New markets, new players and the inexorable march of technology have transformed the foreign exchange market. As the global economy gradually gets back to its feet, 2010 looks to be a seminal year in its development. Writer Charlie Corbett

Three things in life appear to be certain in 2010: death, taxes and volatility in the global foreign exchange (FX) market. It is a well-known fact that foreign exchange is the most liquid and geographically diverse market in the world. Despite faltering volumes in 2009, research firm Celent estimates that average daily turnover on the FX market will hit a staggering $4000bn in 2010. What is perhaps less well known, however, is that it is a market undergoing a period of extensive and profound structural change. In fact, the FX market of today bears little or no resemblance to the market of three to five years ago, and it is likely that the FX market in three to five years' time will bear little or no resemblance to the market of today.

Technological advancements, the impact of the global economic downturn and looming new regulations and structural changes in the make-up of the competitive landscape mean that foreign exchange is about so much more than just trading in currencies.

Even at this, its most raw form, uncertainty stalks the market. Currency volatility surged in the first three months of 2010, not least because of the fiscal troubles in the so-called PIGS economies of Portugal, Ireland Greece and Spain, but also longer-term questions are being asked about the strength of the developed market currencies in comparison to the emerging markets. There is even serious debate about how long the US dollar will remain as the reserve currency of choice in the face of the inexorable rise of emerging markets economies, in particular China. Recent events in southern Europe have led to serious doubts over the longer-term viability of the euro, sterling seems to be in a perpetual state of decline, not helped by the prospect of a hung parliament in the UK general election next month, and the yen continues to be a victim of the Japanese government's huge debt burden.

On the other side of the coin, China's government has yet to make a decision on when to allow the renminbi to appreciate, if at all - a source of ongoing worry for developed economies - and the so-called commodity currencies of Australia, New Zealand, Brazil, India and Russia continue their long-term upward trend. Even these currencies, however, are not immune to short-term and very large bouts of volatility. However, volatility can only be a good thing for those that trade in foreign exchange. Volatility drives volume - it is the lack of volatility in currencies that leads to stagnation.

Average daily turnover of global FX market

Average daily turnover of global FX market

Volumes return

Last year can be seen as a year when the steady growth in volumes of foreign exchange did indeed grind to a halt. According to the Bank for International Settlements, volumes in FX trading fell by 30% globally. The fall can be accounted for by a number of factors. One such factor is that 2009's fall is exaggerated by the huge surge in volumes in 2008, due in large part to FX being the only market with any liquidity at the nadir of the crisis. The implications of the near collapse in global banking were felt most keenly in 2009, in particular the drying up of international trade, which in turn hit FX volumes as companies across the globe struggled to survive.

"Corporates pretty much came to a screaming halt at the end of last year and they've been slowly building back up," says Scott Wacker, head of FX sales for EMEA at JPMorgan. The withdrawal of the hedge funds from the market, a major driver of recent volumes, also hit FX in 2009 as money was sucked out of the funds by nervy investors. Despite a lacklustre 2009, however, most in the market are optimistic volumes will reach new highs in 2010.

"With the amount of cross-border trade and the pick up in trade in general, the corporate business is going to get stronger and stronger through 2010," says Mr Wacker. He is also optimistic that hedge funds will return to the market this year. "Hedge funds performed pretty well in the crisis and I think we're going to start seeing money flow back into this space," he says. According to Jason Shell, global head of FX sales for corporates at Deutsche Bank, more and more new users will be attracted to foreign exchange trading in 2010. "They are being driven to the FX markets because money market yields are so low," he says. "People are looking for a way to close that gap on the money market yield... in a way that they are confident that they can manage the downside. And that is where FX as an asset class has come in big time."

However, not everyone is quite as optimistic. "There is a chance that the recovery in volumes is sustainable, but there is a big but," says Vincent Craignou, global head of FX and precious metals derivatives at HSBC. "If you look at what has happened already this year, compared to last year, there has been a big bounce - particularly in EMEA and Asia - but it varies from one currency to the next."

Many in the market feel that there will also be a return in popularity of trade in more complex FX derivatives and options. This market was hit hard by the downturn as investors ran scared from any kind of derivative product they did not understand, trading instead in plain vanilla products. However, investors were scarred in the downturn and it could be a while before things return to normal in the derivatives and options arena. "In the past nine months we've seen a huge contraction in the FX derivatives space. Basically, the whole market has gone vanilla and it will take us a long time to move back to a more derivative accepting environment," says Mr Wacker.

"When volatility erupted, short volatility strategies turned out to be disastrous. The market got burned and it will take a while before it gets comfortable with derivatives again," he says.

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Scott Wacker, head of FX sales for EMEA at JPMorgan

Regulation threat

The looming spectre of regulation hangs heavy over the financial services industry, and none more so than in foreign exchange. This market's particular worry is potential regulation that will force over-the-counter (OTC) trade of derivatives onto centralised exchanges. It is part of a raft of potential regulations being championed by politicians across the developed markets, which attempt to get at the heart of the causes of the financial crisis. In the case of foreign exchange, most market participants seem to agree, it entirely misses the point.

The scale and nature of foreign exchange trading does not conform to standardisation in any way. Its success, particularly during the crisis, can be attributed to its liquidity and flexibility. Many in the market argue that it neither needs to be forced onto an exchange nor will clients benefit if it is. There is, however, a sense of inevitability in the market. Many argue that since it looks increasingly likely that trade in OTC FX derivatives will be pushed onto a central counterparty clearing house (CCP), it would be foolish not to prepare for it.

"We have little choice but to adapt to whatever regulatory environment is put on us," says François Boisson, head of FX sales at BNP Paribas. "We are gearing up to take more volumes on listed exchanges than OTC and I think it would be foolish of banks not to be ready for a changing marketplace."

Michael Bagguley, head of trading at Barclays Capital, takes a similar line. "We're working on an initiative around counterparty clearing for FX options," he says. "CCP brings us good transparency and we are a strong supporter of that." However, Mr Bagguley emphasises that the big issue in foreign exchange is not so much transparency but strong settlement. It is this that regulators should be focusing on. "I see the boosting of services such as CLS Bank and its payment aggregation initiative, which gives us strong settlement, as the biggest risk mitigator in the FX market," he says. "That is the solution where the industry could show most value to the regulator."

Deutsche Bank's Mr Shell is adamant that FX should be handled with care. "We think regulation for FX should be different to other markets. There are so many fundamental differences that it has to be treated differently," he says.

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Vincent Craignou, global head of FX and precious metals derivatives at HSBC

The way ahead

The global foreign exchange market is going through a fundamental shake up. New technology has transformed not only the way business is transacted, but the also the type of investor that uses FX.

New participants such as hedge funds, and, more recently, retail investors, have flocked to the market. Despite a lull in volumes in 2009, it is clear that the long-term trend is upwards. How banks cope with this assault on the FX market's infrastructure - used in the past to execute bigger trades over lower volumes - and which banks will win in this cut-throat environment is another matter. Axel Pierron, senior vice-president of European markets for FX specialist Celent, says the major sell-side banks of the future will need to avoid their FX services becoming commoditised and offer clients a wide range of value-added services such as prime brokerage, research and advice.

None of this will come cheap. Taking on multi-dealer platforms and devefloping an in-house single-dealer platform that comes up to clients increasingly stiff demands is a challenge for all the major banks. "Four years ago banks were in defensive mode in the FX world, but today they are much more aggressive and going after the FX market," says Mr Pierron.

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