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Home > Blogs > Anthony Harrington > The $4 trillion a day FX market keeps on growing

The $4 trillion a day FX market keeps on growing

FX market | The $4 trillion a day FX market keeps on growing Anthony Harrington

The scale of the foreign exchange (FX) dealing market is enormous and growing. According to an article in the Quarterly Review of the Bank for International Settlements (BIS), the market grew 20% from 2007 to the end of 2010, to the point where it now regularly trades over $4 trillion a day. This was actually a slowdown in the FX market’s growth caused by the global crash. It grew 70% in the three years prior to the crash, and it is now picking up speed again.

The interesting thing about the new growth after the crash is that it has been driven not by the behemoth mainstream banks who have traditionally dominated FX trading, but through the increased activities of “other institutions”. This category refers to the shoal of smaller national banks and specialist boutiques who meet the growing needs of an ever-expanding army of retail investors who want to trade outside the major currency pairs.

To explain, trading in the FX market is always from currency A to currency B, from dollars to euros, or yen to dollars, or sterling to dollars. The major currencies are paired up against each other with the market making institutions quoting bid-ask spreads, which means that there is a slight difference between the buying and the selling price. This constitutes the market maker’s profits. In the “good old days” from the standpoint of the major banks, there was only gentlemanly competition between the big market makers and the bid ask spread range was correspondingly broad. No one, other than the poor old punter, whose opinion on the subject really did not matter, had any interest in narrowing the spreads.

One of the beauties of competition, however, is that it drives prices and costs down. As retail demand has increased and other players have come into the FX market, spread have continued to narrow, making dealing ever cheaper. This, together with the notorious volatility in the currency markets, which can sometimes be very predictable, and often not, has lured large numbers of “ordinary citizens” to take up currency trading in their spare time, or, quite often, as their new, full time “do-it-from-home” job. Many are day traders, making dozens of trades through the course of the day on micro rallies and micro slumps, taking ten pips here and ten pips there out of the market.

With retail demand growing all the time, smaller banks find that they can provide trading facilities so much more easily if they become clients of the bigger banks for the major currency pairs, and concentrate themselves on a range of minor currencies where they can bring in specialist expertise and know how.

Another source of demand in the market today comes from high frequency traders and algorithmic traders. Computerized, rules-based trading using “smart” algorithms takes advantage of small changes in the exchange values of currency pairs. As the report notes:

"A key turning point for algorithmic trading in FX markets came in 2004 when the electronic broker EBS launched the service “EBS Spot Ai”, with “Ai” standing for automated interface […] In 2005 this service was extended to the major customers of banks, allowing hedge funds and other traders to gain access to inter-dealer markets – the deepest and most liquid part of the FX market – via their prime brokerage accounts with the biggest FX dealers.”

High frequency trading aims to profit from tiny incremental price movements, generating thousands of low value trades which are executed in milliseconds. All of this adds substantially to the volumes of FX traded every day, with high frequency traders accounting for about 25% of spot FX activity.

The BIS report points out that the spread of electronic execution platforms is also playing a part in transforming the FX market by “reducing transaction costs and increasing market liquidity”. This in turn benefits all customers, from the retail investor to the bank dealers. This means, however, that being a market maker requires a huge capital investment in trading platforms, which again ensures that the smaller banks can’t compete with the behemoths who run the FX industry on the major currency pairs.

According to data provided to BIS for the report, the investment by the major players is paying off handsomely. Daily average trading volumes on the top single-bank trading systems has increased by up to 200%, the authors say, over the last three years. “The biggest FX dealers, such as Barclays, Deutsche Bank and UBS, have gained market share, reaping the benefits of their IT investment while contributing to the overall growth of global FX markets,” say the authors.

Inevitably, as the costs of trading are driven lower and lower, it becomes much easier for people to engage in speculative trading, with highly leveraged investors such as macro hedge funds piling in at the top end of the dealing range, and retail investors flocking in at the lower end.

“More than any other customer segment, electronic trading has opened up the foreign exchange market to retail investors […] Trading by households and small non-bank institutions has grown enormously, with market participants reporting that it now accounts for an estimated 8-10% of spot FX turnover globally (or around $125 to $150 billion a day).”

Japanese households lead the world when it comes to playing the FX markets, punting an estimated $20 billion a day, or more than 30% of the total FX spot trading in yen pairings. Retail trading is done on margin, which allows the investor to leverage the original stake many times over, creating substantial wins and losses. It might be thought that this is just gambling, of no significance to the “real” business of FX, which is supposed to be about facilitating cross border trading. It is not unusual to hear politicians demanding penal taxes on this kind of “financial transacting” to curb speculation.

However, the BIS points out that the growth of retail investing in FX has added significantly to market liquidity. It has also attracted significant regulatory attention. As the report’s authors note: “The US Commodity Futures Trading Commission recently reduced the cap on retail leverage from 100:1 to 50:1 for major currencies, and down to 20:1 for other currencies."

All the signs are that the number of retail investors keen on playing the currency markets will mushroom over the next few years as electronic trading platforms become more available around the world – unless governments step in to spoil the party and save the citizens from themselves, on the grounds that governments know best…

Further reading on FX trading and cross border trading:

Tags: cross border trading , Foreign exchange , FX , FX dealing , FX risk , leverage , major banks , retail investor
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