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© Copyright 2000 Rogers Media. The following article first appeared in the October 2000 edition of
BENEFITS CANADA magazine.
Electronic Foreign Exchange
The Internet has the potential to transform foreign exchange investing. While there are obstacles
to overcome, it could reduce risk, increase the potential for profit and boost pension funds' direct
participation in this market.
By Mark Bonham
As the largest and most competitive financial market in the world, one would expect foreign exchange to
play a big role in the management of both retail and institutional investment portfolios. But despite the
growing influence of the Internet, this liquid and competitive marketplace remains largely the preserve of
the banking institutions.
Why, one could ask, is the retail day-trading phenomenon that has flourished in the equity markets ignoring
such a large and liquid marketplace? And why, as international investing by institutions grows by leaps and
bounds, have the institutional managers themselves failed to play a more significant, direct role in the
foreign exchange market?
The answers to these questions reveal a lot about the fundamental operations of this market and its risks,
as well as the opportunities which the Internet may still bring about to broaden the direct participation
level in this sizeable market.
It's indisputable that the market for foreign exchange is large and competitive enough for active direct
investor participation.
Daily turnover is estimated at US$1.5 trillion, comprising over a million transactions.
Today, the U.S. large-value payments system handles an estimated 120 times the value of total U.S. bank
reserves (seven times larger than in 1980), and foreign exchange activity makes up about half of that
total.
The largest market participant in 1998 was identified as Citibank. But this institution accounted for less
than 9% of daily turnover. In fact, the largest 20 players in the marketplace accounted for only 66% of all
trading.
How has this impacted participation levels in the foreign exchange market, and ultimately the risk
associated with investing in foreign exchange?
As with any financial commodity, a deterrent to participation in a marketplace is access to information.
INFORMATION FLOW
Not that long ago, banking institutions were the sole purveyor of the information vital to the transaction
of business in foreign exchange.
With no central organized market, bank dealers executed trades solely by telephone or telex, writing trade
details on small chits of paper, keeping positions on blotters and maintaining price charts by hand.
The resulting scarcity of information meant that price discovery was inefficient, bid-offer spreads were
wide, margins were large, the required data to calculate option volatility was proprietary and banking
institutions played the biggest role simply because they knew where activity and prices in the marketplace
were occurring.
As a result, foreign exchange trading was a profitable activity for these institutional banking
participants. The risks of trading were somewhat controlled and isolated at the bank level, and the degree
of volatility was sufficient enough to warrant active participation by only the most sophisticated of
investors.
TRANSFORMATION
Interestingly, this scenario is similar to how the bond market operated only a few years ago. However, the
operations of the bond market changed dramatically as information flows increased and prices in that
marketplace became more transparent. This same type of transformation is now occurring in the foreign
exchange market.
Today, access to price information in the foreign exchange market is widely available. Both institutional
investors and retail investors can now gain live access to multi-contributor price feeds. This information
can be downloaded directly into spreadsheet analysis programs. In addition, up-to-the-minute political and
economic developments are widely available through news sources such as CNBC. The technology to value
options is also available.
As a result of these developments, one would expect an influx of additional direct investors--both retail
and institutional--into the marketplace.
However, in this new market bid-offer spreads have collapsed, as have profit margins. This, in turn, has
hampered the growth of direct investor participation.
Profitability is the compensation an investor earns for taking on risk. And the absence of a respectable
profit margin has acted as somewhat of a deterrent to increased direct participation in the marketplace by
retail and institutional investors.
LOOKING FOR PROFIT
Creating a hospitable environment for the profitable trading of foreign exchange requires anomalies and
disparities in the marketplace. However, governments and central banks in industrialized countries (and to
a good degree those of developing countries) have been able to reduce the disparities in their respective
interest rates as well as rates of inflation and economic growth over the past 10 years.
Through focused and sophisticated planning, monetary authorities have become adept at managing the
financial aspects of their domestic economies and their foreign exchange reserves, reducing the volatility
of domestic currencies.
The mitigation of extreme volatility in the foreign exchange market has inhibited direct investor
participation because it reduces the possibility of profitable trading.
One would have thought that the large volume in the foreign exchange market could compensate for shrinking
margins and increase the opportunity for profitable trades. But the increased volume of trading belies the
fact that, in many respects, liquidity in the foreign exchange market has actually declined.
This is due in large part because of the volume put through the markets by hedge funds and single large
investors, which frequently hit the market in sudden bursts rather than steady flows. To quantify this, the
average spot transaction in the foreign exchange market has soared to more than $10 million today, from
$750,000 in 1974.
The increase in the average trade size illustrates that the capital exposure required by the direct
investor to trade profitably has also increased. For the institutional investor, the required amount of
capital to be set aside to support risk positions for trading in the foreign exchange market has increased
dramatically and is actively regulated through concepts such as Value at Risk. For the retail investor, the
minimum deal size is, at best, US$10,000.
The result is that profitable positioning in foreign exchange today can truly occur in one of only three
instances:
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If the investor is a very large trader.
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If the investor's portfolio includes a diversified product set such as options that benefit from
portfolio effect.
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If the investor's portfolio includes niche currencies where spreads are wider.
INTERNET REVOLUTION
However, the Internet may change this situation and increase the potential opportunity for profitable
trading and positioning in foreign exchange.
For starters, the Internet has created a virtually zero-cost delivery channel--as noted earlier,
information is now universal and market participants can now distribute rates and price spreads 24 hours a
day, seven days a week to an unlimited number of potential market participants.
The Internet will also help to transform the market through the low demands it makes on support staff and
technology. Using the Internet in foreign exchange investing means that there are no errors or transaction
volume constraints. Indeed, even razor-thin margins can be exploited by active traders. The collapse of
margins also increases the potential participation of the smallest retail customer who is used to paying as
much as 5% to buy foreign currencies. Online shopping, for example, certainly creates further demand for
currency transactions.
The growing influence of the Internet will impact the risk associated with foreign exchange investing. In a
positive way, settlement risk can be diminished because transactions between parties should settle
instantly. Today, trading parties generally communicate with each other through a series of messages passed
back and forth that can take days to settle.
Unfortunately, however, with more geographical sources of activity and more players--both at the
institutional and retail level--the probability of a frightening liquidity crisis in the marketplace
increases. After all, not every participant will be backed by a lender of last resort.
While the Internet will play an increasing role in encouraging direct institutional and retail
participation in the foreign exchange market, to date this has been occurring through business-to-business
solutions--notably proprietary electronic systems developed by banks that give clients access to their
research and prices.
For example, Citigroup, Deutsche Bank and Chase Manhattan have teamed with Reuters to offer these foreign
exchange services through Atriax, an Internet site. Another 13 banks have set up a competing site called
FXall.
LEGAL CONCERNS
Although these bank-initiated Internet strategies make perfect sense from a business standpoint, both in
terms of how they have evolved and why, they are not without their own challenges for foreign exchange
markets. As banks scramble to partner up in the creation of these business-to-business Web ventures,
liquidity in the market becomes more and more concentrated--money may then end up costing more simply
because there is less of it circulating in the financial system. Also, the operation of the Web sites
themselves requires back-up systems impervious to any security threat.
There are also legal issues to consider with Internet ventures. For example, with the speed and finality of
foreign exchange transactions both concentrated and increased, what will happen to an unhappy counterparty
or creditor that wishes to reverse a transaction? This is difficult to answer because legal settlements on
bankruptcy vary from country to country.
BENEFITS AND CHALLENGES
Another problematic scenario is government sanctions, including the freezing of assets that accompany
policies aimed at thwarting drug trafficking, the bulk of which involve trading and payment in U.S.
dollars.
These policies force participants to screen transactions before settlement and encourage the settlement of
transactions outside the purview of the U.S. government itself.
The technology of the Internet allows financial services to be conducted almost anywhere, but the
regulations faced by the banks in this type of activity will force the screening of transactions before
they are input into the system.
As with any technological innovation, the Internet presents its own distinct benefits and challenges for
the transaction of foreign exchange. It will present major changes in the way financial
transactions--including foreign exchange--are conducted globally in the next few years.
These changes will impact the risk, efficiency and liquidity of the market. If history repeats itself, the
Internet will tend to reduce the cost of transacting.
However, the jury is still out as to whether this over-riding benefit will result from more direct
participation of retail and institutional investors, or will be forced on the banks through online
competition.
Mark Bonham is chief executive officer of Bonham & Co. Inc. Asset Management in Toronto.
mark.bonham@bonhamco.com.
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