True FX

FX is changing Posted by Izabella Kaminska on Dec 03 09:00. 2 comments.

Harpal Sandhu, chief executive officer of a systems firm called Integral Development, is trying to change the way forex markets function.

Specifically, he wants technology to even-out the jagged playing field, More…

Harpal Sandhu, chief executive officer of a systems firm called Integral Development, is trying to change the way forex markets function.

Specifically, he wants technology to even-out the jagged playing field, where conflicts of interest abound and where rules apply to some market players but not to others.

But before we get to that, a little about how the FX market has been developing over the years.

Before the web really got going, interbank price-discovery was dominated by two key OTC players: Reuters and EBS (now owned by Icap). The bulk of the market was in the grasp of a select inter-dealer banking community. And, because participants knew who they were dealing with, prices were tight and liquidity was solid.

In the last decade, however, a multitude of different and cheaper broker platforms has sprung up to offer competing OTC services to both the retail and institutional FX market place.

But while the forex universe got increasingly fragmented, the key interbank market stuck faithfully to the Reuters and EBS systems for inter-bank business. That is to say, not much changed. The best prices were still to be found there — and the shadow FX market remained as dependent as ever on interbank prices.

On that note, an article penned in August by Mark Warms, general manager of FXall’s European operations, draws on some interesting points from a Euromoney poll earlier in the year.

As Warms notes: As the Euromoney FX poll showed this year, the market share of the top five banks remains remarkably steady at around 61.5% even though several of them were high-profile losers from the subprime crisis. It is also worth noting that in the past year, the combined share of the top 10 banks rose from 76.3% to 79.7%.

Such figures, he says, underscore how FX banks have continued to dominate FX despite rising competition and credit problems of their own — something which happens to go against the expectations set out in the 2007 BIS Triennial central bank survey. As Warms observes: At the time of the last BIS Triennial central bank survey in April 2007, much was made about the emergence of a new breed of market-maker. In reviewing the turnover, BIS stated: “By counterparty, the expansion in turnover in the interbank market was comparable to growth over the previous three years, but was outpaced by the increase recorded in the non-financial customer and non-reporting financial institution segments, which more than doubled in size.”

But BIS makes another key observation: “Consolidation of the banking system was identified in the past as reducing turnover in the interbank market through channels such as efficiency gains and the ability to net trades across related parties within an organisation.”

Interestingly, however, Warms says the reason not much changed was down to FX banks beginning to internalise their order flow — or, as the BIS puts it, net their “trades across related parties within an organisation.” An occurrence which happens to be much more prevalent in FX than any other market, and one that appears to be transforming banks into a new breed of FX market maker. As Warms explains:

Internalisation is a much-talked about concept in other markets; in FX it is a reality. The ability to match-up trades means banks are no longer so reliant on — and perhaps are even independent of — the main external platforms for reference pricing. Banks have rediscovered the true art of market making, albeit with a new, electronic twist.

This has resulted in ever decreasing volumes going through Reuters, EBS, and other alternative platforms, while making banks’ own prices hard to beat.

But, as Warms notes, banks will always have business they cannot match and which needs offsetting externally. And her...