Foreign Exchange: Keeping Pace in an Explosive Market
The foreign exchange (FX) market is by far the largest marketplace in the world. With exponential growth year on year, an average daily trading volume of US$5bn in 1977 has risen to an estimated US$2.9 trillion for April 2007. In the last three years alone, trading volumes have increased more than 38%. Despite slight declines during the second half of 2006, FX trade volume seems posed to continue the trend of exponential growth that we have witnessed during the past few years.
Furthermore, as more countries make their currencies convertible on the capital account, as Russia did in July 2006, the trading volume of that currency increases. Worldwide structural changes are allowing significant increases in assets allocated to international markets. This development is indicative of a fundamental strategic shift to increasing international allocations, a shift that will drive continued growth in the volume of FX transactions.
Looking at the market today, FX is now an asset class in its own right. Hedge funds are increasingly interested in this as an alternative to fixed income. They lead the volumes in algorithmic FX trading and they continue to be the driving force for technology innovation in the FX marketplace. Increased hedge fund participation puts great pressure on response times in IT systems. The key to success is accommodating higher volumes that can be processed quickly, in real-time and in a low-cost way.
To stay competitive in this environment, banks need to find a way to reduce transaction costs. Real-time, high-capacity solutions are becoming essential for processing ever-increasing trading volumes. This, together with an increased focus on electronic trading and the quest for faster execution of secured settlements, is calling for banks to re-examine their internal systems.
Electronic FX trading (e-FX) currently accounts for over 40% of overall FX volume; that number is expected to grow to more than 44% by the end of 2007. Technological advances in electronic trading have significantly reduced processing costs and lowered the barriers to entry for market participants and leveling the playing field between wholesale banks with big IT budgets and the smaller banks. Other factors contributing to e-FX growth include more efficient platforms such as State Street Global Link, Currenex, FXall and Hotspot FX. FX straight-through processing (STP) reduces capital and hardware costs and, in addition, trading fees for buy-side clients have been reduced substantially and on some platforms even eliminated.
The adoption of continuous linked settlement (CLS) over the past few years has reduced the processing cost per trade and helped banks to achieve volume scalability without the need for additional processing staff. This reduction of processing costs has also allowed algorithmic trading to flourish. Because of CLS, traders can now take advantage of even the smallest inefficiencies in the FX market. Prior to CLS, the margin for algorithmic trading would have been overwhelmed by high trade processing costs.
Traditionally, banks held control over FX prices and spreads. The adoption of algorithmic trading, however, has leveled the playing field for buyers and sellers. Trading orders can now be automatically executed; market timing and price can be better controlled; and large volume trades can be automatically divided up into several smaller trades to reduce their market impact.
For banks to regain control, they need to strengthen their operations infrastructure and reduce costs; banks that continue to operate with inefficient systems will be at a disadvantage. It is therefore imperative for banks to process trades quickly and accurately; with the success of algorithmic traders relying upon their ability to execute trades almost instantaneously. With corporate governance regulations, such as Sarbanes-Oxley (SOX), improving the monitoring, structure and vetting of compliance controls have become a priority. Alongside this is the focus on best execution, looking at pricing, the cost of trade and processing transactions, as well as the potential for human error. By automating manual processes, banks can monitor and document electronic controls without human intervention, saving time and eliminating the risk of manual error.
As margins continue to decline in most business lines, banks face new challenges in terms of how they allocate resources. Back-office processes – order matching and confirmation – lend themselves to automation, whereas front-end workers have been more reluctant to do away with manual processes. But the current quest for efficiency and effectiveness has affected how front-office business is transacted. STP increases efficiency and also demonstrates the controls required in an increasingly compliance-centric regulatory environment.
It is extremely important for banks to be able to allocate resources in a flexible, timely and cost-effective manner. They need to re-allocate the sales force from lower-margin business into the higher-margin, more complex business transactions such as OTC options and derivatives.
Without doubt, rising volumes will continue to put pressure on existing trading systems, so an integrated system is critical to show real-time position and risk data, as well as to handle the continuing requirement for efficient STP.
In today’s trading environment, increased trade volume, tightening spreads and declining margins have limited revenue growth opportunities. To cope with and meet the anticipated needs of the future, banks need a robust solution that is economical and scalable, web enabled and globally deployed. In addition, banks need a system that can process today’s volumes, along with anticipated higher volumes in the future.
The FX market has seen and will continue to see remarkable changes. The buy-side is likely to become even more ambitious, capitalising on innovations in e-trading, algorithms and a volatile market. While the buy-side seeks new opportunities, the sell-side is witnessing more dynamic and sophisticated clients on their books.
For banks, the challenge is to evolve to keep pace. With volumes growing all the time, as both proprietary trading and the buy-side use more complicated trading strategies to split large orders, the ability to cope with high volumes is crucial. This includes not simply average volumes, but also the ability to cope with intense, peak volumes associated with highly volatile trading periods.
The requirements for real-time position and risk information has been topical for a few years, but in a market characterised by decisions made in milliseconds by machines using complex equations, the need has become indisputably clear. This need will only intensify over the short-term as portfolios and positions have to be adjusted on an intra-minute basis. This will undoubtedly test all of the major market players. Finding the right approach to deal with these issues is central to their ability to succeed in such a competitive space.