The Changing FX Market

James Sinclair, the CEO of MarketFactory, presents “The Changing FX Market” at the High Frequency Trading World conference in New York City on December 7, 2011.

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The Changing FX Market December 7, 2011 James Sinclair CEO, MarketFactory

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Today’s Discussion Why is FX Different? Where Have We Been? 3. Where are We Going?

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Why is FX Different?

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Less Regulation Nasdaq BATS NYSE Nasdaq OMX PSX CHX CBSX NSX Nasdaq OMX BX NYSE Amex NYSE ARCA EDGX ISE RegNMS: Plus dark pools (<15%) FX ECNs are not constrained and have freedom to differentiate themselves.

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Platforms are All Different Different : Location(s) Price distribution frequencies Depth of book: and indicators of depth. “Structured data” Info about the quotes that make up a price level Tick size Info about deals and amounts done in the market Some have Last Look Upgrades are frequent Understanding of each platform required Barrier to entry

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Global and Fungible London $725bn per day Asia $375bn per day New York $400bn per day Chicago $100bn per day

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Fungible also in Instrument Construction Unlike securities markets, but like other cash markets, synthetic instruments are identical to their traded counterparts e.g. cross currencies: EUR/JPY EUR/USD EUR/JPY USD/JPY

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In Addition… LOW PROFILE For the world’s largest market – we attract little press as the market has self-regulated well Exceptions

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And Also… Credit instrument (but low risk) Substantially a principal market Natural interest arises from non-FX activities: Cross-border capital market activity, FDI, trade Doesn’t fall in value (you were just on the wrong side!)

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Complexities in Equities and FX are Inverted High technology needs vs. high market structure knowledge needs Equities Millions msgs per second Thousands Real-time broadcast Tick by tick – every tick! Thousands / second Centralized markets Heavy – e.g. Reg NMS Standardized NBBO Established; low difficulty Full depth of book None b/c of CCP Order routing from point of order submission Complex Easier Attribute Throughput Symbols MD Frequency Order Submission Fragmentation Regulation Market Structure Price Discovery TCA Transparency Price Filtering Order Routing OTC FX Millions msg per day 20 pairs; 66% of FX in 6 pairs Real-time custom snapshots Max 100 orders per second Globally fragmented venues Unregulated – isolated venues All non-standard; all bespoke Venue specific Difficult – lack volume info 1-3 levels of depth common Heavy b/c of bilateral credit Complex decision process Complex Easier

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Where have we been?

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Spot Volume Growth 1,039 Reporting Dealers; 580 Buy-side Banks; 300 Prop Funds; Real Money; Hedge Funds; Corporates

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Trading Grew Through Financial Crisis Source: Aite Group

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Retail 63% trade only FX; 70% of remainder trade stocks Broad demo: 65% U.S. FX traders’ income< $75K Aite Group

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Interdealer FX Market in 2011 Interdealer FX Market in 2003 Reu EBS CME DB Structure akin to US treasuries: Interdealer: Brokertec, eSpeed; Customer: Bloomberg, Tradeweb Still similar + GovEX. Prop Shop BoA JPM UBS Dres-dner Citi Prop Shop Prop Shop Prop Shop Prop Shop HS Real Money, Corporates CX FXall CX ICE Execution through ECNs, banks and some funds Not shown: Futures brokers Retail Com-merz FXall Barx

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The BIS View – 1990s

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The BIS View – 2000s Bank of International Settlements Study Group of the Markets Committee: “High-frequency trading in the foreign exchange market” chaired by Reserve Bank of Australia, September 2011

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Recent Platform Changes More decimal places Different tick sizes, visible DoB, structured book Faster feeds Faster matching engines More venues NDFs new pairs, new futures contracts New order types Every major platform has had recent releases with substantial new functionality.

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ECN Volume Trends

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So, where are we going?

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Euro – New Currencies Unclear how it could be done. Pessimism about government. But… There have been govt successes: Bretton Woods (’44-’71), Plaza and Louvre Accords (’85, ’87), EMS (’79-’90 until strained by UK joining), Hong Kong modified currency board (’83 – present), China (’89 – present) And less successful ones: Argentina (’02), EMS (’90-’92 when UK and Italy left)

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Euro – New Currencies Even if there are capital controls, would still trade as NDF or akin to Australian hedge market (pre-’83) Modified currency boards also mean currencies trade in narrow range (e.g. HKD). Ideal for electronic. Currency boards have a reserve requirement (at least M0) & suited for smaller, open economies

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Euro – New Currencies From previous experiences: Lehman: orderly market incl. settlement High volatility: Voice trading increases temporarily Futures and cash less correlated New legging and arb opportunities Volume realigns across platforms

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High Growth of HFT in FX Source: ECNs, Interviews with bank and high frequency trading firms, Aite Group

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More Decimals in FX… Equities Has Seen Before Source: Tick Size Regulation, Intermarket Competition and Sub-Penny Trading. Sabrina Buti, Plus options: SEC Penny Pilot 2007 & Ongoing

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Message Rates Increase…

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Spreads Contract… 16ths Decimalization Source: NYSE Factbook NYSE -84%!

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But Unevenly So Before and after moving to 1/8ths. Source: NYSE, Eighths, Sixteenths. Michael A. Goldstein, Univeristy of Boulder

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Source: Aite Group Many Orders already at Major FX Platform minimum But: Order Size Falls … in FX it Cannot

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Equity Options Has Seen Before “It wasn’t introduced in a responsible and conservative fashion….Pennies made sense for options that were trading under a dollar. But as you went above that, pennies didn’t make sense. We said there would be a loss of liquidity and that’s exactly what we saw.” [ Not for all options: “…Pennies made sense for options that were trading under a dollar. ..We said there would be a loss of liquidity and that’s exactly what we saw.” Gary Katz, ISE Shrinking size: “With nickel and dime increments, you might have had 1,000 contracts … often [now] you’ll only see 10 or 15 contracts.” Andy Nybo, Tabb Group Volatility: “… In pennies, you move to the next trading increment much more often.” Ed Tilly, CBOE Quoted in Financial Times, November 3, 2010

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Pipping in FX: Repeat of Sub-Pennies in Equities Source: Tick Size Regulation, Intermarket Competition and Sub-Penny Trading Fig 1. Sabrina Buti, University of Toronto, et. al. June 1, 2011

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Execution New Venues – But they are additive Liquidity only moves to detriment of venues in smaller markets, e.g. TBAs, TIPS, when venues lack differentiation, e.g. European MTFs, or a change on scale of voice-electronic Block trading – four ways to trade: Transfer risk to a Bank Algorithmic Trading (chop it up) Dark Pools/Order Types (akin Pipeline, ITG Posit, Liquidnet) Shop through a Voice Broker And most significantly…

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Spot DMA New Participants, More Participants Next Phase of Market Growth Prime Broking: credit to prop funds, hedge Funds, small banks And now…

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Prime of Prime Broking: Credit to Even Smaller Participants

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New Institutional Platforms ICE FX Futures FXCM Pro Gain GTX And more to come

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CME FX Options – Model for Cash Options?

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In Summary As major platforms reduce minimum size: Tighter spreads in liquid ccys If platforms provide tick-by-tick: Rebate Trading And Waiting Like a Coiled Spring… DMA,Dark Pools, Algos.

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C++ / Java / C# API Market data normalization + order submission gateway Trader Focus Tiered Pricing Core Pricing Internal ECN Hedging / Trading EBS Ai & Live Reuters AQ5 / MAPI Currenex FIX / Scratch HotSpot FIX / Itch CME FXall FXCM Pro MarketFactory Platform APIs: C++ / Java / C# GFX Bank Feeds

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MarketFactory MarketFactory Customer Partnership In 24 hours MarketFactory begins logging market data for customer Nightly SFTP In 2 weeks Customer writes to C++ or Java API Integration Testing In 4 weeks First Trade

Source: HFT World