Development and trends of the global FX market

by James J. McNulty, President and CEO, CME

 

Overview

In the past thirty years world currency markets have been the foundation upon which many Government Bond markets, local money-markets and global equity markets have been able to flourish and become important sources of both debt and equity capital.

 

Where deep, liquid and transparent FX markets allowed investors to find productive investments across borders with manageable FX risks, Governments and corporations were able to raise debt and equity capital at reasonable costs.  This helped create a boom in international investing that is still in its early stages.

 

Global pension fund and mutual fund investors, hedge funds and retail investors along with corporate treasurers have been the customers of exchanges like CME, as well as commercial and investment banks.  These important customers have been the drivers of many of the innovations in the foreign exchange markets, and will continue to define the trends in the FX marketplace of the future. 

 

Customers are the Drivers of Change

In the 1970s and 1980s Foreign Exchange market customers who participated in surveys described their top three needs very concisely:  they wanted quality of price (meaning narrow bid-ask spreads and deep liquidity), consistency of price (meaning quality of price 24 hours a day in both volatile markets and calm markets) and speed in pricing (they hoped to get a price over the phone from a bank or broker in 30 thirty seconds or less).

 

In the 1990s we witnessed the growth in the FX options markets which used highly sophisticated real- time computerized risk management and global order routing.  At the same time we saw the rapid growth of electronic FX brokerage provided principally by Reuters and EBS (EBS was founded in 1990 by a consortium of banks in an effort to keep brokerage costs under control).  In this period a very important trend in FX took hold.  This trend has now spread to equity and bond markets as well.  It is the trend toward creating a faster, more cost efficient and safer marketplace.  In total it can be described as a powerful trend toward greater marketplace efficiency.  This trend was accelerated by the rapid advances in telecommunication, computer and internet technology.

 

I will explore three categories of efficiency that we see driving the market participants:  these include cost efficiencies, risk management efficiencies and capital and credit efficiencies.

 

Cost Efficiencies

In the 1990s some of the big multinational banks created networked trading systems which provided 24 twenty-four hour a day risk management for a single global FX options portfolio that would provide pricing to all of a bank's branches around the world.  This provided the dual benefit of keeping human resources costs down, and more importantly, it allowed risk managers to benefit from the law of large numbers since the hedging for the portfolios followed probabilistic models.  As these global portfolios grew, the revenue streams became more predictable.

 

These networked option trading systems then evolved so that sales operations around the world were authorized to trade up to a notional amount of $5 million in options from automated deal entry screens.  This increased the speed of pricing for client business and allowed each trader and sales person to be more efficient.

 

By 2000 clients were asking their banks to further simplify the trading process.  Most investors and multinational corporations had charters which directed them to obtain several competitive prices before trading.

 

They did not want to have several employees waiting on phones to choose the best price from competing banks.  In 1996 State Street Bank launched FX Connect, the first "bank portal."  In 2000 the portal opened up its platform to additional banks and it became a "multi-bank portal" that enabled buy- side customers to see the prices of 35 thirty-five bank FX providers and execute trades on these prices.

 

Following a similar path, in 2000 seven of the major banks decided to utilize new and relatively inexpensive internet technology in order to solve the competitive pricing problem.  They jointly launched an internet "multi-bank portal" called FXall where all seven banks and member banks could show competing prices at the same time and assure their customers a best price via competition.  Today FXall has 43 forty-three banks making markets to over 500 five hundred customers who are trading approximately $16 billion each day in spot and forward swaps.  This trend could also be seen in privately owned systems such as Currenex.  Currenex acts like an online exchange for bank money market and FX participants, who make prices electronically, settle using bi-lateral credit arrangements and enjoy another innovation for efficiency called "straight through processing" where trades are executed and simultaneously reported to back offices and risk control systems.

 

In 2001 Chicago Mercantile Exchange Inc. (CME) also took steps to bring down customer costs and expand trading to nearly 24 twenty-four hours a day.  We launched a matching engine with technology specifically tuned for the needs of the FX market on our Globex electronic trading system.  This technology allows our bank and institutional clients and the public to execute trades using a standard electronic trading interface, or an automated trading system where a computer feeds prices continuously to the CME.  The ATS or automated trading system reduces error risk and can continuously quote at a rate that is much more efficient than any single trader.  CME also provides for internet connectivity through virtual private net works.  In order to keep telecommunication costs down some clients have been able to replace T-1 lines that cost $3,500 each month with a virtual private network (VPN) solution that costs only $450 per month.

 

As exchanges and banks reduced internal costs through automation, they became more competitive for their customers.  One large international bank estimates that their cost of processing a foreign exchange ticket has fallen from $13 to $1 in the past ten years. 

 

CME Inc. has also recently taken steps to reduce costs by linking to the Continuous Linked Settlement (CLS) process through Citibank and CLS Bank.  We have cost savings examples of one bank whothat might previously have paid $10,000 to make delivery of 4000 four thousand Euro currency futures contracts whothat now pays only $25 via the CME CLS solution.

 

In summary, the recent innovations in FX processing that are setting the trend for the future include:  the use of the internet to reduce telecommunications costs, multi-bank portals which aggregate many banks' prices on one screen, the use of automated trading systems to execute rapidly and continuously and straight through processing to reduce back office and risk management errors and processing costs.

 

All of these are important new trends and help create the foundation for the next round of developments in the FX markets. 

 

Risk Management Efficiencies

The most important developments in the area of risk management efficiency have been related to the real- time risk management models developed for managing FX Options portfolios and the development of electronic trading of Foreign Exchange.  In the early 1990s O'Connor & Associates, in a global joint venture with Swiss Bank Corporation, placed option pricing software on the desks of hundreds of FX sales people and Risk Management Advisors within the SBC network.  When SBC purchased O'Connor in 1993, this software evolved and became a front- end trading mechanism for the sales force which created a network of people who could enter trades from exchanges, trading desks and customer desks 24 around the worldhours a day.  The turn around time for obtaining options prices dropped significantly for customers and the bank's risk managers had a real-time view of a global portfolio.

 

This type of efficiency was further supported by the speed of spot FX electronic brokerage which dropped to approximately .2 seconds on both the Reuters and EBS trading platforms.

 

In 2001 CME Inc. launched a 23 twenty-three hour a day FX product on Globex and reduced trading "ping" times from 2 seconds to less than .2 seconds.  We also allowed automated trading systems to enter orders.  This ability to enter automated orders is the beginning of a new trend in FX where automated trading of FX options will be possible for those banks that can automate their hedge trading at the CME.

 

The other major innovation in risk management efficiency in the past several years was the development of Straight-through Processing (STP).  STP first became available on Reuter's trading system using the industry standard TOF software (Ticket Output Feed).  Today, when spot trades are executed on Reuters or EBS, they are automatically sent to both front- end trading systems and simultaneously sent to back office applications for risk management oversight, payments and updates to the general ledger.  This created both operational efficiencies by reducing input errors and risk management oversight efficiencies by allowing banks' risk managers to have a real-time view of the banks global FX position.

 

The two trends of automated trading and Straight -through Processing will greatly increase the capacity of bank trading organizations and allow them to continue to reduce head count and overhead in the coming years.

 

Capital and Credit Efficiencies

In the post-Enron era FX customers and their banks and investment banks are seeking ways to create capital efficiency and reduce counterparty risk.  Banks have concluded that they are unable to extend unlimited, unsecured bi-lateral counterparty risk.  They are now exploring hybrid solutions that resemble the central counterparty clearing solutions provided by exchange clearing houses for many years.  The hybrid solutions have been found in Prime Brokerage operations where banks do trades with clients for whom they have limited bilateral credit lines.   In some cases they execute an exchange for physical transaction (EFP) in order to transform spot risk into exchange clearing house risk where the spot transaction is transformed into a futures transaction and the CME clearing house manages the client collateral and daily mark to market.  Most prime brokerage operations, however, set their own collateral requirements and do the daily mark to market with their client directly.

 

More recently we have seen prime brokerage become centralized at brokers like EBS or, starting in December, at multi-bank portals like FXall.  In the case of EBS the prime broker banks effectively lease their higher credit rating to lower credit banks who become prime broker customers.  This arrangement allows the lower credit bank customer to see the "inside price."  The lower credit bank customer pays the prime broker bank a spread on each trade and a commission to EBS.

 

Another major FX innovation in the credit area is CLS Bank.  For several years forty- nine major trading banks have invested in and supported the development of CLS bank to create a solution for credit risk at delivery in order to avoid what is known as "Herstatt Risk" where there is an overnight timing mismatch between the delivery of a currency in one country versus delivery of currency to a counterparty in another country the following day.  Today CLS Bank is already settling more than $1 trillion a day through the execution of more than 100,000one-hundred thousand payment instructions.  It is still early in the history of CLS Bank, but it already appears to be making a difference in creating credit and payment efficiencies for foreign exchange banks and their customers.

 

Projecting Current FX Trends into the Future

The current trends in FX are clearly centered on creating greater and greater market efficiencies.  It leads one to ask the question: where do we go from here?

 

It is clear that many of the efficiencies have come from technology upgrades in the areas of telecommunications, internet technology, hardware innovation and software development.  Most of these innovations are leading to lower cost of telecommunications, faster "ping times" for executing trades and the ability to automate trading with automated trading system software.  If one projects from current trends, it is likely that FX customers will see the merging of multi-bank portals and the networking of exchanges with the multi-bank portals so that a customer can chose between a bank price and an exchange price.  Electronic brokers are also likely to show both exchange and bank pricing in foreign exchange.  I would also expect to see a new hybrid type of clearing solution for FX Forwards and FX Options.  It is possible that brokers and portals will be able to offer forwards and options on a bi-lateral credit basis or on a central counter-party credit basis where the forwards and options are cleared through a clearing house like CME's clearing house.  They will have straight through processing and settle with a continuous linked settlement process.  This will then lead to a market place that is more comfortable showing both forward prices and option prices on electronic platforms.  This could greatly expand the use of these markets and lead to the rapid growth of automated trading systems providing spot, forward and options prices 24 around the clockhours a day.  The net result will be a market that has lower costs, higher liquidity and higher growth due to safer settlement and new capital and credit efficiencies.

 

In conclusion, the tremendous efficiency gain that the FX market has seen over the past ten years was just the foundation for the gains we are likely to see over the next ten years.  There has never been a better time for a major economy like China's to be able to benefit from this market.