SPECIAL FX.

Foreign exchange is increasingly seen as an investible asset class by the buyside but it is dogged by a lack of transparency. Dan Barnes reports.

Buyside firms across the spectrum are lining up to improve execution quality in FX. Foreign exchange is seeing a boom in interest from some short-term investors, as other asset classes prove too volatile, correlated or just plain doomed to invest in. Meanwhile a series of high profile lawsuits brought by fund managers against their custodian banks, for allegedly overcharging their clients on FX transactions, has increased interest in active trading of FX with monitoring of and improvements made to execution quality for FX trades.

The FX market has been set up to reflect the supporting function that foreign exchange has for most trading firms as they seek to trade overseas bonds and equities. The single-dealer-platform long allowed sell-side firms a virtual monopoly over their clients’ FX trading, but this is now being questioned by asset managers looking afresh for best execution, as has wholesale outsourcing of FX trading to sellside partners.

At the same time a growth in firms’ trading of FX to generate alpha has required them to build relationships with multiple dealers. This move towards transparent trading across so many counterparties will require a fundamental shift in the way that buyside firms access prices and liquidity in the foreign exchange market.

“Five years ago people started to talk about the potential of FX to function as an asset class in its own right rather than as a funding mechanism for other investments or as a hedge,” says Jim Kwiatkowski, head of sales at FXall. “At the time, there were already some firms investing and we’ve seen that on the rise. There are multi-asset hedge funds that have currency strategies and we continue to see the number of firms participating in that market growing. We’ve also seen high-frequency trading of FX grow as an investment strategy, but I think the bulk of volume in any given day is done by people who have a need to execute FX which is why the liquidity pool is so deep.”

The established models for buyside participation in FX have only been partially profit driven. Typically the group can be divided into three categories: institutional, corporate and retail. Retail FX traders use it as a speculative asset class while corporate traders use it almost purely on transactional basis either to pay bills or to exchange funds that they have received as payment in overseas currencies. In the institutional space it is typically a bit of both, depending on the company in question, partly to support trading of other instruments, but also trading in FX as an asset class.

“A significant driver of FX as an investment nowadays is the fact that it is one of the few relatively uncorrelated asset classes left,” says Paul Caplin, CEO of online trading platform provider Caplin Systems. “Since the credit crunch, there has been an uncomfortable degree of correlation between previously independent asset classes, which makes it very hard for people to build neutral portfolios.

A break with tradition

Service providers are seeing demand from financial services clients grow for multi-dealer FX related products, as traditional assets and markets deliver poor returns over a sustained period as a consequence of the crisis, implying that speculators are becoming increasingly involved in the FX business.

“There is a mixture of players in this space,” says Paul Tivnann, global head of FX electronic trading at data provider Bloomberg. “On the institutional side you have sovereign wealth funds and asset managers running typical FX strategies such as carry trades where you profit from the interest rate differential between two countries, or momentum strategies where you are betting on continued appreciation of currencies that have been performing strongly.”

To accommodate growing interest in FX products, Bloomberg’s multi-bank trading platform, FXGO, launched a request for quote facility for FX options on 15 November, which consolidates pricing from multiple providers across currency options. Firms have been sourcing information on the OTC market as well, suggesting future growth in trading activity.

Rob Lane, head of trading for EMEA at Interactive Data said, “We are seeing a growing demand for OTC data into applications as well as demand for trading connectivity to new venues, which is partly a reflection of the financial crisis; as people edge off local cash equities they look for alpha in either other regions or OTC markets.”

The move away from the single-dealer model does not necessarily require a change in technology to deliver best execution, says Caplin, but rather a selection of partner that are best able to support the business.

“Meeting best execution requirements in FX doesn’t require traders to get multiple quotes in a formal way,” he says. “They can simply look at their Bloomberg, Reuters or other multi-dealer screens and see where the market is at, before executing a trade on a single-dealer platform. There are very few major currency pairs. And when everyone quotes tight two-sided streaming prices in the majors, there isn’t much room for price improvement. If the spread on euro-dollar is less than one basis point, how much better are you going to get? As such best execution is not the issue, it’s more about certainty of execution, speed of execution, functionality and quality of service.”

Of course FX is very different to other assets and the direct transposition of trading styles from other products is not realistic. Firstly the vast majority of trading occurs in a few currency pairs; comparatively both equity and debt markets see trading in hundreds or thousands of products. Secondly the lack of any centralised markets makes the process of data collection for trading far more complex and the measurement of best execution a significant challenge. Nevertheless concerns around transparency mean that the existing model is expected to change, with eight new currency trading platforms launched in June 2012 and some noticeable changes taking place in the composition of the players.

A new way

Research provider TABB Group notes that FX trading volumes have grown by 20% since 2007 to US$4 trillion per day but have tailed off more recently due to the wider economic conditions and regulatory changes impacting both the dealer-to-client and interdealer market makers. However the growth in electronic order flow from just 20% in 2001 to 60% in 2010 will continue to be a driver for change in FX market structure.

“Roll forward five years and the foreign exchange markets will be unrecognisable from the voice-based bilateral OTC model which has dominated until now,” says Rebecca Healey, senior analyst at TABB Group. “Liquidity in FX is a mirage. The prices on the screen are not a stock and that is a challenge as firms to try to establish what is real and what is phantom liquidity. With high-frequency trading (HFT) firms coming into the market that has massively impacted people’s level of comfort in interacting with the market place.”

High frequency trading firms are a cause for concern in the equity markets where their trading tactics of placing and cancelling multiple orders at sub-millisecond speeds have seen them characterised as middlemen that serve no useful purpose. “FX traders are currently struggling to compete as HFT traders shift away from equities and into their domain. As technology costs continue to fall we can expect further innovation as FX market participants will look for new methods to understand and engage with this new type of flow” Healey states.

Where reporting dealers accounted for 70% of FX trading in 1992 according to the Bank of International Settlements, they now only account for 39% and as Healey notes, “Bank’s customers are now trading more than the banks themselves.”