Democratisation of risk masks volume discrepancy

The surge in the number of clients willing to take on risk is pushing banks to move towards the agency model and driving underlying growth in daily trading volumes, despite lacklustre activity at top-tier banks and established trading platforms.

In August, data from industry utility CLS showed a 4% rise in average daily values month-on-month and a 9.1% increase year-on-year, while average daily volumes were also up by 11.9% from July. Yet, over the course of this year, the majority of trading platforms and banks reported lower activity.

"CLS volumes are quite strong, even as trading platforms and banks report lower volumes. The reason for the discrepancy may be that the number of market participants continues to increase, including in some emerging market regions," says James Sinclair, co-founder and chief executive of technology company MarketFactory.

While the ability of clients to take and warehouse risk has grown significantly in recent years, regulatory initiatives in the wake of the global financial crisis have severely reduced banks' willingness to do so. The now year-long investigation into the fix and the ensuing raft of suspensions have further dampened dealers' appetite for risk.

"Banks that now have fewer traders may do less volume. Back in the day, when I and others started in FX, traders at banks were the only major risk takers. Today, you see many different market participants, prop funds, retail brokers and some regional banks moving away from being pure clients and taking risk themselves," Sinclair adds.

Among the new risk takers are regional banks. Until recently, they were purely the customers of top-tier banks in the FX space, but are now carving out a niche for themselves in their local currencies as technology becomes more widely available.

"A lot of mid-tier banks are now forced to expand their FX capabilities because they need to protect their customer franchise from the top-tier guys," says a senior employee at a trading platform.

The rise in emerging markets participants has boosted this trend significantly. Local banks in countries such as Turkey, Israel, Poland, South Africa and Indonesia have  begun to challenge the dominance of top global players in their own markets.

"There is an opportunity for these larger regional banks to compete toe-to-toe with foreign ones, using their market expertise and strong client relationships to make better prices. With a winning technology offering that enables the banks to more accurately price their risk, they can now attract a wider global customer base and are seeing increased volumes as a result," says Illit Geller, chief executive of TradAir in London.

Additionally, many clients are taking control of execution, including benchmark-related orders, which they usually passed on to their global dealers to handle. In the wake of the fixing investigation, many clients have turned to execution tools themselves.

"It will be interesting to see what happens when heavy users of the fix start to execute those flows rather than passing it on. Will there be a net increase in volumes or will the overall number remain the same?" asks Phil Harris, head of FX derivatives at Nasdaq OMX.

As the roles of buy- and sell-side participants change, so the relationships and business models will also need adjusting. The move towards an agency model has already started at some of the world's largest currency-trading banks, as compressing margins on principal FX trading compounded the problem of market structure shifts.

"The overall cost of execution has declined by some 80% over the last five years. This is obviously good for us, as buy-side players, but not so much for banks that have to rethink their business models and decide whether the principal or agency route is more appropriate going forward. The core existence of banks is to match flow, but they are increasingly offering tools such as algorithms to offer to customers who want to execute themselves, rather than just matching flows. This trend will continue and I think it's beneficial for the market," says the head of FX at a large European pension fund.