Structural changes in the FX market:
Are we moving towards an exchange model?
by Nicolas de Sze, Deputy Director General of Operations, Banque de France
Major trends and conclusions derived from the latest triennial BIS survey
The triennial survey carried out in April 2001 revealed a substantial decline in the overall foreign exchange market activity, in contrast with the sharp rise recorded in the previous surveys: the average daily turnover in the FX market indeed decreased by 19% between 1998 and 2001 (whereas it had increased by 39%, 45% and 25% respectively over the periods 1989/92, 1992/95 and 1995/98).
This overall decrease nevertheless conceals varying trends on the different market segments: spot transactions declined by 32%. They are now back roughly to 1992's level; foreign exchange swaps decreased by "only" 11%; outright forwards increased by a modest 2%.
The 2001 survey's figures also reveal substantial changes in the relative importance of trading between different counterparties: interbank trading fell substantially, with its share in total turnover dropping from 64% in 1998 to 59% in 2001; the share of trading between banks and non-financial customers (corporates) declined from 17% to 13%; by contrast, transactions between banks and financial customers increased, with their share rising from 20% to 28%; anecdotal evidence suggests that the increased activity between these counterparties reflects the growing role of asset managers, while the role of hedge funds in the FX market seems to have on balance receded somewhat since the previous survey.
For its part, the geographical distribution of foreign exchange trading does not appear to have changed substantially over the past three years. Consequently, the overall decline in FX market turnover has not brought about substantial changes in terms of the geographical breakdown, as local turnovers have declined more or less homogeneously: thus, and non surprisingly, London has consolidated its pre-eminence, while markets in continental Europe have lost some ground. More significantly, a handful of market places have benefited from "specific" factors such as, in Sweden, a relaxation of restrictions on institutional investors' activity (increased possibilities to invest abroad).
Therefore, the overall picture is more or less as follows: a decline in volume, especially in spot transactions, a deflating interbank market, a fall in corporate activity but, conversely, an increase in financial customers' business. These are the facts and figures derived from the last BIS survey.
Some structural changes in the FX market
Most of the factors behind the changes revealed by the BIS survey are generally well-known to market participants. Ongoing qualitative analyses carried out by the Eurosystem and the BIS have identified or confirmed several important structural changes in the FX market.
The continuing consolidation trend in the banking industry has undoubtedly contributed to the decline in FX market turnover. One meaningful piece of evidence of this concentration process was the decrease in the number of reporting banks in the BIS survey (for countries that participated in the three last surveys): 2,417 in 1995, 2,205 in 1998 and 1,945 in 2001.
In addition, there is also looming evidence of a concentration of turnover among the larger players: it is thus estimated that, in the US and the UK, as much as 75% of turnover is conducted by 13 and 17 banks respectively (compared with 20 and 24 banks in 1998). The decline in the number of interbank players is not only the consequence of the concentration trend in the banking industry. It is also the result of extensive internal reorganisation: international banks have generally concentrated their FX trading/market-making activity on only three market places (one for each time zone) and consequently shut down their other trading desks.
To some extent, a similar consolidation process has been witnessed on the "buy side". An initial reason for the fall in non-financial customers' activity is the concentration in the corporate sector. For sure, some "mega-deals" executed in the FX market in relation to M&As have occasionally inflated FX turnover during the past three years but, overall, consolidation in the manufacturing sector probably contributed to the decrease in FX market activity.
As well as the consolidation, the centralisation of flows from industrial companies has led to a significant reduction in the need for foreign exchange on the part of corporate treasurers. Big multinational firms have increased the centralisation of their FX and treasury operations so that every currency inflow or outflow from any company's branch or subsidiary is routed to a single treasury centre, thus allowing for netting of payment flows and a reduction in the number of FX deals to be executed in the market.
The successful introduction of the euro, on the one hand, and economic globalisation on the other hand have considerably contributed to reinforcing the polarised nature of international financial markets. Indeed, the financial system is becoming increasingly polarised around the three major currencies, namely the dollar, the euro and the yen.
As such, the introduction of the euro has been an obvious and important factor in the contraction in turnover since it resulted in the disappearance of intra-EMS trading. Informal estimates suggest that this accounted for one third of the 19% drop in total turnover. However, trading among EMS currencies had started to decline well ahead of EMU: between 1995 and 1998, intra-EMS trading had already fallen by some 5% of total turnover.
The growing role of so-called electronic brokers has also had a dampening effect on FX turnover on the spot market. Although their market share is difficult to assess accurately, EBS and Reuters probably account altogether for more than 70% of the spot market on major currencies. As a matter of fact, the primacy of system-driven trading has changed the very nature of the market: the price discovery mechanism has shifted from the traditional quote-driven system to an order-driven mechanism. End users' orders are channelled into a global virtual market place and matched without giving rise to the number of interbank quotations and deals which were formerly necessary to make the market price "emerge" from the traditional interbank trading.
However, although electronic broking has led to a substantial fall in spot FX turnover, its impact has been more limited, so far, on other/less fungible FX market segments where such tools are not yet available or, when available, definitely less popular.
Developments of online portals (i.e. Internet-based dealing systems) could also introduce significant changes. So far, neither proprietary platforms nor multi-dealer platforms have succeeded in attracting the bulk of customers' flows. However, the present reluctance or lack of enthusiasm on the "buy side" for these new tools could well be counteracted by the ongoing consolidation in the sector (illustrated, for instance, by the recent failure of Atriax). If and when "critical mass" is reached by one or a couple of platform(s) -most likely multi-dealer platform(s)-, we can expect an acceleration in the use of online portals, with two potential consequences: first, rationalisation on corporate sales desks, second, further concentration in the FX trading business.
What next: Are we moving towards an exchange model?
Most of the general trends identified so far are likely to continue and intensify in the coming years:as far as the consolidation process in the banking industry is concerned, one might expect some more mergers, especially in Europe where cross-border operations have been scarce so far; what I called the polarisation process will probably, over time, further reduce the number of actively traded currencies. The medium/long-term prospect for entry in the EMU of the so-called "accession countries" and of some other EU members will further mechanically scale down FX turnover; lastly, while electronic broking has hardly been successful so far on less fungible FX market products like swaps or options, further development on these market segments could be expected.
In addition, two new elements are likely to play a key role in the near future: the first is CLS, and the second is the possible emergence of a single, broad-based Internet system.
The emergence, with CLS, of an entity playing some of the roles of a clearing house and providing a PVP settlement system for the FX market will further help to moving the interbank market from an OTC market towards an "Exchange" model.
Another potential impact of CLS may be to foster the consolidation of FX activity in the banking industry and possibly of a two-tier market.
Thus, there is not just one possible evolution for the FX market: a possible shift towards a two-tier market may be a concern, but an even more global, transparent market may result from the combination of CLS and a single or a handful of electronic trading systems.
Conclusion
Neither the consequences of, nor the risks induced by, the coming changes should be overestimated. The ongoing changes are the signs of the FX market's ability to respond to a general demand for ever-improving efficiency: for instance, Internet-based systems are aimed at reducing operative cost and increasing transparency, CLS' objective is to eliminate settlement risks which is of course an objective shared by the central banks. The challenges are real, but taking into account the impressive track record of FX market professionals in terms of adaptability, I feel reasonably optimistic.