THANKS TO THE RISE OF HIGH FREQUENCY TRADING in foreign
exchange markets, many smaller banks have found themselves
squeezed out of buying and selling major currencies like the
euro and the British pound. Those banks are concentrating on
higher-profit trades in emerging-markets currencies and
developing other businesses where they have a competitive
High frequency traders have had the same effect on foreign
exchange that the conversion from eighths to penny increments
had on equity trading, says Marc Chandler, global head of
currency strategy at Brown Brothers Harriman & Co. in New
York. Major currency pairs now get quoted to an extra decimal
point. For combinations such as the U.S. dollar and the euro,
that means banks are trading on thousandths of a euro cent.
We found that spreads between bid and asked are
narrowing at 9 percent a year, and high frequency trading is
accelerating that process, Chandler says. We have
to grow our volume by 10 percent a year just to break even,
which is harder and harder to do because its like
compounding in reverse.
In their 2010 paper on foreign exchange, economists Michael
King of the Bank for International Settlements and Dagfinn Rime
of the Norwegian central bank noted that high frequency trading
on electronic networks is marginalizing small firms. The
tight bid-ask spreads and guaranteed market liquidity on such
platforms are making it unprofitable for smaller players to
compete for customers in the major currency pairs, King
and Rime observed. Increasingly, many smaller banks are
becoming clients of the top dealers for these currencies, while
continuing to make markets for customers in local
Sang Lee, managing partner at Boston-based research firm
Aite Group, estimates that high frequency trading accounts for
36 percent of the $4 trillionplus daily turnover of
foreign exchange globally. But in contrast to the equity
market, where high frequency trading is the domain of specialty
firms, proprietary trading shops in foreign exchange must now
compete with big banks like Deutsche Bank, JPMorgan Chase &
Co. and Royal Bank of Scotland Group. Those players all have
specialty platforms that allow customers to participate in
their algorithmic trading, much of which is high frequency. The
banks act as market makers by setting prices.
Lee thinks multinational companies, investment firms and
other traditional buyers of foreign exchange will keep relying
on smaller banks because they provide credit and other key
services. In turn, smaller banks use their big
counterparts high frequency platforms.
Ed Mount, an American who became London-based head of FX
technology-based trading for RBS last September, says his
banks expertise in algorithmic trading has attracted many
new customers, including smaller banks that used to be rivals.
Were market makers to them now, Mount notes.
They aggregate prices from larger banks, and then they
provide a personal relationship with their clients. Were
giving them more and more of our tools as well, and they are an
important distribution mechanism to us.
Computerized trading is also drawing clients like investment
managers with large portfolios of foreign shares that need to
hedge currencies quickly using thousands of pieces of data,
Mount says. The algorithms are instrumental in performing gamma
hedging, a type of portfolio rebalancing based on price
movements of the underlying securities.
Besides compressing spreads, high frequency trading makes it
more profitable for proprietary shops like Chicago-based Getco
and Austin, Texasbased RGM Advisors to do thousands of
small transactions, shrinking the size of individual
Many firms for which trading Group of Ten
currencies is no longer worthwhile are choosing to specialize
in emerging-markets currencies, where spreads are much wider,
BBHs Chandler says. If you give a bank a choice
between doing $10 in Brazilian reais and $100 in euros, they
will make more money in $10 worth of reais than in $100 worth
of euros, he asserts. Its not the volume;
its how wide the spread is.