Special FX

The buy side's search for best-execution strategies is no longer limited to equities. As regulators have stepped up scrutiny of all aspects of fund managers' trading activity and fiduciary responsibility, the buy side has become more interested in trading on electronic foreign exchange (FX) platforms, due to the speed of execution and transparency they offer. Buy-side customers also are attracted to the electronic platforms by the lower transaction costs they offer.

"There is much more focus from regulators on compliance and auditing," says Ian Battye, manager of currency management for Tacoma, Wash.-based Russell Investment Group, which handles $131 billion in assets. "The phone doesn't give you a time stamp - you ask for a quote and maybe you get it," he says. The audit trail is much easier to follow with electronic platforms.

"The returns people get from stocks and bonds are much lower than they used to be," adds Howard Tai, currency and derivatives specialist at Kansas City, Mo.-based American Century Investments. This is focusing more attention than ever on the bottom line.

Jodi Burns, analyst with Celent Communications in Boston, estimates that 43 percent of dealer-to-client FX volume is now traded electronically, a figure she predicts will leap to 70 percent by 2007, driven first by hedge funds and commodity trading advisers (CTAs) and later by traditional asset managers.

The FX market, lacking a centralized exchange, is fragmented and largely under the control of the primary dealing banks, which historically have held the cards in FX trading, making their profit on the difference between the fees they are charged when dealing with each other and the fees they charge when dealing with customers. The credit requirements needed for the interdealer market prohibit the entry of most other participants. But over the past decade or so, the prime broker community has risen to provide trading services and collateral credit for buy-side customers that otherwise would not be able to participate on interdealer platforms.

Electronic trading among banks mainly takes place on two platforms - Reuters Dealing and Electronic Broking Service (EBS). The anonymous EBS platform generally deals tight spreads that are not available to downstream customers. But in May 2004, the company launched EBSPrime, which allows small banks to be sponsored on the interbank EBS Spot platform through prime brokers. In December, EBS Prime Professional was extended to the hedge fund community, through a pilot program of 18 funds, representing a "baby step toward the merging of the dealer-to-client and dealer-to-client spot markets," Burns says.

The dealer-to-client market is dominated by single-bank dealing platforms, such as those run by Citibank, Deutsche Bank and ABN Amro. These request-for-quote (RFQ) platforms require customers to submit their quote requests to receive a price from the bank, which usually offers the service as a free add-on to existing services. The obvious disadvantage of this model is that the client is beholden to a single price maker. Still, more than two-thirds of overall e-FX volume is transacted over single-bank platforms, according to FX consulting firm ClientKnowledge.

"Single-bank platforms are useful when people want to have an instant transfer of risk, particularly if the size of the transaction is very large relative to a currency's underlying liquidity," says American Century's Tai. "The end user may not have all the tools he needs to reach all liquidity pools at once, whereas you can tap a dealer with whom you have a good relationship to explore the pools more efficiently than you would yourself."

Multibank dealer-to-client platforms, such as FXAll, Currenex and State Street's FX Connect, however, offer both RFQ and a constant stream of prices from multiple competing banks. But dealing is usually not anonymous, which can prove disadvantageous for buy-side managers that are attempting to conduct large trades without tipping their hands to the marketplace.

"If a bank client requires that on every transaction the bank must demonstrate they dealt the best price and document that, [using a multibank platform] is a good way to service that request," Tai says. "However, in the multibank platform setup, it is very easy for information leakage to happen. The losers on any deal are competing with and front-running you and the winning dealer."

Attracted to Anonymity

The latest FX trading market model to emerge is the anonymous, prime-broker model, typified by Hotspot FXi, which launched in 2000. In this model, all counterparties are anonymous to each other until after a bid has matched an offer and the trade is consumated. The fact that buy-side firms trade through a prime broker and do not reveal themselves during the trading process makes the platform an appealing choice, and its exchange-like structure may make for an easier transition for unaccustomed equity traders. Celent's Burns says Hotspot FXi's clientele is 80 percent hedge funds and CTAs.

"In a live marketplace, if you are a buyer, you don't have to take an offer - you place a bid, making you a price maker inside the spread," Russell's Battye explains. "I like the concept of Hotspot. We use it at the moment for price transparency, but we have never executed a trade on it. Our anticipation is that we will [execute trades on Hotspot] in the future."

Some buy-side firms have ventured far enough into FX to warrant the interest of vendors offering consolidated views of quotes in the market across several platforms and model types. FlexTrade Systems, Lava Trading and Integral Development have all made steps into this field.

FlexTrade Systems, a Great Neck, N.Y.-based provider of equities trading software, has begun building an FX trade management system, FlexFX, that it has installed for 10 customers in the last six months, according to Lee Ratner, head of FX sales at FlexTrade. Clients "want to log into one place and see pricing from all liquidity pools," he says. Ratner declines to name any clients, but he says most are hedge funds that trade frequently.

Lava Trading, which runs a quote aggregation service across equity ECNs, also entered the FX market in October with Lava FX, continuing its anonymous model from the equities market. Its plan is to migrate to an ECN-collation service, but it currently has eight banks on the service quoting prices within Lava. Buy-side firms also can trade directly with each other through Lava, but this is an unfamiliar model in FX trading.

"Buy-side-to-buy-side trading is still less than 50 percent of volume on all sites; on Lava, it's 1 percent," Celent's Burns says. "The market has not evolved to a point where the buy side is self-sufficient from a liquidity standpoint."

That isn't to say there wouldn't be interest from the buy side in such a model, but to start a platform solely on that proposition would be tantamount to revolution - or suicide, as it runs counter to the bank-driven model currently in place.

"If there were a platform that was not a monopoly bank system, but that would allow Russell to populate prices and trade on the system, that would open up fascinating opportunities that would fundamentally change the marketplace," Russell's Battye says. "The role of the FX sales person would be radically different. The value-add of FX sales people right now is that they can just pass the price on to you. But if you can access the price itself, there is a whole element of cost in the marketplace that just goes away."

The banks are still very much dominant in the marketplace, and phone trading is still commonplace. Battye uses FX Connect and FXall for smaller transactions and trades larger amounts over the phone, because he finds phone trading is still the best way to trade large blocks discreetly.

He also cautions against becoming too enamored with anonymous e-trading that cuts out the traditional bank-customer relationship, because in illiquid situations, the trader could be left high and dry.

"People look at the marketplace and say, 'If I can chop this other group out, there is an element of cost reduction.' But that needs to be balanced," Battye says. "A trusted partner will make you a price when the marketplace shouldn't. They will lose money on that deal to make more money in the long run from the relationship. The faceless e-platforms will never be able to do that."

Celent's Burns says it's very difficult to generalize about which platform type is truly drawing the buy side because each is meant to serve a different trading style and end purpose. While Hotspot is geared toward active traders interested in making and taking prices, FX Connect is focused more on serving fund managers' portfolio-funding requirements. FXall and Currenex are in some ways in the middle and have expanded their trading and post-trade processing functionality to be more appealing to a broader range of buy-side customers.

"An overall interest from the buy side will benefit all platforms," Burns says. "Certainly, hedge funds are becoming a larger part of the buy-side trading community. Hotspot, and, to some extent, FXall are well suited for that."

It's less likely that FX Connect would benefit from hedge fund interest, since it is geared toward providing processing and other services for large fund managers, Burns says.

FX Connect already provides FX services for 65 percent of global assets under management, says Simon Wilson-Taylor, managing director and worldwide head of Global Link, the State Street subsidiary that runs FX Connect. However, its volume historically has grown by more than 100 percent annually.

American Century's Tai believes that all three models will persist, and that "the exchange model will improve," he says. But he says he expects many firms will stay with the platform that they first began using, incrementally increasing their use of others. "Don't forget how powerful habit is," he notes.