In May 2006 Reuters and the Chicago Mercantile Exchange (CME) announced the formation of a joint venture to launch a new foreign exchange trading platform.
The venture marked some firsts for both organisations. For the CME, famous and successful for its futures and options products, this was its first move into any spot market - trading for immediate delivery. For Reuters, this was the first time it had ownership in a business providing clearing.
The company, called FXMarketSpace, is 50% owned equally by CME and Reuters. The President is Mark Robson, formerly of Reuters. The Chief Sales Officer is Richard Seals and the Chief Operating Officer is Bryan Hunter, both formerly of CME. CME and Reuters each invested USD45m each to fund the venture.
The resulting platform is also a first. The company will provide the world's first ever central counterparty clearing platform in the forex market.
Does the market want this?
Counterparty risk is the danger that one side of a trade fails to make good on its side of the trade. In the foreign exchange market, currencies are traded bilaterally and therefore participants need individual credit lines with everyone with whom they wish to trade.
The larger banks that have long participated in this market may prefer to keep the market restricted to trading with their familiar counterparties and have used credit as a tool to control prices in the FX market.
However foreign exchange is the most actively traded asset class in the world and considered a high-growth market for potential new platforms. What FXMarketSpace does, if nothing else, is provide a choice for organisations that wish to participate in this market. FXMarketSpace should attract more participants to the market by removing some obstacles.
A wealth of experience
CME is the largest futures exchange in the US, and forex futures contracts are the CME's fastest-growing business. CME's FX futures and options contracts all traded on the CME Globex platform, had compound annual growth of 34% for 2000 to 2005. Hedge funds have been a big factor in this growth as well as algorithmic trading, which needs electronic platforms. However CME's foreign exchange contracts represent about only 7% of the total foreign exchange market.
Reuters already has a strong position through its existing interbank trading terminals. Reuters has operated a FX dealing service for years and its current product is called Dealing 3000. However, it faces a renewed threat from its bigger rival EBS, which was recently bought by Icap, the interdealer broker. The combined group will be able to offer trading across a wider range of asset classes.
FXMarketSpace will provide a centrally cleared marketplace that will reduce counterparty risk, and allow for trading anonymity. CME Clearing will play the role of the central counterparty.
FXMarketSpace also plans to move into other asset classes after FX. The partners have predicted that they will extend into the forward, over-the-counter and currency options markets in the future.
Increasing competition
Lava Trading, owned by Citigroup, has announced plans to launch an interbank spot foreign exchange trading platform. ICAP's purchase of EBS will create the world's largest over-the-counter trading system.
The multi-bank systems dominated the market for some time, but that dominance appears to be declining. Hedge funds are entering the market and looking at FX as just another asset class, making the concept behind FXMarketSpace more attractive.
FXMarketSpace will try to mitigate settlement risks for market participants. CLS, the foreign exchange settlement system, is used by most major banks and financial institutions. However CLS was created by and for the major FX players (the banks). FXMarketSpace brings services more commonly found in other asset classes.
Hedge funds and money managers now represent about a third of the daily volume in the FX market, up from about 20% in 2002.
Exchanges have lessons to teach
It has often been suggested that exchanges are stuffy, slow moving and out of step with the markets. 2006 has shown how far this is from reality.
FXMarketSpace illustrates that even in a market that traditionally was as far from an exchange as possible (FX), the facilities traditionally associated with exchanges have applicability.
Exchanges can also learn from the OTC markets. There is a role for both on-exchange, and OTC in the same way that there is a market for off-the-rack suits and bespoke. It should be noted however that the foreign exchange market has trading volumes 30 times larger than all of the US equity exchanges combined.
The proliferation of electronic trading platforms in the FX market (and no one actually knows how many exist) has increased turnover in the spot market but at the same time reduced spreads.
Forex is the largest market in the world, with a daily turnover of more than USD2tr a day, so why does it have a liquidity problem? Probably there are too many platforms, which is why Lava FX offers an aggregation facility
In the equity markets, there are block trading platforms that allow for large trades, often with anonymity.
An exchange person's view of FX markets
EBS, with its Prime initiative, has opened its platform up to the buy side. There is a view among some of the major banks that the pendulum has swung in favour of the buy side.
In reality, it doesn't matter. Newer traders want anonymity and it is standard on regulated exchanges. It would be a surprise if any major market participant didn't accept that anonymous trading was inevitable in FX.
With regards to EBS, the sell side may have some reason for complaints, as the liquidity providers can be identified by hitting a price on the system, even for just one dollar. The taker of the liquidity is not identified on EBS. Some participants can trade anonymously on the main platforms while others, notably the actual liquidity providers, cannot.
Most of the major banks do not like anonymous FX trading. Although full anonymity works well on regulated exchanges, credit has always played a big role in the FX market in controlling prices.
Probably liquidity needs to be pooled. Smart order routing technology is being touted as another possible solution. Lava FX provides an aggregating platform that tries to overcome the plethora of technology platforms. The platforms that are the most forward thinking and inventive will be well positioned to address the technology needs of the foreign exchange trading community. Smart routing technology has certainly had positive results in the equity markets.
Another comparison to the cash equity exchange market is the concentration of trading in a few instruments. Although numerous currencies and different products are traded, activity is concentrated in the 'majors' the US dollar, euro, yen and pound sterling. According to BIS, the forward market accounts for about 50% of turnover, and spot - what most people think of when considering FX generally - accounts for around a third of activity. The rest of the volume is made up of outright transactions, which are a combination of spot and forward deals and options. By currency pair, euro/dollar accounts for 28% of the market, dollar/yen 17% and sterling/dollar 14%.
Each of the various FX currency segments is a huge market in its own right. Daily turnover in the spot market is now estimated to be about USD800bn a day. However, despite the market's huge size, FX participants frequently claim that the spot market is illiquid. This seems totally inconceivable.
A factor is that the market has consolidated over the past seven years. There are now 11 banks that account for 75% of the turnover in the US compared with 20 in 1998. In apparent contradiction, while this consolidation has occurred, the market has also fragmented considerably.
Consolidation in the banking industry is one obvious reason why market share has concentrated into fewer hands. Technology has also played a part, introducing transparency and efficiency. This has led to a substantial reduction in the bid-offer spread. The erosion of margins has effectively squeezed many banks out of the business.
Technology, however, has certainly made the market far more accessible. FXMarketSpace is another step on the path for more access by helping with counterparty risk.
Technology has also enabled liquidity providers to distribute their prices much more widely, and to process smaller deal tickets cost effectively. It is estimated that the number of internet trading venues catering for those who want to trade FX is between 200 and 600. At the moment there is no reason to believe that the ceiling has been reached.
At least part of the reason is that, as spreads narrowed with the uptake of electronic trading and broking, a new spot FX business model started to emerge. To run a viable spot business now either requires the ability to warehouse substantial risk or the capture of enough market share to allow the bid-offer spread to be earned as many times as possible. The spread might be minimal, but the size of the market means that if sufficient flow is garnered, spot FX remains a viable proposition for the sell side. Many banks, therefore, decided to provide liquidity to as many platforms as possible to attract flow.
There are hundreds of trading platforms, but they are all essentially showing the same rate. This gives the appearance that the FX market is far deeper than it is. If several of the platforms are hit at the same time, which market participants say is happening more regularly, the sell-side liquidity provider is likely to find itself inheriting a sizeable position.
Another factor contributing to lack of liquidity in FX is that this market not centralised. It does have at its hub two electronic brokers, EBS and Reuters. EBS is the larger of these market hubs, reporting average daily turnover of USD12bn. But impressive as this is, prices on its screens are often only for small amounts. According to the company, EBS's average deal size is just under USD3m.
A bank able to trade USD3m when they have a much larger position will then be exposed to the market.
Whatever the true situation, several of the top FX banks are checking out who they are streaming their prices to, in the belief that some of the alternative platforms are either abusing the system themselves or have clients who are doing so.
Multi-asset trading is here
Another link between traditional exchanges and FX is seen with the purchase of Hotspot FX by Knight Capital Group. Hotspot FX also offers anonymous currency trading but is firmly focused on hedge funds. Hotspot FX has about 200 users, and Knight has about 1,000. Their intention is partially to introduce Knight's traders to currencies for possibly the first time.
FXMarketSpace's owners also are focused on this trend. CME is busy expanding its product offerings, including FX. Reuters has customers that trade all asset classes.
With EBS and Hotspot now under new ownership, what will happen to FXall and Currenex?
FXMarketSpace is a bold move
Even competitors of Reuters and CME acknowledge that FXMarketSpace has set the standard for what may develop in the foreign exchange market. The relationship between Reuters and CME is longstanding. Few may remember, but Reuters actually built the original Globex trading system in the 1990s. Recently Reuters launched a CME FX Futures service, accessible via Reuters network.
Reuters understands the value of maintaining and building strong relationships with the market participants and is committed to working with the major industry participants to serve the growing and changing demands of the financial marketplace.
