3:16 pm - Saturday January 21, 3004

Foreign Exchange: Relationships do matter

Relationships do matter in any market – leave alone foreign exchange market. Without such relationship transactions cannot take place. One can easily assign relationship as a key contributor to any increase or decrease in volumes handled by an individual, institution, geography or the global market place.

One may be under the impression that in a highly automated environment, relationships may not really matter. The spread of electronic trading has only brought about significant changes in structure of the interbank foreign exchange markets and the relationship between foreign exchange dealers and their clients. Even in such an automated environment, relationship is the key for any transaction to take place.

  • Part A –Record growth in Foreign Exchange Market
  • Part B –Execution methods in Foreign Exchange Market
  • Part C – Differentiators in Foreign Exchange Business
  • Part D – Relationship is the key in Foreign Exchange Market

Part A – Unprecedented growth in Foreign Exchange Markets

Bank for International Settlements, Basel, Switzerland conducts triennial central bank survey on foreign exchange and derivatives market activity. The last such survey was conducted in December 2007. As per the findings of this survey, the average daily turnover has grown by an unprecedented 69% since April 2004, to a record US$3.2 trillion. This increase was much stronger than the one observed between 2001 and 2004. Even abstracting from the valuation effects arising from exchange rate movements, average daily turnover rose by 63%.

The growth in turnover across foreign exchange instruments was equally impressive during this period. Of particular mention were foreign exchange swaps and outright forward contracts though sport markets turnover also went up but not to that extent. Changes in hedging activity may have provided the impetus for this growth.

The composition of turnover by counterparty also changed substantially. Transactions between reporting dealers and non reporting financial institutions – hedge funds, mutual funds, pension funds and insurance companies more than doubled during this period. Factors underlying the strength of this segment include strong investor activity.

Currency composition of turnover has become more diversified during this period. The share of the four largest currencies fell and other currencies went up, although US Dollar/Euro continued to be the most traded currency pair. The share of emerging market currencies in total turnover has increased.

Coming to the foreign exchange trading centers, the market share of Singapore, Switzerland and the United Kingdom gained, while the shares of Japan and the United States dropped.

Part B – Execution methods in Foreign Exchange Market

One of the most significant developments in the foreign exchange market over recent decades has been the introduction and growth of new electronic trading technologies. In addition to increasing the efficiency of foreign exchange markets, the diffusion of this technology has allowed new market segments to develop.

First, electronic means of execution are more commonly used for spot transactions, which are more homogeneous and therefore more readily automated. Second, although electronic methods are more likely to be used in the interbank market, their prevalence has increased rapidly to similar levels for transactions between foreign exchange dealers, typically banks, and financial customers, such as hedge funds or pension funds. Finally, the take-up of electronic execution methods varies considerably across economies.

As a result of the increased penetration of electronic broking systems, the efficiency of interbank foreign exchange markets has improved significantly. This can be observed in the decrease in the bid-ask spreads quoted in the interbank market over the 1990s and early 2000s.

One consequence of the associated sharp fall in margins has been a shift by market participants towards a business model that focuses on high volumes of low-margin transactions. The high fixed costs of making the investment required to put in place and maintain the systems that can handle high volumes of transactions have been one of the factors behind the increased concentration of liquidity provision and market making in the interbank market.

Sometime after the development of electronic broking systems became established in the interbank market, some foreign exchange providers developed electronic trading systems that allowed them to transact electronically with their customers. This opened electronic execution methods to counterparties that had not had access to electronic broking systems. Initially, some large foreign exchange trading banks provided electronic execution to their customers through “single bank” platforms.

These largely internet-based systems allow a client to deal directly with their bank and, generally, to automate trading processes. Banks were motivated to develop these proprietary platforms both to create new opportunities as the profitability of the interbank market decreased and to meet demand for foreign exchange services from a range of clients, from smaller corporate customers to sophisticated financial institutions, such as hedge funds.

Subsequently, demand from clients for prices from several sources led to the development of multibank electronic trading systems. These systems allow different market-makers to quote prices in competition with one another. In contrast to electronic broking systems in the interbank market, there are a large number of electronic trading systems that allow clients to execute foreign exchange transactions with banks.

The developments described above have significantly changed the relationship between banks and their customers. In particular, as larger banks have invested in technology to handle large volumes of transactions executed electronically with their clients, a number of new market segments have emerged, such as white labeling, prime brokerage, algorithmic trading and retail margin trading.

The development of electronic broking and trading systems represents one of the most significant catalysts of structural change in foreign exchange markets over the past decade. There has been substantial coverage about the increased penetration of electronic execution methods for foreign exchange and the changes in business models and strategies it has enabled.

Part C – Differentiators in Foreign Exchange Business

A survey was undertaken to ascertain the needs and requirements of the market place in this business. However the key to make this survey a purposeful was in selection of the participants in the survey in addition to its open-ended coverage. The contents were frozen after a pilot study and survey focusing on the processes involved. Considering the importance the emerging world is attracting in the market place, the majority of the participants were selected from these markets. There was also another reason behind this assumption and action. The knowledge base of the customers in the developed world was much better than those of the emerging market. And hence it was assumed that these customers were comparatively well placed.

The customers in the various groups of countries have identified the following as the key areas of foreign exchange business – Skill specific, Customer specific, Marketing and Planning

While Americas and Europe have accorded ‘customer specific’ area as the top ranking, Asia focused on ‘skill specific’ and ANZ (Australia and New Zealand) on ‘Planning’. Other than ANZ, everyone has given ‘marketing’ the lowest ranking. In ANZ ‘skill specific’ issues are accorded the last ranking.

Probably the customers in Americas and Europe require the focus area as ‘customer specific’ issues as they appear to be hungry for new products and services. In Asia the customers expect market players to be more knowledgeable and raise their standards as available in Americas and Europe. In ANZ, the ‘planning’ focus may be due to their felt need for integration and up gradation.

A more detailed analysis of the four key areas of foreign exchange business brought out an interesting revelation.

Skill specific – The customers have voted overwhelmingly in favour of the following components that merit attention and importance under skill specific area – Competitive price, Quote speed, Settlement, Credit rating and Liquidity management

All these components focus on the background and knowledge base and operational skills of the players in the market place. It is indeed heartening to note that customers now demand more from their service providers and would like to dictate a ‘standard’ to the market place

Customer specific – Where the market is more matured, the customers turn in to their specific requirements as the key focus. These requirements have been listed as follows – Selection criteria, Flexibility, Any time /anywhere facility, Relationship and Strategy advice and guidance

One may observe that these requirements are turned towards the individual customers as they expect high quality offerings from the market players.

Marketing – Marketing is an evergreen topic for markets and naturally customers are no exception. However our customers in almost all the country groups have voted to retain ‘marketing’ as a key area but none of them ranked it higher. This does not mean that it has lost its ‘relevance’. The components chosen by the customers to group under ‘marketing’ make an interesting reading – Research and development, Product breadth, Currency breadth, Innovation and Service at door steps.

These components are not ‘plain vanilla’ expectations. Each of them has their specific focus and naturally the customers have prioritized them.

Planning – It is interesting to note that the customers have identified the following components to come under planning – Technology, Risk management, Developing market, 24 X 7 desks and Integration with other markets

Other than Europe, all the other country group customers have retained ‘planning’ as the top ranking (either 1 or 2) key area in foreign exchange business. Probably in Europe the pressure is not felt that much as the customers appear to be satiated – comparatively. An important finding is that the customers from ANZ group expressed their felt need for better integration with the world markets due to their time zone placement.

Compared with the developed markets’ foreign exchange business volume, technology up gradation and best practices, our emerging markets appear nowhere in the picture.

If these emerging markets judge the mood of their markets right and pursue the right strategy, internally enormous scope and opportunities exist for developing their foreign exchange business. To sustain and succeed they may need to start from the end customer perspective and focus on customer orientation in their basic framework. Technology will definitely come to their rescue.

Competitive pricing, relationship with the customer, relationship with the dealing person in customer organization, quote speed, credit rating (of course of the market player), back office settlement, strategy advice and guidance, liquidity, research, innovation, currency breadth, product breadth, 24 hour service / night desks, technology available and risk management are, to name the core issues, in these basic requirements.

There is also a lesson or two for the developed markets to learn. Though they are advanced, their customers are also more demanding and require their market place to specialize in their chosen field and focus on their requirements. This by no means is an easy task. The market place will need more advanced tools and techniques to facilitate them and technology up gradation would be the only solution for this.

This leads us to another conclusion. Whether it is developed or developing market, technology remains the ultimate solution provider to the requirements of the market place in meeting the needs of their customers.

Part D – Relationship is the key in Foreign Exchange Market

With the volatility and liquidity stresses seen during the recent financial crisis, greater client interaction with sales desks at banks has occurred as clients have sought advice on executing trades in the new liquidity environment. Banks would like to monitor such transactions on real time basis on one on one basis.

Data from the foreign exchange markets provide an opportunity to look at the importance of electronic execution methods across economies for different foreign exchange transactions and counterparties. They confirm that the prevalence of electronic execution methods declines as the complexity of the instrument increases. More than half of foreign exchange spot turnover worldwide is executed electronically, whereas less than one tenth of foreign exchange options are. When the electronic executions decrease, relationships take over; periodic customer interactions predominantly rule the market place.

With the ever-increasing volume of business handled in the market place and with every player trying to position aggressively to have a major share, there is a coordinated effort to win over the hearts of the customers. More and more players are willing to invest in efforts to ascertain the requirements of the market place rather than focusing on what they have already to offer. This sincere effort in checking up with the customers on their needs and expectations is building up relationship.

There is already a talk in the market place to focus on relationship based pricing in the foreign exchange market. Some banks have already started interacting with their prime customers. Going by the recent experiences and fall-out audit observations, banks are reconsidering extension of electronic execution over fears of counterparty risk to their customers. Banks will be revisiting their customers to negotiate new terms and conditions for such state of art technology service. And here again the relationship will be the key.

Whichever way you look at – differentiators in foreign exchange business or current imposing trend in the market place – relationship is the key of foreign exchange market.

Without relationship businesses have no existence or relevance. Foreign exchange business is no exception to this cardinal rule.

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