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Thursday, July 19, 2012

Scooping FX Bubbles Out of a Boiling Pot

Posted by Ben Ernest-Jones

Foreign exchange trading appears to be moving from a beneath-the-radar, bank-dominated activity into the international trading limelight. There has been an explosion of new trading platforms and a wave of newer participants lately, partly thanks to new transparency afforded by Dodd-Frank and partly because of the relentless hunt for alpha. Increasingly automated, FX is also becoming the next go-to asset class for high frequency and algorithmic trading.

It wasn't always that way. As TABB Group's Larry Tabb said in an article in Wall Street & Technology: "FX has always been different. Be it that currency is a bank’s core product, be it that banks control the payments infrastructure, or be it that banks are critical in implementing Central Banks’ monetary policy, the banks have historically dominated FX."

Because FX is mainly traded via single dealer platforms, multi-dealer platforms such as FXall, and interdealer marketplaces, it is fragmented in a different way from equities.  Traditional trading platforms along with a couple of the sturdier newcomers like multi-dealer platforms FXall (which Thomson Reuters is buying) andCurrenex have been the dominant destinations for electronic trading of FX.

But now that the SEC and CFTC have clarified that forex contracts will be determined to be swaps, they will become part of the centrally cleared instrument pool. This means a whole new layer of banks, brokers, and venues are already popping their heads up. FX will soon emulate the expansion, consolidation, and then contraction of destinations experienced by the equities markets. 

There will be more opportunities for market participants to trade, hedge, arbitrage and manage risk. Algorithmic strategies will dominate, attracting more and more destination venues - and then fragmentation will be the mantra. So how are traders going to position themselves to scoop the profitable FX bubbles out? It is not as easy as you would think. In many cases, what appears to be an increase in liquidity is actually an increase in “phantom” orders, as institutions advertise the same underlying liquidity across an increasing number of locations. Trading algorithms will need to be smarter, and tuned over time to counteract this as the landscape changes.

Bank traders are looking for ways to handle the new world order of FX. Because their clients want to be able to trade forwards, swaps, spot and even options on the same system, banks are having to do the once-unthinkable: merge their forwards desks with their spot desks.

In the old days of voice trading, forwards and spot traders ran completely separate books and dealt with (mostly) different customers. Today clients are asking to hedge forwards and spot on the same system at the same time. Some want to trade using forward-to-spot conversions against aggregated spot prices from several platforms and some want to use aggregated forward rates directly. Some want a blending of both. The opportunities for banks are plentiful, if they can harmonize FX products, trading and hedging across trading systems successfully.

Many bank clients have seen what has happened in the equities markets; with high frequency trading and algorithmic strategies becoming problematic and largely vilified. When the world’s largest interdealer brokersaid recently that it would tackle “disruptive” practices by high-frequency traders on its foreign exchange platform it became clear that some of the lesser-loved equities issues were already creeping into FX markets.

The Wall Street Journal says that there are already fears of an FX "boom" reminiscent of the equities venue explosion in 2001. "Some market insiders fear the trend for highly specialized new systems aimed at separate pockets of clients could end up splitting the liquidity that underpins this $4 trillion-a-day market, making it harder to trade," said the paper. Pigeon-holing traders, whether it be by class of trader, asset class or by delivery date, only creates more fragmentation. This could equate to lower volumes (like equities), more volatility (like equities) and an increase in manipulative practices (like equities). Regulators will no doubt be watching, and new rules will be implemented even faster than has happened in equities.

In a discussion at the FX Week USA event in NYC recently one FX trading platform provider said that you need a full market ecology to provide proper efficiency. This means having all market participants operate in the same liquidity pool.  In the end the unique self-regulating properties of the FX markets mean that the market will shift towards what is best for the market - because it can. Preparation for this inevitability will determine who survives. 

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