As the world’s largest financial market, the ability to swiftly identify and capitalize on key trends in foreign exchange is crucial – which is why the BIS Triennial Central Bank Survey of global FX trading is one of the most significant datasets currently produced for the capital markets. The latest report, published in September 2016, underscored a particularly noteworthy shift for many participants in this space, namely the increase in market share for Asia’s three key FX trading hubs – Tokyo, Hong Kong and Singapore – from 15% to 21%. But since its publication, the nascent world of cryptocurrency trading has also exploded, exceeding most expectations and even starting to make the cross-over into the world of institutional FX trading.
In this article, Mike O’Hara and Nicola Tavendale of the Realization Group discuss the main drivers behind these trends, and how firms can make sure they are in the best position to take advantage of the opportunities they present, with Michael Ourabah of BSO, Societe Generale’s John O’Hara, Eddie Tofpik of ADM Investor Services International Ltd, ING’s Stephane Malrait, Ramy Soliman of Stater Global Markets, Tom Higgins of Gold-i and R5FX’s Jon Vollemaere.
“There are a few forces at work as it pertains to the changing dynamics of the global currency markets,” explains John O’Hara, Americas Head of Prime Brokerage and Clearing, Societe Generale. The fi rst of these trends is that Asian hubs such as Tokyo and Singapore, which are actively embracing fi ntech technologies, are now starting to emerge as viable centres of FX activity – and as such are pulling fl ow from established centres such as London. Furthermore, two additional factors are complementing the movement to the region, O’Hara argues. “More investment management companies, whether hedge funds or asset managers, are starting to open up shop in the Asia,” he says. “Because of this there is a natural increase in local currency trading and fl ow tends to beget fl ow. As a result, you’re starting to see more people interested in trading those markets, even if they themselves are outside the region.”
And according to the BIS FX survey data, while activity in the major currency pairs such as the euro and yen declined over the three-year period, trading in emerging market currencies grew, with the Chinese renminbi becoming the world’s most actively traded emerging market currency. “These trends are now coming together and creating the perfect storm,” O’Hara adds. As a result, Societe Generale is now seeing notable increases in client interest, and reports increases in the double-digit range for transactions emanating both from – and into – the APAC region.
This movement ties in to the backdrop of broader market structure changes which have impacted FX trading over the past three to four years, explains Michael Ourabah, CEO and founder, BSO. Until very recently, the market was dominated by the major tier one banks, FX was still in the main an OTC market and despite being mostly electronically traded, there was little demand for low latency, more stable connectivity – with banks instead opting for meshed connection integration points where needed.
But more recently, many leading Electronic Communication Networks (ECN), such as EBS BrokerTec and FastMatch, have established single matching engines located in the three key data centres, namely New York, London and Tokyo. “By connecting these three matching engines together with the lowest latency paths, suddenly all the big tier one banks have been seeing a significant drop in their FX margins,” says Ourabah. “And more importantly, they have seen that all the HFTs, algo and prop-trading firms are actually now starting to exploit that and trade on these FX platforms instead of using the big tier one banks.”
Eventually the incumbent banks were no longer able to ignore the flows that these low latency networks were attracting and the impact this was having on their own FX trading revenues. Even so, the drive to invest in upgrading their trading infrastructure to compete with the FX matching engines has only really started to manifest in earnest since around mid-2017, Ourabah claims. “Around 10 of the tier-one banks started to knock at our door almost simultaneously in Q2/Q3 2017,” he says. “That’s the big move we can clearly decipher out of the BIS data”.
Yet although FX market share appears to be shifting towards Asia, this appears to be skewed by non-corporate FX flows, argues Stephane Malrait, MD Global Head of Market Structure and Innovation for Financial Markets, ING. “The growth in Asia makes FX an even more global asset class than it already was, as there are now three regions with significant FX activity in the US, Europe and now Asia,” he explains. “But Europe is still the main driver, with a very active corporate client base looking to hedge their FX exposures.”
“The growth in Asia makes FX an even more global asset class than it already was, as there are now three regions with significant FX activity in the US, Europe and now Asia”
Stephane Malrait, ING
The importance of these processes to the overall value proposition to customers varies not only between industries but also firms, of course. As such, the level of investment a firm makes in digitising its fulfilment process or migrating service delivery to a mobile app, for example, will be informed by its wider impact on the bigger strategic picture.
In addition, electronification continues to be a significant theme, Malrait adds, with a recent move by many trading venues to expand their offerings to terms of more streaming prices and new trading workflows. In addition, there is a significant uptake in the use of algo trading by both the FX dealing banks themselves and sophisticated corporate clients. “Some platforms, instead of being specialised into one client segment, also now go after multi-client segments,” Malrait adds. “As a result, they have to offer different trading protocols from anonymous trading to disclosed RFQ.”
While five to ten years ago there was only an internal dealer market and a dealer-to-customer market, because of regulatory changes these two paradigms are now merging, with platforms now also needing to be RFQ trading venues in a bid to attract clients. According to Malrait, this has resulted in a more level playing field, with market participants now able to select a venue based on their preferred best execution model or business strategy. But the rise of algo trading strategies and the repacking of liquidity also presents challenges for FX trading in Asia, warns Eddie Tofpik, Head of Technical Analysis & Senior Markets Analyst, ADM Investor
Services International. For example, sterling’s “flash crash” in October 2016 took place during night-time trading in Asia, according to a BIS report of the incident. This served to highlight how illiquid and fragmented the Asian FX markets can be and how susceptible they are to gaps in liquidity, Tofpik explains.
In addition, the global crackdown on binary options, CFDs and now retail FX trading is particularly significant in the Asian markets, he adds. In recent months China has imposed restrictions on foreign brokerages in the country in a bid to prevent FX losses fuelling civil unrest. “There is a significant proportion of the world’s population trading these markets because the access to international capital markets or international investments is otherwise relatively limited,” Tofpik explains.
“There is a significant proportion of the world’s population trading these [FX] markets because the access to international capital markets or international investments is otherwise relatively limited”
Eddie Tofpik, ADM Investor Services International
Even so, Singapore and Hong Kong have noticeably increased their ability to make markets, with a number of global banks now having established a presence there in addition to Tokyo, adds Ramy Soliman, CEO, Stater Global Markets. Increased hedge fund activity in the region is starting to move into FX and, despite the regulatory pressures, aggregated retail flow remains significant in certain markets such as Japan and Indonesia. “These flows have percolated up into the upper echelons of price making and contributed to the rise in Asia FX activity,” Soliman says.
But it may also be that Asia is at an earlier stage in the maturity cycle of its FX markets than Europe or the US, explains Tom Higgins, CEO, Gold-i. “Outside of Asia, FX markets grew rapidly and then they flattened out and may now be slowly declining,” he says. “But in Asia there’s still plenty of opportunity as it still has another four to five years before you can expect to see a flattening out, which is why people are now rushing in.” Banks tend to be much slower to react than anybody else because of their enormous size and infrastructural constraints and Higgins doesn’t believe they are seeing the benefits of this shift. “However, non-bank liquidity providers definitely are entering the market because they’re much fleeter of foot and many are looking to expand their direct liquidity provision from Asia,” he says.
“In Asia there’s still plenty of opportunity as it still has another four to five years before you can expect to see a flattening out, which is why people are now rushing in”
Tom Higgins, Gold-i
Given this cyclical nature of the FX markets, is the next BIS Triennial Survey (due to be published in 2019) expected to show further growth in the Asia region? The market share is likely to continue to go up, but given that the next survey is only around a year away then it is unlikely to have dramatically increased, says Jon Vollemaere, CEO, R5FX. “But if we were talking another three years, then I think that number difference would be quite significant,” he adds. Shanghai in particular is expected to become more and more relevant as an FX dealing centre, Vollemaere claims, with the potential for greater internationalisation of the renminbi which will have a big effect on the global trading figures. Until Shanghai is truly connected to the global FX markets, then the growth in Asia will mainly be centred around Singapore and Hong Kong. “The difficulty is you need a big magnet,” Vollemaere explains.
Beyond the fiat currencies monitored in the most recent BIS survey, at the time of its publication the world of cryptocurrencies was also on the rise. Bitcoin trading in September 2016 notably broke through an early barrier of $600 to reach an all-time high of $630, with reports predicting it to climb further to $850. By December 2017, bitcoin had soared in value past $20,000 and made the cross over into institutional trading with the debut of bitcoin futures on both CME and CBOE. Yet the rise of cryptocurrencies also presents a peculiar dichotomy of opinion in the FX industry. Unusually for such a nascent market, the explosion in the number of trading platforms, different types of cryptocurrencies and extremely high volatility has meant the implications for the industry are now being seriously considered by many of the leading institutions.
But how much appetite is there in the industry for crypto-trading at an institutional level and how can it be more widely adopted in the FX industry? According to Vollemaere, R5FX isn’t seeing any demand from their customers for this and although some hedge funds trade cryptos, he does not believe the banks will be actively trading them anytime soon. “Cryptos are around 99.9% speculation and then one guy in the US using it to buy his coffee,” Vollemaere explains. “That’s why you get these massive swings, but that is not a global currency.”
“Cryptos are around 99.9% speculation and then one guy in the US using it to buy his coffee. That’s why you get these massive swings, but that is not a global currency”
Jon Vollemaere, R5FX
One of the key issues with the more widespread adoption of cryptocurrencies by the FX market is that the market structure is currently at a very immature stage in its development. Soliman explains: “The cryptocurrency space reminds me of the FX market 15 years ago, when no-one was trading via FIX API, or had sophisticated ways of consuming market data or low-latency environments. All of that means nothing in the crypto world.” However, because it is a highly volatile product with plenty of arbitrage opportunities, Stater Global Markets is certainly seeing demand from many in its hedge fund and retail aggregator client base.
“It’s taken time to find a truly institutional way of delivering good liquidity in cryptos to our customers. Compared to offering other asset classes, or offering FX, it’s not a very easy solution to quickly deliver.”
Ramy Soliman, Stater Global Markets
As a result, Soliman says that Stater does have a prime broker and futures clearer in place, and is talking to its providers about gaining access to clear the CME and CBOE products. “But it’s taken time to find a truly institutional way of delivering good liquidity in cryptos to our customers,” he adds. “Compared to offering other asset classes, or offering FX, it’s not a very easy solution to quickly deliver.” The main FX dealing banks are also deliberating whether to become involved in this space and if so, how that can be done in a secure fashion. According to O’Hara, while Societe Generale has begun to see an “increased client appetite” for trading these instruments, the bank is taking a much more measured approach as to whether it will start clearing them. “The benefits of the underlying technology are beyond dispute,” he adds.
“Yet uncertainty remains around the viability of the crypto-currency product, particularly as it is increasingly used to finance illicit activities.”
Due to these concerns, there have been recent moves by governments, global regulators and the central banks into looking at whether the market could, or should be regulated. But one of the key problems with regulating these instruments is that this clashes with the reason behind their creation: to have a digital currency that is autonomous, self-sufficient and free from central bank intervention. “From a conceptual perspective, who are we to decide to regulate on something that’s not bound to a specific regulatory environment or under the control of a central bank?” asks Ourabah. Instead, he suggests that self-regulation might be the way to enable cryptocurrencies to operate and evolve, because ultimately there is a definite demand for trading.
Tofpik adds that ADM has also certainly seen a specific interest in the bitcoin futures, mainly for the CME contract. “We’ve had interest from customers, but everybody’s walked into that very, very cautiously given that some of the major banks have said they won’t initially clear those contracts,” he adds. But in terms of growth, Tofpik predicts that the main interest will be for trading Asian currencies, particularly the deliverable CNH and the NDF on the CNY, while its nearest competitor is the Indian rupee. “But there are interesting opportunities wherever you look, be it Asia or elsewhere,” explains Tofpik. “It’s whether the ability to then
expand those markets and get a greater international appetite for them will pan out.”
In addition, O’Hara believes that going forward, the markets will see more of a convergence between fiat currencies and cryptos. He also believes that the potential from the underlying blockchain technology will be transformational. “It’s just a case of needing to get comfortable with the technology and how firms can utilise it,” he explains. “Societe Generale is an interesting example of how institutions are exploring these key trends and their practical applications at the institutional trading level, having established its own in-house digitalisation technology team. So, we’re looking at it for things across a wide plethora of applications. Real-time movement of collateral, for example. Which will then allow us to potentially place larger credit limits with
our clients because we know there isn’t that delay in actually moving the monies.”
“The use of FX prime brokerage as a gateway into centralised clearing is also something that people are starting to consider and that’s why we’re really keen at Societe Generale to offer a hybrid model,” O’Hara adds. “Flexibility around retaining trades in a bilateral fashion and potentially clearing other trades will be key, as will the increasing convergence between the FX futures and OTC markets. They are all key shifts that are driving the market forward.”
“Flexibility around retaining trades in a bilateral fashion and potentially clearing other trades will be key, as will the increasing convergence between the FX futures and OTC markets. They are all key shifts that are driving the market forward”
John O’Hara, Societe Generale
Vollemaere agrees, adding that this ties into a wider movement in FX to take on more of the characteristics of the equity markets, where trading platforms will increasingly move towards more of an exchange model. On R5FX, for example, clients only need one credit relationship with a CCP in the middle. “And the reason we did that is because the OTC bilateral credit model doesn’t work for emerging economy financial institutions, because they don’t get sufficient credit,” he explains. “For these more regional banks, an exchange model is better.”
As a result, emerging markets have been left aside for the last almost 10 years by many, because there was enough profit to be gained by trading established markets. But this has faded over time, both in terms of volatility and volume, according to Ourabah. In addition, there has been less political pressure in the last 18 months. “We’ve the same pattern repeating, with the nimble and reactive players making the big leap into trading the emerging markets – and profiting from that decision,” he says. All firms faced the same challenges before pulling the trigger of the markets being too far away or too complicated to trade in, he adds. So many took the move in small steps, for example by taking a circuit in London and trading remotely on these exchanges instead.
“We’re seeing a huge trend towards trading in the emerging markets, not only the currencies themselves but also many of their derivatives… many firms who aren’t trading them yet are missing out on valuable, and very profitable, opportunities”
Michael Ourabah, BSO
Once they do this and realise the potential for profitable trading strategies, then they move into closer proximity and try to optimise the latency from here to all the key exchanges as well, Ourabah adds. “We’re seeing a huge trend towards trading in the emerging markets, not only the currencies themselves but also many of their derivatives,” he adds. While initially the focus was on connectivity to New York and London, Tokyo has picked up significantly in recent years. “Asian traders are now actually trading on the Tokyo matching engines and locations more than New York and London,” Ourabah concludes. “And I think many firms who aren’t trading them yet are missing out on valuable, and very profitable, opportunities as a result.
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