Traditional FX market volumes are still growing rapidly, but FX is increasingly being used to support other asset class requirements, thereb...

Traditional FX market volumes are still growing rapidly, but FX is increasingly being used to support other asset class requirements, thereby spurring tremendous growth outside the scope of normal FX market participation. With overseas investments continuing to increase as a percentage of investor portfolios, the requirement for currency conversion to support cross-border asset purchases, as well as the need to hedge currency exposures associated with those investments, is continuing to drive this secondary tier of FX growth. Foreign exchange has, for many portfolio managers and traders, traditionally been an activity of less importance. For instance, merely using currency overlay programmes to offset the currency risk arising from trading. This practice still continues but currency overlay is also responding to the changes wrought by technology replacing manual systems. Similarly, the trading of foreign exchange as a discreet asset class is growing in importance: a popularity that is also largely the result of technological advancements. The growth of both activities is the result of key trends - trends that have affected both institutional dealing desks and smaller hedge and retail or “day” traders. The enabling power of technology to widen and deepen market access is at the centre of this story. As the leading supplier of enterprise-wide automated foreign exchange dealing and e-commerce solutions to financial services institutions worldwide, Cognotec enjoys a unique vantage point from which to observe the electronic evolution of the foreign exchange marketplace. Increase in Cross-border Trading Foreign exchange markets are an integral part of a wider financial world market, with participants across all asset classes developing a more global perspective. Ten years ago, the majority of portfolio managers and traders would have traded mainly domestic fixed income, equity and commodities, with currency exchange requirements arising from limited cross-border trading supported via a manual currency overlay programme. Today, there is huge growth in cross-border trading, to the point where even a bank’s retail customers will have an international dimension to their portfolio. It is expected that foreign exchange trading volumes will increase from $2 trillion daily to $3 trillion by 2010 according to a report published by research and analysis firm ClientKnowledge (June 2006), partly as a result of cross-border activity in other asset classes. As a consequence, there has been an increasing need to transact currency arising from the trading in underlying assets as efficiently as possible. Manual hedging is quickly becoming too time-consuming, error prone and expensive, with insufficient scalability to meet high volume requirements. The evolving sophistication of banks’ automated pricing engines means that currency trades arising from the trading of underlying instruments can be automatically priced, transacted and reported to counterparties and associated back offices with no need for manual intervention, thus saving time and money for bank and client alike. Further, this automated FX pricing and execution capability can be easily integrated into traditional fixed income or equity focused electronic communication networks (ECNs). This technology leverage enables banks to seamlessly provide high volume, real time FX price execution in support of cross-border purchases, hedging or as a directly traded asset class. Regardless of the underlying purpose of the trade, these transactions are part of an automated “straight-through process” resulting in dramatic reductions in administrative time, cost and errors, while facilitating real time trade reporting for both the bank and client. The trickle-down affect of this is that the cost of foreign exchange trade support is coming down, and with it the costs of accessing pricing and transacting trades for smaller clients. Thus, the needs of the big bank trading desks are enabling smaller and smaller trading parties to access foreign exchange markets for realistic and affordable transaction charges and at keen rates. FX as a New Asset Class The growth in participants in the foreign exchange markets has in turn lead to the growth of trading FX as a discrete asset class. Foreign exchange has become very popular very quickly partly because of the market’s inherent characteristics, which make the use of foreign exchange for the purposes of diversification very attractive. These have been well documented elsewhere but importantly here include non-correlation with debt and equity markets, particularly with regard to volatility. This allows a portfolio manager to access alpha even when their traditional markets are relatively dormant. For an active portfolio manager, this opens up the ability to exploit cross-asset trading opportunities, over and above opportunities which exist in discrete markets. Again, the convergence of asset classes on the trader’s desk top is the result of the pin-point accuracy of pricing enabled by the new generation of pricing engines. Banks now have the technology to tailor a price based on sophisticated, flexible pricing methodologies and criteria. These prices can then be broadly distributed to a wide variety of end clients using a diversity of distribution channels ranging from proprietary bank web sites to multi-bank portals or in-house trading applications. Another important new characteristic is the continuing reduction in the latency associated with price display and execution: active traders and portfolio managers now know that the price they see – and can execute with a single click of the mouse – is the price they will achieve on the settlement of the deal. Add to this the ability of pricing engines, and bolt-on applications, to perform position netting and margin calculation in real time, and it can be seen that the technology now exists to allow the most sophisticated trading strategies to be automated and thus transacted at a lower cost. At the same time, extra cash flow is freed (via margining) to enable a more efficient allocation of funds across the portfolio. New Opportunities Technology means that traders and managers can now enjoy a situation where seamless cross-asset class trading is possible. For example, a hedge fund manager experienced in cross-asset arbitrage will find new opportunities, as the price information from unregulated foreign exchange markets can now be fed directly into their modelling programmes, thereby enabling a fresh perspective on the relationship between the volatility of discrete asset classes. This may mean an equity-only trader will begin to build black box models using historical foreign exchange data. Such a model would be able to track event-driven activity and use programmable logic to analyse the relationship between events in the equity markets and subsequent activity in the foreign exchange markets, utilising the resultant analytical data to trigger trading opportunities. Increasingly, automated FX pricing and execution technology, such our RealStream solution – working in cooperation with the largest and most sophisticated financial institutions in the world – can enable trading opportunities like these by allowing banks to cost effectively distribute scaleable, real-time pricing and execution to non-traditional FX market participants trading other asset classes– a first for the foreign exchange markets. However, it is clear that this advanced functionality has important implications for all tiers of the marketplace and all kinds of participants. How quickly these new opportunities are exploited will test the responsiveness and creativity of portfolio managers across all asset classes.