Changing dynamics of the global forex market

Updated: Dec 28 2013, 08:27am hrs
Every three years, detailed information on the structure of the global foreign exchange (FX) market becomes available via the Triennial Central Bank Survey of Foreign Exchange and Derivatives Markets Activity (widely known as the Triennial). The 9th Triennial conducted in April 2013 covered 53 countries. It is the most comprehensive effort to collect detailed and globally consistent information on the trading activity and market structure of one of the worlds largest and most active over-the-counter markets.

The 2013 Triennial shows that global FX turnover grew 35% from the previous survey in 2010 to $5.3 trillion per day in 2013 (see figure, left panel ).* By way of comparison, growth between 2007 and 2010 was 20% (King and Rime 2010). In this column, we take a closer look at the drivers and trends behind the growing FX volumes based on our research in Rime and Schrimpf (2013).

Trading in currency markets is increasingly dominated by financial institutions outside of the dealer community (other financial institutions in the survey terminology), as shown in centre panel of the accompanying figure. Transactions with non-dealer financial counter-parties grew by almost 50%, and accounted for roughly two-thirds of the rise in the total.

New counter-party information collected in the 2013 Triennial provides a more granular picture than before of the trading patterns by non-dealer financial institutions and their contribution to turnover (see right panel of accompanying figure). These non-dealer financial institutions are very heterogeneous in their trading motives, patterns and investment horizons. They include smaller and regional banks, institutional investors (e.g. pension funds, mutual funds), hedge funds, high-frequency trading firms, and official sector financial institutions (e.g. central banks or sovereign wealth funds), among others.

The increased importance of non-dealer financial customers has led to the demise of the once clear-cut two-tier structure of the market, with clearly delineated inter-dealer and customer segments. Via computer-based algorithms for order placement, financial customers contribute to increased volumes not only through their investment decisions, but also by taking part in a new hot potato trading process, where dealers no longer perform an exclusive role.**

A significant fraction of dealers transactions with non-dealer financial customers is with lower-tier banks. While these non-reporting banks tend to trade smaller amounts and/or only sporadically, in aggregate they make up roughly one-quarter of global FX volumes (as shown in right panel of accompanying figure). As they find it hard to rival dealers in offering competitive quotes in major currencies, they concentrate on niche business and mostly exploit their competitive edge towards local clients.

The most significant non-bank FX market participants are professional asset management firms, captured under the two labels institutional investors (e.g. mutual funds, pension funds, and insurance companies), and hedge funds. Both groups accounted for about 11% of turnover each (see figure, right panel). The group of hedge funds also includes proprietary trading firms specialised in high-frequency trading. The ecology of the FX market has clearly been affected by the increased participation of such players.

The trading of non-dealer financials such as institutional investors and hedge funds is concentrated in a few locationsin particular London and New Yorkwhere major dealers have their main FX desks. With a share of over 60% of global turnover, these two locations are the centre of gravity of the market. Dealers trading with non-dealer financial customers exceeds that with non-financial clients by a factor greater than 10 in these centres.

Prime brokerage has been a crucial catalyst of the concentration of trading, as such arrangements are typically offered via major investment banks in London or New York. Through a prime brokerage relationship with a dealer, non-dealer financials gain access to institutional platforms (such as Reuters Matching, EBS or other electronic communications networks) and can trade anonymously with dealers and other counter-parties in the prime brokers name.

Inter-dealer trading, by contrast, is growing more slowly. A primary reason is that major FX dealing banks have effectively become deep liquidity pools themselves, given the large concentration of flows with a handful of large dealers. This allows top-tier banks to cross more trades internally and reduces the need to offload inventory imbalances and hedge risk via the traditional inter-dealer market. Trading volumes on traditional interbank venues like Reuters and EBS have thus either stagnated or even contracted as a consequence.

A similar mechanism also partly explains that the trading volume of non-financials (mostly corporates) contracted. Firms are increasingly centralising their corporate treasury function, which allows reducing hedging costs by netting positions internally.

The distinction between the inter-dealer segment and customer-dealer segment has become much more blurred in recent years. A key driver has been the proliferation of prime brokerage, allowing smaller banks, hedge funds, and especially high-frequency trading firms to participate more actively in the process of sharing risk.

Trading activity remains fragmented, but so-called aggregator platforms allow end-users and dealers to connect to a variety of trading venues and counter-parties of their choice. With more counter-parties connected to each other, search costs (a key feature of over-the-counter markets) have decreased and the velocity of trading has increased. The traditional market structure based on dealer-customer relationships has given way to a trading network topology where both banks and non-banks act as liquidity providers. This is effectively a form of hot potato trading, but where dealers are no longer necessarily at the centre.

Trading activity in the foreign exchange market reached an all-time high of $5.3 trillion in April 2013, 35% higher than in 2010. The results of the 2013 Triennial point to a growing role of non-dealer financial institutions (smaller banks, institutional investors, and hedge funds) in FX markets. Currency trading has become more international (especially for key emerging-market currencies like the Mexican peso or the renminbi) and trading activity is gravitating more and more to the main financial centres.

The market structure has evolved quickly in recent years, driven by technological innovations that accommodate the diverse trading needs of market participantsfrom retail investors to high-frequency traders. The once clear-cut two-tier structure of the market, with distinct inter-dealer and customer segments, no longer exists. The number of ways the different market participants can interconnect has increased significantly, suggesting that search costs and trading costs are now considerably reduced.

This has paved the way for (non-dealer) financial customers to become liquidity providers alongside dealers. Hence, financial customers contribute to increased volumes not only through their investment decisions, but also by taking part in a new hot potato trading process, where dealers no longer perform an exclusive role.

* When interpreting the 2013 Triennial it is necessary to bear in mind that the survey month was probably the most active period of FX trading ever recorded. The monetary policy regime shift by the Bank of Japan in early April triggered a phase of exceptionally high turnover across asset classes. Without this effect, however, FX turnover would likely still have grown by about 25%.

** Although algorithmic trading methods have become more and more important, the subset of High-Frequency Trading (HFT) has most likely not been a very strong driver of growth in turnover. HFT strategies can both exploit tiny, short-lived price discrepancies and provide liquidity at very high frequency benefitting from the bid-ask spread. EBS estimates that around 3035% of volume on its trading platform is HFT-driven. Speed is crucial, and as competition among HFT firms has increased, additional gains from being fast have diminished.

Dagfinn Rime & Andreas Schrimpf

Rime is senior researcher, Norges Bank and adjunct professor, Norwegian University of Science and Technology, and Schrimpf is economist, Bank for International Settlements.

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