The foreign exchange (FX) market is the largest and most liquid financial market in the world, and foreign exchange trading increased by 70 percent between 2004 and 2007. The volatility that has characterized the FX markets in recent months, is also one of its key attractions to investors, coupled with its high liquidity and low costs per transaction.

The continued growth in value of FX over the past few decades is a reflection of the globalisation in international trade and expansion in global finance and investment. Driving growth has been the increasing involvement of retail investors, hedge funds and the accumulation of official exchange revenues by emerging markets. Facilitating this dynamic market has been technological innovation, most notably the development of internet broadband and sophisticated trading platforms, which have driven accessibility to a greater number of investors.

Despite its recent depreciation, the dollar is still the most widely traded currency, due to its multiple roles: as an investment currency in a number capital markets; as a reserve currency of many central banks, as a transaction currency in many international commodity markets; and as an invoice currency in many contracts. The UK, and London in particular, is by far the largest global market for FX trading, well ahead of the US and Japan.
Recent trends

The traditional foreign exchange market recorded an average daily turnover of a record $3.2 trillion in April 2007 (according to BIS), accounting for 90 percent of overall turnover. Overall turnover, including non-traditional foreign exchange derivatives and products traded in exchange averaged nearly $3.6 trillion a day. Within this total, spot transactions accounted for 31 percent (down from 38 percent in 1998), outright forwards 11 percent (up from 9 percent in 1998) and foreign exchange swaps 53 percent (up from 49 percent). In the period between the launch of the Euro in 1999 and mid-2000, the dollar appreciated against most major currencies. Since then it has generally been on a downward trend, whilst the euro has continued to gain strength.
Technology a key driver of growth

All brokered business until the early 1990’s was handled by telephone, but over the past few years, electronic broker systems, or automated matching systems have gained a significant share of the spot Interbank market. The development of electronic trading has the advantage of being transparent and providing good liquidity; it also means that there is a great deal more choice in how investors connect to the market. According to Tabb Group, electronic trading accounted for over 60 percent of turnover in 2007, and this figure will approach 80 percent by 2010.

Advances in internet technology and the development of sophisticated software packages have enabled the foreign exchange market to be accessible to a rapidly growing pool of individuals. These advances have driven the introduction of non-traditional players such as retail investors to invest in FX. As internet trading platforms have become more sophisticated, the customer segment of the foreign exchange market has become more competitive and has enabled the emergence of non-bank service providers.

CMC Markets, based in Australia, launched the world’s first online real-time FX trading platform in 1996, and the company’s Marketmaker software provides private investors access to institutional style trading products, including FX. Demonstrating how technology is increasingly shaping the market, the company recently launched a mobile phone version of Marketmaker, which gives investors even more trading flexibility to monitor prices, positions and place trades on the move.

In the October-November issue of World Finance, Nicholas Bang, Managing Director of AMC explained the demands placed on automated service providers: “Our market is very competitive. As an online broker you have to constantly improve your services in order to stand out from the existing offer. Many of the early online sites did not perceive this constant need for innovation and improvement and consequently fell by the wayside. In-depth analysis is obviously crucial to what we do”.

Retail trading
The introduction of non-traditional players into the FX market, has resulted in a declining share of activity for inter-dealing trading. Advances in technology have reduced the need for intermediaries, driving the involvement of retail investors; inter dealing trading generated 43 percent of FX activity in April 2007, down from 63 percent in 1998. Stavros E Stavram, Managing Director of FX Pro, a company helping individual investors manage trading in the forex marketplace, told World Finance in its February-March 2008 issue, “During the past few years, retail investors have been able to participate in the forex market by utilizing the trading platforms of companies like FX Pro, though even today they represent a small fraction of the overall forex market”.
Role of hedge funds

A growing number of counterparties have entered the core and downstream markets, using both traditional interbank markets and the downstream retail offerings. In part the growth has been due to the increasing participation of hedge funds treating foreign exchange as an asset class in its own right, which have contributed to driving this expansion in values.

Hedge funds, such as George Soros Quantum, have gained a reputation for aggressive currency speculation since 1996, most notably on Black Wednesday (September 16, 1992) when Soros himself was dubbed “the man who broke the Bank of England”. Hedge funds control trillions of dollars of equity and may borrow millions more, and thus have the power to overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are right.
Role of emerging markets

A driving factor in the money market turbulence of 2007 and early 2008, has been the accumulation of official foreign exchange reserves which increased significantly in 2006, limiting the effects of upward pressure on currencies in the Asian region, and in a number of oil exporting countries. China showed the largest accumulation of FX revenues in absolute terms, followed by Russia, which registered the second largest increase, double that of 2005. As a result of exchange rate intervention, both Brazil and India also recorded large increases in foreign exchange accumulation. In the current environment, with the dollar depreciating in value, the concern is that these emerging countries will seek to offload their dollar reserves on to the global foreign exchange market.
Leading players

Foreign exchange trading is dominated by large banks, and has becoming increasingly concentrated in recent years due to mergers and acquisitions. According to Euromoney’s 2007 FX poll, the top three banks account for more than 40 percent of all trading in 2007, up from 22 percent of the top three dealers in 2000. Deutsche Bank captured a 19.3 percent market share in 2007, nearly identical to 2006, representing $24 trillion worth of activity. UBS is second, but its market share has risen almost 5 percent points to an impressive 14.85 percent. Citi were third, RBS fourth and Barclays Capital fifth.

The future
In the short term the USD has continued to depreciate against major currencies on the back of unattractive interest rates and deteriorating economic conditions. According to Scotiabank group, European currencies will receive a boost from gold differentials and renewed global portfolio diversification away from the US dollar. In terms of growth, emerging market currencies will find support from favourable growth and interest rate differentials, high commodity prices and a sustained appetite for carry trade portfolio investments.

In the long term, developments in technology will drive growth, as the global financial community becomes more integrated. This will present challenges for professional trading organisations, in ensuring that they make the business case for investment in transactional tools and the source market data to inform their trading decisions. Despite the economic uncertainty, the foreign exchange market is continuing to show strong growth, and the outlook is positive for providers. According to FX Pro’s, Stavros E Stavram, “the forex market will continue to be the leading market in the world capital markets in terms of volume and liquidity. Investors should take note.