Forex legion

Technology was hot, tech shares were even hotter, and online trading was all the rage as investors rushed to get in on the stock market's seemingly limitless upside.

That was five years ago. Today, thankfully, such a market bubble is only a fading memory.

Or is it?

Take a quick peek at the foreign exchange market circa 2004. Now, as then, investors are pouring in, enticed by a host of automated trading systems promising cheap and easy access to currencies over the Internet. Institutions are hooking up through wholesale networks such as FXall and FX Connect, while retail investors are flocking to online firms like FX Solutions and Global Forex Trading in a rush reminiscent of the 1990s day-trading boom.

"It's a case of déjà vu -- FX today is where stock trading and day trading were between 1998 and 2000," contends Jeffrey Brown, who rode that earlier wave as co-founder and CEO of Hottrend.com, a developer of software that flags unusual trading patterns in securities. (Hottrend was acquired in 2001 by Townsend Analytics, a Chicago-based supplier of technologies for virtually all traded financial products, including forex; Brown is Townsend's head of global sales.)

The biggest of all financial markets, with daily turnover of about $1.5 trillion, forex has seen a surge in trading by investors exploiting the volatility arising from global upheaval (terrorism, the Iraq war and the dollar's long decline) while capitalizing on the proliferation of electronic foreign exchange, or eFX, technology to conduct their trades. This newfangled machinery includes everything from automated order-entry systems to liquidity-seeking tools to order-matching and clearing engines -- the eFX analogs of electronic communications networks, trade order management systems and other technologies that have transformed the equity and bond markets. Connecticut consulting firm Greenwich Associates recently identified no fewer than 60 eFX systems operating today.

The forex market as a whole can't, of course, crash the way stocks did in 2000­'01; even as traders move in and out of currencies, the total volume remains immense. But the superabundance of electronic trading networks suggests that the eFX systems business may itself be caught up in a bubble.

True, eFX has emerged just as the forex market has come of age as an asset class (rather than as a tool for carrying out global trade). In its latest forex market survey, in 2001, the Bank for International Settlements found that the daily volume of transactions by "other financial institutions" -- chiefly investors and speculators -- more than tripled in a decade, to $329 billion, while that of "nonfinancial customers," mainly corporations, rose only 14 percent, to $156 billion. Lately, because currencies are lively while stocks are lackluster, forex has been especially alluring to mutual and hedge funds, which prefer to trade many asset classes electronically, as well as to hard-core day traders. Last year half of the largest institutions -- those trading $10 billion or more annually -- were doing so online, up from 39 percent in 2002, according to Greenwich Associates.

But as in the equity and fixed-income markets, there are limits to how much trading will go electronic; some complex transactions will always require the expert touch of a traditional institutional broker. Robert Iati, director of securities and capital markets at Needham, Massachusetts, research firm TowerGroup, estimates that these voice brokers will retain control of one third to one half of the business.

Still, the potential of eFX is vast, and today's platforms have only begun to tap it. Greenwich Associates estimates that $8 trillion in currencies was traded electronically in 2003. That's a staggering number, but it's equivalent to only about one week's worth of total forex activity.

And what happens when comparative calm returns to the forex market? How many eFX trading platforms can the market sustain then? For that matter, how many day traders?

In equities only three of more than a dozen ECNs formed in the 1990s still control significant market share postbubble: Archipelago Holdings, the Nasdaq Stock Market's Brut and Instinet Group's INET. In bonds -- out of more than 100 e-trading services at the height of the bubble and 77 still extant, according to the Bond Market Association -- MarketAxess, Thomson Financial's TradeWeb and MTS Group in Europe have emerged as the strongest candidates to dominate multidealer trading in a variety of actively traded products.

Forex, by contrast, is still at the point where market players are struggling to create order. Borrowing a page from equities, several banks and brokerages -- including HVB Group of Germany and Prebon Group and Tradition Financial Services, both London-based -- have formed the Trader Notification Service Consortium to promote a standard for presenting a unified view into all electronic trading platforms. "There isn't enough space on the desktop for 20 interfaces to 20 different systems. The banks need a utility approach, a single log-in and single window," explains Arthur Howlin, technical director of consortium member City Networks, a London-based supplier of FX and other transaction-processing systems. And, he adds, "there are simply too many of these systems -- there has to be consolidation."

Yet eFX consolidation, though perhaps inevitable, appears to be a long way off. Overall forex activity continues to expand. Mark Warms, chief marketing officer of electronic trading platform FXall, estimates that global forex trading volume has grown by at least 20 percent since 2001, when the BIS pegged the market at $1.2 trillion. (He expects to see that figure confirmed in the BIS update due out this month.)

Volatility resulting from rising oil prices and geopolitical uncertainty drove forex volumes higher in March and April, and "many commentators are expecting another big move in currencies before the year is out," notes Mark Fitzgerald, director of Barclays Global Investors' alternative-investment group in London. "We're seeing much more interest in currency funds as a stand-alone strategy."

EFX start-ups continue to form, but at a slower pace than a few years ago. TowerGroup's Iati says that this slowdown has more to do with the tapering off of the "typical product cycle" than with the state of the forex market.

Last month Bloomberg signaled its desire to become a major force in forex by announcing a strategic alliance with London-based Cognotec, a leading developer of e-trading software, and this month Citigroup-owned Lava Trading, which made its mark as a liquidity-seeking engine for institutional equities trading, plans to launch an offshoot, Lava FX.

The eFX trajectory, indeed, has been straight up: Last year's e-volume was double that of 2002. Among 472 institutions responding to the Greenwich Associates global forex survey earlier this year, a projected 54 percent of trades will be electronic this year, up from 47 percent in 2003.

The eFX phenomenon is part of a larger trend. Investors, who demanded efficient access and transparent pricing for the stock and bond markets, are now doing the same for the forex market.

"Eventually, all products move to a marketplace model, and it's FX's turn," asserts Harpal Sandhu, CEO of Mountain View, California­based Integral Development Corp., which supplies eFX systems to major banks.

The move to e-trading, in turn, is transforming the very nature of the forex market. "Liquidity used to be an asset that banks held back and got paid for," Sandhu says. "Now flow is the asset that people pay for, just like in the equity market. You used to see many banks risking their capital to make markets in equities; now very few do. They've figured out that to trade huge volumes while avoiding market risk, they have to automate."

The technology of a "marketplace model" has a built-in allure: Liquidity is readily accessible, pricing is transparent, and processing efficiencies mitigate risk. "For traders and technology providers alike, FX is the space to be in right now," says Townsend's Brown. "Investors who were burned by equities are moving in; they find FX attractive because it's easy to get in and out of the market and it's relatively unencumbered by regulation." What's more, a diverse, globe-straddling trillion-plus-dollars-a-day market offers a lot of niches.

New York­based Lava Trading, for one, decided to make a run at forex as the first, logical extension of its original equities system. "A lot of the technology we needed was already built," says Lava CEO Richard Korhammer.

Last month Citigroup acquired five-year-old, 200-employee Lava for a price estimated to be more than $300 million. The fledgling forex venture wasn't the banking giant's foremost consideration -- global equities chief James Forese says Citi wanted to "catapult into a leading market position in electronic [equity] execution" to better compete against the likes of Credit Suisse First Boston and Morgan Stanley. But as one of a handful of global banks that dominate forex trading -- and that have grappled with the entry of Internet-based trading platforms like Currenex, FXall and Hotspot FXi -- Citi is bound to get significant eFX mileage out of Lava.

But can Citi, or any other player or joint venture, ever hope to dominate forex? The sheer size of the market means that it can support numerous electronic platforms. The most apt analogy, say some observers, is not to the stock market but to the U.S. and European fixed-income markets, where the abundance of bond varieties -- governments, corporates, municipals, asset-backeds -- supports a plethora of specialized trading venues. Similarly, the currency market is so big and varied that it can accommodate countless alternatives. And those niches, incidentally, are big enough to attract some of finance's most technology-savvy outfits.

"FX is a powerful market and growth opportunity for us," says Craig Donohue, CEO of the Chicago Mercantile Exchange, which over the past year has moved a majority of forex contract trading onto its electronic Globex platform. "Both the spot and forward markets are increasingly, extremely electronic and are more and more exchangelike in the way they operate. That's a sweet spot for us."

Technology is democratizing the forex market even as it disrupts it. Existing dealers must respond to new competitors and business models, and virtually anyone with an Internet connection, professional or amateur, can get into forex trading. "The market has historically been very tiered -- you have a top wholesale tier consisting of the biggest banks, and then smaller dealers in the next tier and also corporate and retail markets," says the CME's Donohue. "Technology interfaces and exchangelike structures level the playing field and bring costs way down."

Indeed, plenty of online brokerages cater to the retail crowd: Forex Capital Markets, FX Solutions and Global Futures and Forex's Global Forex Trading division, to name a few. The come-ons blare from the latter's Web site: "The most liquid market in the world . . . commission-free trading on more than 60 currencies . . . no restrictions on shorting." Need to get educated? Charge your credit card $50 a month and get unlimited access to GFT's virtual interactive refresher and training course.

Institutional marketing takes place on a somewhat higher plane. Unveiling an exchangelike forex twist of its own in May, the CME linked its eFX futures capabilities with the Reuters FX Dealing 3000 system used by 3,500 institutions worldwide. This permits what Donohue calls spot-equivalent trading of futures by hedge funds and other clients of sell-side brokers. Because of the siloed nature of trading systems, many interbank FX traders had lacked direct electronic access to the CME; Donohue believes the interface will spur growth on both the CME and the Reuters platforms.

"We do $50 billion a day in notional value of FX contracts," Donohue says. The market segment he is targeting is about ten times that size, indicating eFX's potential -- and why people like Donohue find it impossible to ignore.

UNTIL ABOUT FIVE YEARS AGO, FOREIGN exchange was a big headache for people like Paul Shen, head trader at New York­based investment manager R.G. Niederhoffer Capital Management. He had lots of choices -- a multitude of banks offering quotes on various currency pairs -- but the data on his screens was stale more often than not. He could assure timeliness and accuracy only by picking up the phone and speaking to a broker, a process he had to repeat over and over to get the best price.

EFX has changed all that. The unwieldy array of single-bank quotes has given way to streamlined screens of aggregated market data. Shen, like many institutional traders, still looks at multiple screens, but each affords a real-time view into a slice of the market that suits his purposes.

Shen can go in any of several directions, depending on his strategic needs: He uses two open e-trading markets, FXall and Hotspot FXi, as well as a number of systems provided by individual banks. "Each one fills a niche," he says. Smaller trades tend to go to Hotspot; bigger deals are worked through the "institutional strength" FXall or single-bank systems.

Such trading advances did not emerge full-blown during this latest forex market upsurge. The process actually started in the early 1990s, when major banks stepped up automation of what had long been a labor- and paper-intensive, voice-brokered business to improve efficiency and risk management. Wielding their technological prowess and their balance sheets, the banks then consolidated their hold on forex trading, snatching business away from smaller brokers and futures commission merchants that couldn't meet the credit needs of hedge funds and commodity trading advisers, which were just then becoming active in the forex markets.

In 1993 a consortium of international banks that today numbers 13 and includes units of ABN Amro, Bank of America Corp., Citigroup, Credit Suisse First Boston and J.P. Morgan Chase & Co. launched Electronic Broking Services. That London-based technology venture became the forerunner of multibank dealing platforms. With their dominant share of forex dealing, the banks use EBS systems for a majority of global forex volume, and most of the rest goes through Reuters Group's trading network. The new-breed eFX specialists are hoping to grab a chunk of these long-timers' business.

In the mid-1990s finance technologists, venture capitalists and entrepreneurs began to explore the Internet's potential to handle online dealing, not only by banks but also by their clients through direct connections into e-marketplaces. Boston-based State Street Corp. was among the first in eFX: It introduced FX Connect as a trading venue for mutual funds in 1996, and today more than 400 buy-side firms and 50 liquidity-providing banks participate in it. FX Connect's $20 billion in daily volume makes it the most active eFX platform.

Following FX Connect in that early, Internet-fueled eFX wave were Cognotec, which supplied forex e-commerce systems to major international banks, and several multidealer liquidity pools that matched buyers with sellers. These included Atriax, financed by Citigroup, Deutsche Bank, J.P. Morgan Chase and Reuters; Currenex, a Silicon Valley start-up serving the corporate market; and banking consortium FXall (formally FX Alliance), a New York­based venture spun out of the old J.P. Morgan & Co.'s LabMorgan technology incubator. Because it was quicker to get up and running, FXall won the battle of the banks and suctioned liquidity away from Atriax, which closed in April 2002 after 17 months in operation, the lone major venture to have folded.

Atriax's demise led many to predict a shakeout in eFX. But niche-focused platforms continued to thrive. GAIN Capital of Warren, New Jersey, cast itself as a futures commission merchant serving retail and professional traders; New York­based brokerage Oanda introduced the first Internet currency-quote service in 1995 and the FXTrade platform for individuals and institutions in 2001; Watchung, New Jersey­based Hotspot FXi, started by veteran currency traders in 2000, did well in the hedge fund market; and London's Centradia concentrated on the European middle market.

While the eFX providers were jockeying for position, forex-dealing banks developed automated portals to serve clients directly -- even as they supported shared platforms. Thus today's eFX market can be divided into single-bank portals with one set of available quotes (along with proprietary research and other client-targeted benefits) and multibank marketplaces with competing liquidity suppliers. The allure of the latter was to aggregate data from many banks and provide instantaneous exchangelike execution against posted prices.

These days, however, the single-bank portals can essentially match the multilaterals' functions. Although the single-bank platforms offer only their proprietors' prices, those prices are live and in most cases executable -- it takes only a click to initiate a transaction at the displayed price. Most of the multidealer venues offer price discovery from many currency providers but use a request-for-quote, or RFQ, protocol that is not immediately executable.

But these contrasting technologies are converging: GAIN Capital, for example, pioneered streaming, executable quotes in 2000, and Hotspot soon came out with a similar ECN-like execution capability. "We went right to the endgame, developing a marketplace in which customers and banks have equal market information," explains John Eley, Hotspot's president and CEO. He contends that systems clinging to the old RFQ model "have done nothing more than automate a phone call. That's an important stage in the development of the marketplace, but it's not the end stage."

Executable quotes are key to Bloomberg's alliance with Cognotec. "No vendor matches Bloomberg's global penetration of the buy side, and we will link it seamlessly with sell-side banks providing streaming, dealable price quotes and full straight-through processing," says John Beckert, president of Cognotec International in New York.

Scott Greene, a principal of London-based currency fund SRG Capital, is partial to the ECN- or exchangelike model. "It's no different from being in a trading room, where you see live prices," he says. "It's your pulse, your connection to the market."

Hotspot and other upstarts may be penny-ante in a trillion-dollar-a-day market but, thanks to automation, their low overhead theoretically gives them staying power that many traditional, high-overhead voice brokerages lack. Several of the independent eFX ventures claim to be profitable or nearly so. FXall says it turned its first profit in the second quarter of 2003, three years after launch.

The manner in which institutional traders spread their business around ought to give the eFX programs reason for optimism. Of those institutions trading electronically, Greenwich Associates reports, 52 percent use multibank portals and 38 percent use single-bank sites -- and 10 percent use both. Hotspot's Eley reports that a growing number of active traders take a portfolio approach to selecting eFX portals, aiming to optimize execution.

R.G. Niederhoffer's Shen sees advantages and disadvantages to each portal option. On FXall, he notes, traders can request quotes from one to five banks, and the banks not only know who's asking but also that the inquirer can solicit responses from as many as four other banks. "We might deal with one bank or none," says Shen. But he adds that "there's potential for leaving a footprint in the market," because a bank that doesn't get his trade may well suspect that another bank did.

On Hotspot, on the other hand, the trade is dealt out on behalf of a dealer, so Shen's firm stays hidden. He prefers that anonymous, fast-execution route for trades of up to, say, $100 million. But for very large orders, Shen likes a single-bank platform. He explains: "We often get a tighter quote from a bank -- because of established relationships -- than from an algorithm. Banks only allow their computers to generate auto quotes up to a certain amount. If it goes above that, a trader handles the deal anyway."

For his part, Hotspot's Eley is counting on a technological convergence between electronic currency trading and electronic stock trading -- notably, in terms of trader anonymity and instantaneous execution. He notes that these qualities appeal to the growing hedge fund contingent. "It's anonymous trading on a totally open, level playing field," explains Eley. "What's true of Instinet versus market makers on the New York Stock Exchange is true of Hotspot versus EBS" in forex.

To others, anonymity isn't vital at all. "Why would a bank provide liquidity into an anonymous trading model?" asks Warms of FXall, which abides by the relationship-banking philosophy of its bank owners. "There's no motivation to make a price in a significant amount if the other side is unknown."

Here, familiarity (and liquidity) apparently breed contentment. Richard Noble, principal of London-based hedge fund Harmonic Capital Partners, which manages $260 million, uses FXall because, he says, "I do a lot of tickets, so I need a platform that handles high volume."

EFX venues also offer mix-and-match options. ESpeed, the technology spin-off of New York­based interdealer brokerage Cantor Fitzgerald that brought its bond-tested technology to forex late last year, positions itself as a neutral, anonymous platform: Customers can act as both buyers and sellers. "We're composed of multiple buyers and sellers, whoever or wherever they may be," says Nigel Renton, the firm's head of forex.

ESpeed uses the RFQ approach to price discovery but adds a wrinkle from equities and derivatives clearing: a central counterparty. A Cantor unit takes the opposite side of each ESpeed-initiated transaction (as buyer to a seller, and vice versa) -- in essence, guaranteeing completion. Buyers and sellers can hook up without having to establish one another's creditworthiness, as is the case for conventional bilateral trades.

"A central counterparty is unusual in the forex space," admits Renton. And the service wouldn't be possible at all without Continuous Linked Settlement Bank, the two-year-old industry-owned utility that coordinates global interbank forex settlements. Banks are aggregating more than $1 trillion in settlements a day through London-based CLS, which City Networks' Howlin views as another technological driver of increased forex activity: "Growth in the market would be constrained without CLS and the ability to settle payments with certainty in real time."

Forex-dealing banks, meanwhile, are largely staying on top of this crowded scrum. As technology has made it easier to trade currencies, the forex market has gotten bigger, and banks are capturing a fair share of this incremental business through both voice brokerage and their portals, according to Eisso VanderMeulen, director of FX prime brokerage at ABN Amro. The Dutch bank's forex volume grew 30 percent last year.

Clients who used to stay loyal to their banks for years now go where the best price is. Says VanderMeulen: "Portals like FXall, Currenex or Hotspot allow clients to change their banking relationships and put every deal they do up for competitive bid."

TowerGroup's Iati sees the banks staging a successful, indirect counterattack against the eFX intruders. He discerns an incipient trend in which "banks are pulling away from [shared eFX] platforms, and their effort in the next year or so is to drive customers to their own portals." Many prominent forex banks -- ABN Amro, Citigroup, Deutsche Bank, J.P. Morgan Chase, UBS -- operate proprietary portals but are also members of the EBS and FXall consortia while supplying liquidity to the likes of Currenex and FX Connect. It stands to reason, says Iati, that over time they will want to rationalize their investments. "The banks realize these platforms do not offer them sufficient return on their investment," he says. In a multibank forex system, after all, a Citi or a UBS is just one among several equals struggling to differentiate itself and eke out a profit.

J.P. Morgan Chase, in one of the higher-profile attempts of a bank to set itself apart, began developing a proprietary eFX portal two years ago. Forex is now incorporated into the New York­based bank's JPeX electronic trading system, which also executes electronic trades in fixed-income securities and equity derivatives. To handle extra-large or tricky forex transactions, the bank introduced a chat feature that allows clients to "talk" online with its salespeople -- allowing for a middle ground between old-fashioned voice brokerage and all-electronic execution.

Similarly, Banc of America Securities is including forex in an aggressive initiative to upgrade its e-trading capabilities over the next several months. "We consider ourselves a major player in the forex market, but over the past few years we have underinvested and underfocused on this market segment," concedes Scott Freeman, the bank's new head of electronic trading services for global markets.

Nonetheless, there has been no noticeable exodus by banks from multibank platforms. Moreover, there should be plenty of eFX business to go around, provided the forex market -- and the world at large -- remain unsettled. As SRG Capital's Greene notes, the forex market has no "directional bias"; it thrives on volatility tied to geopolitical uncertainties, which have been plentiful since September 11, 2001, and are likely to remain so for years to come.

In this climate the prospects for the leading eFX firms are good. As David Poole, a principal at London-based research firm ClientKnowledge, points out, "What seems to be happening is that investment banks and hedge funds -- which have been trading forex online for some time -- are sending increasingly larger volumes down the electronic pipes because they are used to that protocol." And forex traders who have resisted the electronic age will find themselves tempted by more options as new systems and service enhancements come onstream.

Currencies, unlike stocks and bonds, may not have a directional bias. But it's becoming pretty clear that the directional bias of the forex market itself is toward electronic trading.