The Future of Currency Trading
The foreign exchange market of the future is likely to be bigger, more tightly regulated and more diverse—in terms of currencies traded, the range of market participants, and the technology and strategies applied.
Larger volumes will reflect not only continuing economic growth and greater interconnectedness, but also forex's increasing importance as an asset class. The big banks and hedge funds will become less dominant, as new entrants with different aims and trading strategies enter the market.
Indeed, there are many reasons to believe that the era of the big, high-risk position trader will end. One is the relentless rise of algorithmic, or automated, trading: in 2004, these accounted for just 2% of all trades; this year, for the first time, they surpassed 50%.
Then there are the new types of trader. "The globalization of investment, with insurance and pension funds now major investors in international capital markets, has led to the diversification of entities that regularly turn to the forex market," says Professor Mark Taylor, dean of Warwick Business School in the U.K.
"The market is becoming more fragmented with new players coming in, sometimes from unexpected sectors," says Michael Kitson, an economist at the University of Cambridge Judge Business School in the U.K. These include forex-focused mutuals and exchange-traded funds, which may be the vanguard of a host of alternative mass-market investment products. There is also a growing army of independent retail investors, especially in Asia and the Far East. Mr. Kitson believes that greater competition and market fragmentation will help create a more level playing field.
However, the greatest impact on forex markets may be new legislation, such as Dodd-Frank, EMIR and Basel III. Dodd-Frank's so-called Volker Clause, for example, aims to separate high-risk activities, such as derivatives trading, from retail and commercial banking, effectively restricting proprietary trading by banks (i.e. banks trading with their own money). "A fundamental reason for the volatility is the diminished role of the banks as 'market makers' due to the ban on proprietary trading," comments Patrick Teng, founder and chief dealer of Six Capital. He notes that "banks have started to play broker and the role of proprietary trading is now being taken over by independent entrepreneurial firms (such as Six Capital), banks spinning off independent units or even by hedge funds."
"Clearly, dealers are cutting down on proprietary trading," says Chiara Banti, lecturer in finance at the University of Essex in the U.K., although this may also be because Basel III exacerbates banks' funding constraints. And while dire predictions of disruptive new regulations have not yet materialized, the most likely impact of greater transparency will be narrower spreads. "Restrictions on proprietary trading must have reduced liquidity, so the banks are offloading their orders elsewhere in the market," Prof. Taylor says.
Tighter regulation to prevent rate rigging—for which more than $9 billion of fines have so far been imposed—will make it easier to press charges against individual traders and their managers. However, some regulators are moving faster than others. "The plethora of new financial regulations are not being internationally coordinated," says Mr. Kitson.
Another major effect of new regulation is that banks will execute client orders at the daily fix electronically, eliminating the human element and reinforcing the trend towards algorithmic or automated trading.
Dr. Banti notes that "regulation makes trading more expensive, while low bid-ask spreads renders market-making less profitable. As a result, there is less proprietary trading and a decline in the liquidity provided by dealers."
As to what will be traded, Mr. Kitson expects, "a more diverse pool of currencies, including the yuan and the rupee, to eventually join the main currency pairs traded, as these economies are large and growing faster than the U.S. or Europe."
The very structure of the market is changing. Prof. Taylor foresees a shift from the present "oligopoly" of banks, whose market makers and trading platforms are widely used by other players, towards a multilateral forex market. "The emergence of new players will depend very much on developments in technology and trading platforms," he says.
"Thinking small and looking for ways to aggregate success consistently is the way to create substantial profits and regenerate liquidity," Mr. Teng says.