Thoughts on the Evolution of the Foreign Exchange Market

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The Bank for International Settlements, set up after WWI to collect war reparations from Germany, who at the end of last year made its last payment, organizes a global survey every three years, conducted by central banks, to assess the parameters of the foreign exchange market, such as turnover, geographic distribution, and instruments.

The preliminary results were available in late September 2010 and in late December, within its quarterly publication an essay highlighted the growth of the foreign exchange market.

These reports may not be on many radar screens and in any event had to compete with a number of critical events that has kept volatility in the foreign exchange market relatively high, like QEII in the US, and the debt crisis in Europe. Yet, there were some elements important to a wide range of market participants. Usually we are interested in the drivers of foreign exchange prices, the direction and magnitude of moves, but in this essay, we are interested in the foreign exchange market itself.

Size and Growth

The first thing to appreciate is the size and growth of the foreign exchange market. The BIS survey estimated average daily turnover to be $4 trillion. It is the largest of the capital markets. It is a massive number and of course adjustments were made to avoid double counting. Already this year, the turnover has likely been sufficient to cover all of world trade for the year.

This represented a 20% increase over the last survey in 2007, which is a relatively slow pace of growth. In the three previous three years (2004 to 2007) turnover grew 72% and the three years before that, turnover grew by 56%. What this means is that turnover in the foreign exchange market has more than tripled since 2001.

Instruments

Spot foreign exchange transactions account for 37% of the turnover at $1.5 trillion. Spot turnover jumped 50% over the past three years. Growth in other foreign exchange instruments, such as forwards, swaps and options was estimated at 7%. Option turnover actually declined.

In terms of currency pairs, the euro-dollar is by far the most traded, accounting for a 28% of the turnover alone. This means that on any given days the euro-dollar volume is in excess of $1 trillion. The second most traded currency pair is the dollar-yen and it is half the size of the euro-dollar market (14%). Both of these are flat from both of the last two surveys. The third most comment pair is the British pound-dollar at about 9% market share. This is about a third smaller than in 2004. The euro-yen and euro sterling each account for about 3% of the average daily turnover.

The dollar itself remains the most commonly traded currency, being on one side of almost 85% of the trade. This is down from 86.8% in 1998. Given the interpolations and estimates required, it is does not seem to be a significant change.

The euro is the second most frequently currency. It is on one side of 39% of trades. The point we make about the euro as a reserve currency also applies to it s role in the foreign exchange market—it is hardly the sum of its parts. For example, in 1998, the countries that gave up their currencies for the euro and the ECU were one side of more than half of all trades.

We also have pointed out that the Japanese yen’s role as a reserve asset has diminished, even more pronouncedly than the dollar’s. The yen is on one side of 19% of foreign exchange trades. This is down from just less than 22% in 1998. Sterling accounted for 13% compared to 11% in 1998.

The turnover of the Canadian and Australian dollars has grown markedly in recent years to stands near 5.5% and 7% respectively. In 1998, the Canadian dollar was on 3.5% of trades and the Australian dollar was on 3% of foreign exchange trades.

Among emerging markets, only four currencies accounted were more than 1% of the trades: (Hong Kong dollar 2.4%, South Korean won 1.5%, Singapore dollar 1.4% and the Mexican peso 1.3%). Note that the Hong Kong dollar is pegged against the US dollar and has withstood numerous tests, which may account for the elevated role.

There are a couple of other interesting developments to note. The most impressive growth over the past three years was recorded by the Turkish lira, which rose from 0.2% to 0.7% of trades. The Brazilian real increased from 0.4% to 0.7%. Of note, the BIS data suggests that the turnover accounted for the Chinese yuan actually slipped from 0.5% in 2007 to 0.3% in 2010.

Location

The UK remains the largest foreign exchange center and its role has steadily increased at a rate of almost 1% a year over the past dozen years to almost 46%. The US position as number two solidified. It is home to almost 24% of the foreign exchange market. The rise has come largely at the expense of Japan, which has seen its share declined below 3.5% from a little over 9% in 1998. France’s share of the foreign exchange market has fallen to almost 7% from nearly 12% in 1998.

A couple of smaller financial centers have seen modest gains in recent years. Singapore is roughly the same size as Switzerland in terms of market shares (almost 3%) and the pace of growth has remained relatively the same since 1998 (a little more than 1.5%). Australia’s foreign exchange market share has also roughly doubled since 1998 to stand at 1.5% in 2010.

Participants

Most of the growth (85%) in the turnover over the past three years is accounted for by small banks, mutual funds, pension funds, hedge funds and other financial institutions. The trend has been in place for the first time the turnover accounted by this market segment eclipsed the dealers in the interbank market.

Drilling down, the essay in the BIS quarterly suggests that the growth in foreign exchange market was a result of increased activity by high-frequency traders, smaller banks there were clients of the large banks, and retail investors. What makes this possible is technological advancement and especially electronic execution methods. Algorithmic trading, for example, involves computer generated trades and order execution.

This is not simply employed by hedge funds and proprietary dealers, making macro bets or profiting from minor price moves in nanoseconds, but also by dealers themselves to automatically hedge or offset positions given to them by their customers. It is not clear, how much of the foreign exchange turnover accounted for by high frequency trading, but some estimates put it as high as 25% of spot market activity or near $375 bln a day.

In addition to the economies of scale, the importance of cutting edge technology for trading itself makes foreign exchange operations very capital intensive and this is appears to be contributing to the concentration in the industry. The number of banks that account for 75% of the countries’ foreign exchange turnover has steadily fallen in the UK, US and Japan to stand in 2010 around 7-8. This applies to Singapore as well. However, in Brazil and Hong Kong the number of banks that account for three quarters of their respective foreign exchange markets has increased in recent years, though in Brazil it is still less than 8 banks and Hong Kong is about 13 banks.

Spreads and Retail

Increasingly small banks cannot compete directly and have become customers of the top banks, especially for the highly liquid “global” currencies, while still making markets for clients in the local currency. These global banks participate in multi-bank platforms to provide competitive prices, but many have developed their own bank’s platform that secures the local bank’s business while consistently providing liquidity and tight spreads between bids and offers.

The BIS data does not address it, but the spreads in the foreign exchange market continue to steadily tighten. This is partly a reflection of the technology, competitive pressure and the commoditization of many of the major currencies. A proprietary study found the spread for the major currencies has been narrowing by a little less than a 10% pace for several years.

The spread between the bid and offer in emerging market currencies is wide but as the currencies are become more liquid and are used by not only speculators, but businesses and asset managers those spreads narrow.

Electronic trading has also helped democratize the foreign exchange market by making it accessible not just to those business, banks, and official institutions, but to retail investor and small non-bank institutions. Estimates suggest that this market segment has grown quickly in recent years and now accounts for 8-10% of the daily turnover in the spot market globally and nearly a third of the spot yen trading (in excess of $20 bln a day). This has brought greater oversight and consolidation in this space. The number of retail electronic platforms (aka retail aggregators) in the US has been slashed from 47 in 2007 to 11 in 2010. In Japan the number of retail aggregators has dropped to around 70 from over 500 in 2005.

Ironically, Europe lags behind the US and Japan in regulating the retail foreign exchange market, including in terms of limits on leverage. This appears to be creating some opportunity in regulatory arbitrage.

The relative decline of the importance of interbank dealing may also be influenced by technology. The large banks with sufficient economies of scale and smart computers are increasingly able to match customer trades internally. Barring conflicts over best execution, this trend is likely to continue.

Turnover in the foreign exchange market is likely to continue to increase overall. The competitive pressures driving participants to adopt newer technologies in narrowing spreads (proxy for profit margins) and higher industry concentration and a particular skilled work forces encourages the cluster or geographic concentration as well. Sometimes, technologies like single bank platforms or numerous other electronic gateways to foreign exchange may seem to fragment the market for a period, but this occurs within the overall trend toward concentration.