High-Frequency Trading in FX: Open for Business

A new report from Aite Group entitled, “High-frequency trading in FX: Open for Business” examines the presence of high-frequency trading in the global FX market, providing details on the changing market dynamics of the last three years and analyzing the evolving bank-to-high-frequency-trading relationship.

The introduction of EBS Prime and Ai into the non-bank community triggered the floodgate to high-frequency trading in FX. Despite the influx of high-frequency trading flow, the banks still maintain enough market clout to hold onto their competitive edge. In fact, the FX market remains very much a two-tiered market; single bank platforms tend to interact against customers who can be perceived either as less sophisticated or less sensitive to explicit transaction costs (i.e., willing to take wider spreads to get the trades done). On the other hand, most high-frequency trading is occurring on FX ECNs. While the liquidity ultimately comes from banks, this two-tiered approach has enabled banks to be more efficient in trading against different types of end customers.

Another important thing to note is that high-frequency trading in FX is not driven entirely by independent low latency proprietary shops or hedge funds. In fact, most of the global FX banks have either acquired or developed robust low latency FX prop desks to compete in the marketplace and account for a significant percentage of the overall high frequency market share.

While the banks have gone through a series of consolidations, leading to fewer banks making markets, the FX market continues to evolve with new types of customer segments beyond the traditional corporate and asset manager customer base. Since 2002, actively trading hedge funds and proprietary trading firms have made a huge impact in the FX market, driven by a robust IT infrastructure and development of automated trading strategies.

In fact, some would argue that the large FX banks learned a painful lesson between 2002 and 2006, driven by latency arbitrage strategies in the first wave of high-frequency trading firms. As a direct consequence of this experience, the banks initiated massive overhaul of their trading infrastructure, not only focusing on drastically lowering latency levels within the single bank platforms, but also on developing more efficient pricing engine and internalization capabilities to better manage their risk books against different types of customer segments. It was also during this time that the banks decided to kick out those high-frequency trading firms whose relationships they deemed unprofitable.

Since 2008, however, banks and certain segments of the high-frequency trading community are attempting to peacefully co-exist. As banks continue to increase their internalization efforts, potential liquidity from high-frequency trading firms has become more attractive. On the other hand, high-frequency trading firms have come to realize that banks have a vital position in the FX market; in order to ensure continued success, co-opetition has become a competitive necessity.

FX high-frequency trading is poised to grow quite rapidly over the next few years, as the first-generation high-frequency trading firms are joined by an influx of next generation equity and futures high-frequency trading firms looking to capture uncorrelated alpha in FX. At the end of 2009, high-frequency trading accounted for approximately 25% of overall trade volume. This figure is expected to hit more than 40% by the end of 2012.

In recent months, several traders from major banks have left to start their own firms, taking with them not only their quantitative skills, but also their market structure knowledge, which could potentially pave the way for the next phase in high-frequency trading, in which non-bank trading firms play a larger role in liquidity provision. The first round may be over in FX high-frequency trading, but many more remain before the real winners can be determined in this rapidly evolving marketplace.

About the Author

Sang Lee is a managing partner with Aite Group. His expertise lies in the securities and investments vertical and he has advised many global financial institutions, software/hardware vendors, and professional services firms in sell-side and buy-side electronic trading technology, market structure, retail brokerage technology evolution, and wealth management.