By Eugene Markman, Chief Operations Officer, ION Markets (FX) and Chief Executive Officer, MarketFactory
With the entry of more diverse participants, new technologies, and increasing complexity to today’s foreign exchange (FX) structure, the execution of forex trades is evolving towards increased electronification with a focus on automation. Although, it is worth asking if the evolution is rapid enough? So far, this trend has largely taken shape in response to increasing regulatory requirements (such as Dodd-Frank, MiFID, EMIR and the Tobin Tax), as well as rising market volatility, initially caused by the COVID-19 pandemic and more recently by the Russia-Ukraine conflict.
Whilst a wider trend of electronification swept through the FX spot market over a decade ago, with swaps, forwards, and non-deliverable forwards (NDFs) soon following suit, this has yet to be fully embraced by FX options. Two reasons for this delay are complexity and liquidity, but the demand for options is now increasing. So, is it finally time to fully embrace electronification? Also, how far off are FX markets from taking advantage of automation?
Automation: taking stock of where we are now
So far, the areas of spot, swaps and forwards have been disrupted by technology through a wider trend of automation; the benefits of which are starkly clear. Automation not only ensures a more strategic approach to trading, as any human bias is removed from the process, but it saves time, reduces risk (both operational and market) and shows best execution – this is more important than ever in foreign exchange, given the high volumes and volatility which characterizes this market.
However, this is much easier in some instruments than others. Looking at G20 spot currencies for example, there is always someone trading in the market, so there is always deep liquidity. This, coupled with the repeatable nature of transactions, makes the instrument prime for automation. It is not as simple for NDFs, as liquidity depends on the market – those with lower volumes, for instance the Indonesian Rupiah, proving harder to automate, and there is still a strong reliance on liquidity provider (LP) relationships for liquidity.
Benefits: defragmenting FX markets, making prices transparent
FX is an over-the-counter (OTC) market and comes with its own set of challenges: for one, since the market is not centralised, it is highly relationship driven. Customers rely on their relationships with their LPs for pricing, especially during periods of high volatility. Two, there’s less transparency as the price is not publicly disclosed, so it is difficult to evaluate an LPs pricing. And three, there are very noticeable counter-party risks as majority of trading is executed bilaterally.
The FX market continues to be highly fragmented, and prices remain opaque. It is also heavily swayed by unpredictable market conditions, making voice trading the preferred channel or protocol. However, recent events have shifted traders’ focus to digitising their risk management and trade settlement systems.
For instance, when it comes to options, which are more complex with less available liquidity, automation is not as straightforward. Whilst the simpler, more liquid “vanilla” options have begun to embrace this transition, less liquid “exotic” options continue to lag in their adoption, as demand for electronification is not there yet. However, this is changing.
Banks are starting to see demand and the potential profit from electronification in this area, as for complex trades like options they are able to charge a higher spread and create more room for profitability. In comparison, for other instruments such as spots, where spreads are much tighter, transactions have to be of a high volume for the bank to make a profit, making this a much more difficult task.
What happens next?
The options market is continuing to build up and now nearing critical mass, where there are enough transactions to justify the transition to electronification and workflow automation. Over the years, FX options have experienced an exponential growth, starting with the first financial crisis of the 1990s and continuing with the expanding intermediation of international capital flows. Currently the BIS quantifies the FX Options market to have an average daily volume that exceeds $250 billion (£199bn).
If the FX market continues to scale at its current rate, given the sheer volume, it will become increasingly important to automate every segment to perform at full efficiency. By switching to electronic pricing, FX options traders would be better placed to efficiently navigate the fragmented market by aggregating liquidity, seamlessly accessing different types of liquidity pools and trading venues – which if done manually, would otherwise be difficult.
An essential element of option workflow automating is access to real-time data. In FX, there is a mix of longer-dated instruments like forwards and shorter-dated ones like spot, so it’s important that traders are equipped with the necessary tools which enable them to use real-time and historical data in tandem, so they can accurately contextualise and make predictions, maximise returns and minimise risk.
Among other asset classes, the foreign exchange market is one that closely reflects macroeconomic trends. Primary electronic venues remain important sources of liquidity for price discovery in the FX market, but its share has dwindled in recent years, which has in turn given rise to alternative ECNs (Electronic Communications Networks) and liquidity pools. There is clearly both demand for FX options on the buy side as well as a push from the sell side. Automation of the entire FX market is clearly desirable as traders seek ways to both consolidate data points and increase transparency in a rather opaque market. Electronification and automation are the solutions that will make this desire a reality.
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