED UTILITIES. HOW APPLICABLE IS THIS MODEL TO THE FX MARKET AS IT STANDS?

There have been a number of attempts over the years. But we now feel that the time is right for something to step in. The big guys are getting bigger, so their volume is increasing, therefore their unit cost, for processing, is going down. But the smaller guys want to be in this market and provide a service – and they’ve got to be efficient. So we feel the time is right again for a co-operative utility where people can get the economies of scale by pooling their trade processing capacity together, and get the same processing benefits as the big guys, at the same cost.

• HAVE YOU BEEN INVOLVED IN ANY PARTICULAR INITIATIVES ALONG THOSE LINES?

We’ve done a lot of work over the past year, and we’re about to launch – with a number of utility partners – an industry-wide utility to provide co-operative processing capacity in the space.

• HOW WILL THE PRICING MODEL OF AN INDUSTRY-UTILITY DIFFER FROM WHAT WE'VE SEEN IN THE FX SPACE HISTORICALLY?

Traditionally, in our business, we’ve sold software to capital projects. You pay a licence fee and maintenance fee with big upfront expenditure, a lot of people to maintain it, and you’re left with this for life. And some people like that model. The smaller guys would feel that the systems we provide are outside their reach. They can’t afford to buy them. And the purchasing price may be just the start of it; they can’t afford to run them over a 10-year period; they’ve got to hire staff, and these systems are complicated – so the pricing model is outside their reach. The pricing model for a utility is like many utilities – pay as you go. You sign up and you get for a certain fee a block of processing capacity. If you want more, you just utilise that and we will deal with it in a pay-as-you-go model. It is a fundamental shift in our business.

• SO YOU'VE TAKEN THE TEMPERATURE AND YOU'RE PRETTY CONFIDENT THAT THERE IS AN APPETITE OUT THERE?

Yes, we’ve done that. You’ve got providers in this business who just make a living out of providing connectivity for venues and bank portals, [and] they’ve done a really good job in this space: so the connectivity is not an issue any more, the pricing is radically different, and the model is fairly rigid.

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