23 Sept 2011 Profit & Loss Magazine: Voice of the Markets
by James Sinclair, CEO of MarketFactory

FX is different – we know that. But how do we visualize the differences for people coming from other asset classes? Whatever our roles, it’s important to understand and convey the unique aspects of FX. This particularly applies when developing and selecting technology. To help highlight the differences, we produced a summary chart.


Complexities top left
Equities and other asset classes pose throughput and symbology processing challenges. The major U.S. equities and equity options feeds produce 6 billion messages per day; there are over 7,000 listed symbols in the U.S. alone and at least 400,000 international securities symbols. By contrast, there are 128 currency pairs traded across all major FX ECNs combined and 66% of the activity is in just six pairs.

Foreign Exchange
Complexities lower right

Reasons that underlie the unique FX market structure include these:
– The reasons to transact FX are far more diverse than other asset classes. The UK Foreign Exchange Joint Standing Committee, in a 2009 paper, summarized them as:

– The need to pay for goods and services or to effect foreign direct investment (FDI)
– ‘Induced’ foreign exchange deriving from other financial market activity; for
example buying foreign currency denominated bonds or equities.
– Hedging commercial or asset portfolio currency risks.
– Direct investment in currencies as an asset class.

These diverse demands for FX lead to the market’s growth. UBS’ analyst Mansoor Mohi-uddin observed, while predicting late last year that the market will grow to $10 trillion per day by 2020, that “Neither financial market shocks, nor disruptions to international trade are likely to halt the expansion of currency trading, as the resilience of foreign exchange markets to the crisis events of 2007-10 has proved”.

– Institutional FX is very lightly regulated. The positive side is that ECNs and other venues are free to differentiate themselves. ECN order books can be as transparent or opaque as they wish, include unique features and update market data with different frequencies (ranging from 2x, 4x, 10x, and 20x per second, to tick by tick). However, the flip side is that these ECNs change frequently, sometimes with mandatory releases. Even when optional and no immediate opportunity is seen, users may need to take new releases, feeds and features to remain competitive – and the feeds tend to use, of necessity, modified protocols each requiring a one-off effort even when FIX. This results in developers being pulled off alpha-generating projects to code and test conformance with the ECNs irrespective of whether the user actually perceives benefit. Indeed, existing prop and hedging strategies may be negatively impacted by market changes requiring further work.

– FX is global with ECNs, exchanges, banks and other venues in multiple centers including Chicago, New York, London and Tokyo. No other instrument is as fungible and has liquidity that is as globally distributed. In effect, these are simultaneous, distinct, indirectly linked markets for the same instruments divided by vast distances – with associated network transit times. For example, GBP/USD is liquid and traded concurrently on the CME in Chicago, Currenex in New York and Thomson Reuters in London among others.

– FX is a credit instrument so no two participants see the exact same sets of prices or market data.

The Chart in Two Years
If we look again at the chart in two years’ time, how will it change? I make a few predictions for the FX side.
Firstly, fragmentation across multiple ECNs, exchanges and venues will increase. As we noted, light regulation means venues are free to innovate and differentiate themselves. For example, when one major ECN decimalized recently, a major competitor said they saw the market differently and had no plans to do so. Some bank platforms have begun to look like ECNs and some funds are actively selling their market-making facilities.

Related to this, as ECNs become more transparent, with streaming price feeds, and narrower tick sizes, it will become less risky for a user to monitor one ECN and make prices on another. Liquidity will therefore be replicated more easily from one venue onto another, whether existing today or new.

A note here: I’ve sat in conferences and listened to colleagues argue since the late ’80s that there would be consolidation among bank branches, banks, ECNs – you name it, they’d merge and we’d have fewer. The point they miss is the role of innovation. Consolidation does happen, but then new entrants arise each with an innovative twist; they in turn attract new customers to the market with new needs. We have always ended up with more – not less – venues by any count, be it number or volume. Need I list the innovations since the late ’80s? Surely not…

Secondly, the pace of change will accelerate. A competitive environment breeds such energy and several major ECNs are shaking off their legacy technologies. Indeed, ECN enhancements and new features have become much more frequent over the past year with new feeds and protocols from all the major ECNs, new order types, new matching engines and new venues.

Thirdly, perhaps most importantly, it will become simpler to navigate and access the FX market. There has been a very long term trend of broadening access to the primary market. Prime broking accelerated this dramatically. However, the barriers to entry for new participants, including start-up funds or existing funds in other asset classes, are still high. There are fixed fees to access some markets, credit approvals take time and this is in addition to developing the appropriate FX-specific technology to connect to the markets. Lowering the barrier to entry will become important for FX growth as it competes with other asset classes.

FX options will feature, of course. It’s interesting that over the last year equity options volumes have grown even as the underlying cash equity volumes have fallen significantly. This has confirmed what many had been saying for some time – that equity options is an asset class in its own right. Something to which FX options will look forward.

Some FX innovations will be reflected also on the equities side, but the fundamental underlying differences between our asset classes will remain in terms of the diversity of customer needs, light regulation, fungible, global markets and credit. FX will still be different – I’ll update the chart.

Source: Profit and Loss

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