The global foreign exchange market has adapted to the new normal of low volatility, electronification and greater regulatory oversight, driving important changes in the market structure. Joy Macknight reports.
The foreign exchange (FX) market remains by far the largest in the world, with FX and over-the-counter (OTC) derivatives trading rising to $6600bn per day in April 2019, according to the most recent Bank for International Settlements (BIS) Triennial Central Bank Survey.
It is also a complex market with participants using FX for many different reasons, from the multinational corporation making cross-border salary payments to high-frequency traders searching for alpha. “FX has different workflows based on client types and trading methodologies,” says Stephane Malrait, global head of market structure and innovation for financial markets at ING. “As a market maker, we need to cater for different client types and workflows.”
For banks, the historical market-makers, FX trading remained a robust line of business following the global financial crisis. According to banking intelligence firm Coalition, in 2019 the top 12 global banks earned $7.7bn from trading G10 currencies, including spot ($3.1bn), forwards ($3.2bn) and options ($1.5bn).
However, in recent years the FX industry has had to adapt to electronification, low volatility and new regulations, resulting in fundamental changes in market structure.
Going electronic
FX spot was one of the first OTC markets to move from voice brokers to electronic platforms, with the FX forwards market quickly catching up. An estimated 56% of FX trading is now done electronically.
“By reducing transaction costs, electronification has boosted trading and changed price formation and liquidity provision,” says the recent BIS Quarterly Review, published in December 2019. “Electronification has enabled automated trading, in particular high-frequency trading. This, in turn, has made OTC markets more attractive to those engaged in such strategies, mainly hedge funds and principal trading firms.” Non-banks, such as Citadel Securities and Virtu, are starting to play a bigger role in market-making.
Paul Houston, global head of FX at international markets company CME Group, focuses on the changes in liquidity provision. “Another trend is for the bigger banks to get bigger and for the smaller banks to adopt more agency-style models to service their customers,” he says.
But the pressure on profitability makes a tough environment for liquidity providers, according to Peter Plester, head of FX prime brokerage at Saxo Bank, a Danish investment bank. “It is a very fragmented market and liquidity is available in hundreds of places. Therefore, it is a huge task for the big liquidity providers to feed their pricing into so many venues, brokers and so on, and requires a lot of technology, which comes at a cost,” he says.
As a result, some liquidity providers are reducing the number of venues where they are willing to offer prices. “That has forced participants to move to the more standard and popular venues, rather than taking a chance on a smaller venue trying to build itself,” adds Mr Plester.
Yet David Woolcock, director of business consulting at Eurobase, a software provider to financial institutions, underscores the continuing decline of primary platforms EBS and Reuters (now Refinitiv) Matching. “Many tend to see the evolution as continued aggregation of a fragmented market, but the diminishing dominance of the primary platforms – which everyone still uses for price formulation and primary market benchmarking, along with CME – is one of the big stories,” he says, adding that this is a result of banks internalising their flows.
Low volatility
Another contributor to the current market configuration has been a prolonged period of reduced volatility, as a result of low to negative interest rates in the G10 currency countries. “Low volatility has challenged many business models, particularly for firms that don’t have scale. Everyone [has been] building out their models around low volatility being the new norm,” says Andrew Edwards, CEO of Saxo Markets UK. However, the market shock from the Covid-19 pandemic has seen FX volatility spike to a level not seen since the financial crisis.
Marc Bayle de Jesse, CEO of CLS, a global financial market infrastructure that provides FX settlement, data and processing services, points to the rising importance of emerging market currencies in the FX market. According to the BIS survey, the trading of emerging market currencies outgrew that of G10 currencies between 2016 and 2019.
“With low G10 interest rates and flat yield curves, a global macro hedge fund or a multi-asset long-only account must look to the emerging markets to get extra return,” adds Jeremy Armitage, global head of FX trading at State Street. “We have seen a big shift in the share of business between G10 and non-G10 currencies, so we are expanding our footprint onshore and offshore across the emerging markets, as well as providing electronic solutions in those currencies.”
Regulatory oversight
New regulations have also been a driver of change. While the FX market was not the main target of the post-financial crisis regulatory blitz, some segments have been caught up in their scope. For example, FX spot is exempt from the Markets in Financial Instruments Directive II; however, the regulation’s mandatory best execution requirement has “transformed the buy-side”, according to Mr Armitage.
“They need to first determine what best price means in a variety of situations, whether that is settling a dividend for an overseas security, making an asset allocation decision, moving between markets, launching new funds and so on. [Deciding] what best execution means in all those scenarios is a big burden,” he explains.
In 2018, State Street bought FX transaction cost analysis (TCA) start-up BestX, which, according to Mr Armitage, “does the data scrubbing to determine what the best price is at any point in time, and that is a valuable service for an asset manager. It is not possible to rely on any one venue to be the sole determinant of where the market is."
Despite weathering the global financial crisis well, the FX industry’s crisis moment came in late 2013, when collusion among currency traders to manipulate the market at the ‘fix’ (the 60-second windows when benchmark rates are set) came to light. This resulted in banks paying out billions of dollars in fines and greater regulatory scrutiny of the OTC market; but, positively, it also led to the FX Global Code of Conduct, a market participant-led initiative launched in May 2017.
“Thanks to the FX Global Code, there is a greater harmonisation of, and reliance on, best practices in the market, resulting in better transparency, risk management, and overall improved functioning in the market,” says Mr Bayle de Jesse.
Searching for synergies
At the outset of electronification of the FX market, there was an explosion of independent multi-dealer platforms whose aim was to eat into the share of the primary venues. However, most have now been gobbled up by exchange groups, as well as EBS and Refinitiv.
For example, in 2015, Deutsche Börse bought 360T and then GTX in 2018. In 2017, Cboe acquired Bats Global Markets, an equities platform with an FX platform, Hotspot, and Euronext picked up FastMatch; in 2018, CME bought EBS via NEX Group; and, assuming it goes ahead, LSEG is purchasing Refinitiv, which itself had acquired FXall in 2012.
According to CME’s Mr Houston, exchanges are looking to offer more holistic FX solutions by bringing exchange-traded clearing, bilateral and cash FX together on a single platform. “This structure offers more efficiencies and reduces connectivity costs for customers. Then all the pieces can be brought together with pre-trade analytics, post-trade clearing and margin efficiencies, with trading across bilateral, cleared and listed pools,” he says. “The platform of the future should be able to offer a solution across those different components of FX and bring in more asset classes to offer customers greater efficiency.”
David Mercer, CEO of LMAX Group, which operates institutional execution venues for electronic FX and cryptocurrency trading, says that it makes sense on paper for the exchanges to add another asset class, with efficiency gains in infrastructure, technology and market data provision and distribution. “Calculating it on a spreadsheet, there are obvious cost synergies. The trick is revenue synergies, however, and on that front it could also be argued that existing exchange customers would pay for the new FX market data,” he says.
Making it pay
However, the jury is still out as to whether these purchases can move the needle in terms of value for those exchanges, according to Mr Mercer. “The challenge for these groups is whether they can make an institutional-only transactional FX business pay dividends for stakeholders and show a return on investment. Because, ultimately, the trend in institutional FX is that everyone is paying less to transact,” he says.
The exchanges are not buying FX platforms solely for the revenue, says Mr Malrait, as the targets are well-established trading venues, with large client bases, high volumes of transactions and existing revenues. “They buy them because there is value in the data that they could monetise, and there is value in the clearing that they could bring as a service on top of execution,” he says.
The demand for data and analytics has boomed. Mr Woolcock says: “The exchanges saw that happening in equity markets, causing the development of tools such as TCA, which can be very powerful in FX.”
Mr Houston agrees: “The data from cash platforms alongside listed, regulated marketplaces can be offered together and is valuable for analytics such as TCA. The final piece of the puzzle is offering one-stop-shop trading and clearing.”
Ledger technology
Recourse to better technology has fuelled innovation and allowed new entrants such as BestX to enter the market. “Many fintechs are developing tools to allow the buy-side to be more efficient and make more use of the market infrastructure,” says Mr Woolcock. “While they are usually regarded as disruptors, quite a few are working in a collaborative way.
“The big picture in market infrastructure, particularly with the advent of distributed ledger technology [DLT] and blockchain, is that such technology gives us the opportunity to take some meaningful cost out of the whole process.”
One newcomer is Cobalt, which has built a post-trade network on a shared ledger. The company, which went live with its first clients in September 2019, has built a centralised infrastructure that is focused on removing costs in post-trade processing, from reconciliation, messaging, matching engines, balance sheet usage and infrastructure such as middle- and back-office systems.
“Cobalt mutualises post-trade activities on a centralised infrastructure, which is faster and cheaper. There is only one version for each transaction – it is fully normalised, with all parties in a trade seeing the same thing. Therefore, they do not need to reconcile from that point onwards, which speeds up the process,” says Andy Coyne, Cobalt’s co-founder and chief product officer. “A centralised infrastructure provides a huge opportunity to bring the cost base down. There is no point in talking about 10% to 15% savings; we must talk about savings of at least 50% to really grab people’s attention.”
DLT start-up Baton is collaborating with several banks. It is providing the foundation of HSBC FX Everywhere, which uses a permissioned shared ledger to settle FX transactions for cross-border payments across the bank’s internal balance sheets. “DLT provides singularity, transparency and immutability,” says Mark Williamson, global head of FX Everywhere at HSBC. “The immutability part is important because [in the case of FX Everywhere] it is backed by a legal rulebook, which describes settlement finality. With finality, we can treat the funds on the ledger in a different way, which is important considering the challenges that all banks have around what is held on the balance sheet.” FX Everywhere has been live for two years and HSBC has settled more than $1350bn on the platform.
Industry utilities such as CLS are also beginning to adopt DLT. “CLS has the first global FX market enterprise application running on DLT in production, CLSNet,” says Mr Bayle de Jesse. “The service is a bilateral payment netting calculation service, which provides risk mitigation and operational efficiencies to emerging market currencies [not eligible for CLSSettlement], as well as CLSSettlement-eligible currencies.”
What’s next?
CLS is now looking to address the evolution towards resolving multi-currency settlement exposures increasingly quickly, in particular, on an intraday basis. With this in mind, CLS has recently developed CLSNow, which allows bilateral same-day gross payment versus payment settlement. “The live service is helping the industry to answer current challenges such as intraday liquidity management,” says Mr Bayle de Jesse.
A new development that Mr Woolcock highlights is peer-to-peer FX trading platforms. “The growth is coming primarily from the asset management space,” he says. “For example, Vanguard recently announced such a platform using blockchain. We are watching this space more closely, but the jury is still out whether it is a successful initiative or not.”
Mr Woolcock also points to central bank digital currencies (CBDCs), which he expects to go beyond the emerging market space where a few have sprung up. “These tend to be more payment-based, but they will have a major impact on how we view FX,” he says. “The real-time gross settlement systems will need to expand their hours to make these CBDCs work and achieve true instant payments, which are irrevocable once they are made, as opposed to faster payments.”
Importantly, a three-year review of the FX Global Code has begun, and Mr Malrait expects it to extend to algorithmic trading and TCA. “Central banks see the FX market evolving fast and they want to be able to have a code to be able to adapt to those types of new trading activity,” he says. “While algorithmic trading is not new, it is still not heavily used in the FX market – just 10% of volume goes through algo trading – but we think the volume will grow in the future.”
