Changing the Business Environment: The Third Phase for Online Trading
The thrust of this piece is to comment on the developments in online trading in the recent past and near future. My experience in this field is largely devoted to FX and Money Markets but the same general characteristics will apply to any asset class. In order to understand the way that the market will develop you have to look not just at the recent past, but also at the whole history of online trading. Looked at historically distributed electronic trading in FX is typical of the way that many services have developed.
Simply speaking you could break this down into three distinct phases. Firstly technology is used to simply replicate what was previously done manually. During this phase the providers and users get comfortable with the concepts involved. At the next phase providers start to differentiate themselves and to try and win business through the technology. During the first and second phases the providers, which in the case of FX are the trading banks, maintain control over the core franchise. The third phase, which we have been gradually entering for the past few years, is where the technology starts to change the whole environment in which the business is carried out.
In macro terms the growth of both corporations and institution trading online over the past two years has been very impressive, with the number of corporations and institutions participating electronically almost doubling to 49 and 58 per cent respectively. It is a given that this trend is going to continue, although perhaps not at the same phenomenal pace. Efficiency of processing, again driven by seamless technology, is one of the key drivers of this. Banks are still by far the largest category and dominate the sell side. Over $100bn is now traded online daily with some 30 per cent of the market concentrated in the hands of three institutions and approximately 12 major institutions overall maintaining the majority of the market.
Against this environment supra regional and regional banks are facing the cold winds of competition in their home markets by adopting the technology being offered by the major trading banks. Again this is technologically driven. It is no co-incidence that those banks with the most sophisticated delivery systems are outstripping their rivals in the quest for market share and flow. Regional banks are left with the uncomfortable dilemma of deciding how to deal with all of this. Certainly there are a number of options open to them, white labelling offerings being just one. But as far as these regionals are concerned some tough decisions are going to be required. The attractions of outsourcing the whole FX operations of a bank have to be offset against the loss of the core franchise and the implicit lack of independence, not to mention the impact on the share price.
Moreover it is almost inconceivable that some banks would be prepared to loose control over FX. For example purposes take Commonwealth Bank Of Australia. It is inconceivable that this bank would even consider losing control of its Australian Dollar business. But the question of whether this bank needs to be able to make a market in Latin American exotics for its australian clients is somewhat more difficult to answer. Solving this dilemma is probably easier than the more vexed question posed by the fact that the STP (Straight Through Processing) aspect to the technologies are becoming increasingly important. Despite that fact that the quality of FX advice still figures strongly in buy side selection, the processing element still means that regional banks are going to have to raise their game in order to standstill.
But despite the fact that the spread of online trading capability is asking a lot of questions it is also providing many of the answers. Online technology solutions are well within the budgets of most supra regional and regional banks. These solutions can provide access and connectivity to a variety of liquidity and service providers as well as the ability to distribute within core franchise. Certainly technology strategies have been absolutely crucial to the success or otherwise of the FX trading operations of major banks but we are moving beyond that now with the surge of activity coming from various FX Portals and ECN’s. Whether this phenomenon is just a passing phase or a permanent feature of the markets is open for debate but the entry of these houses has allowed the buy side to have options in their choice of transaction conduits. Is this because of technology? Well arguably yes. In a perfectly functioning market where all needs were adequately catered for there would be no need for outfits such as HotSpot or Currenex. The success of the business models supporting these initiatives is almost entirely technology based. they have the ability to provide high quality service to the buy side and through their credit models they have been able to attract the interest of prime brokers, thereby at a stroke eliminating credit issues. According to figures supplied to me by Client Knowledge these “absolute return seekers” have grown as a group by 75 per cent so they must be doing something right.
The impact of these new players cannot be underestimated. Clients can expect market pricing on even relatively small deals so the attractions to the buy side are obvious. In addition, prime brokerage eliminates the credit questions from the sell side therefore justifying the market pricing. More importantly perhaps the enlightened credit and margin trading models used by the portals are allowing access to non traditional players, hedge funds etc. and allowing them to trade on a highly leveraged basis based on slick real-time mark to market calculation capability. That this area is having an impact on traditional banks’ thinking is obvious. At a recent Cognotec user group meeting, margin trading was the second most important consideration, yet in 2003 it did not appear on the user group’s radar screen. Moreover some middle market banks are now using the portals as a substitute for a deep commercial franchise. What drives this? Once again technology. The portals don’t care who hits the price but you have to be quick. Those banks getting the price there first are the ones likely to get the deals. If these houses continue to display the exponential growth which they have been showing then the lines between the buy and sell sides which were already being eroded are likely to diminish even further.
The advent of streaming executable pricing and the individual amounts which are now being traded electronically has meant that more focus than ever is now needed on the ability to price correctly. In this essence the FX market has now turned full circle. Trades are just too large and too tightly priced to rely on electronic price feeds alone. Trader Rate management tools are now essential to market makers allowing them to shape the prices they make to the result that they want to achieve. Some of the factors affecting these decisions are house specific, economic or emotional. Technology is even reaching these areas looking at logic based solutions to particular situations.
So in terms of the FX market significant changes are still taking place. Ten years ago the market was much simpler comprising of just corporate and institutional clients, wholesale banks and brokers. Today the market is multi-dimensional. Wholesale banks are differentiated into price makers and takers or combinations thereof, non-traditional brokers and ECN’s, leveraged funds and flow aggregators etc. Most of the recent changes have been driven or influenced by technological development. For the corporate client the developments have been good news. Credit is available in much greater amounts and prices across the board are tighter. For the banks more attention needs to be focused on the true costs of maintaining their franchises and keeping ahead of the game. The selection of technology partners in this space is crucial. Online trading will dominate the market across all asset classes in the next ten years and the decisions taken by players now will go a long way to defining how well they are going to do.