The future of FX trading

The foreign exchange market has remained robust during the financial crisis and continues to grow while more traditional asset classes suffer, says Simon Smith, Research Director at FxPro

 

Trading volumes have increased across the Forex market, and the trend towards migration onto electronic platforms such as FxPro has continued unabated. In Euromoney magazine’s April 2012 e-trading survey it showed that participants (banks, corporates and investors) are executing just 18 percent of transactions by voice, with this expected to fall to 13 percent in the not-too-distant future.

The aim is to generate returns that are uncorrelated, not only with other markets, but also with broader macro themes

New and exciting opportunities for the retail Forex space have resulted from developments in electronic trading and execution. This has narrowed the divide between retail traders and their larger institutional peers and a ‘them and us’ playing field is in most cases becoming a thing of the past. Nowhere is this more apparent than in the field of ECN (Electronic Communications Networks). It may not be the catchiest acronym but it has been one of the most significant developments in making the same opportunities available to both retail and institutional participants.

Trader advantages
ECNs such as FxPro’s cTrader platform work by pooling prices for a wide range of currency pairs from multiple liquidity providers and presenting them to traders on a customised trading platform. By scanning the market for the best bid and offer on any pair at any point in time, bid-offer spreads are, on balance, tighter than what is available from any single price provider. For some currency pairs, bid-ask spreads may approach zero, although this is dependent on the available liquidity and positioning of the liquidity providers.

In addition, traders can view market depth, as most platforms show the size of the bids and offers available on the platform. This element narrows the divide between foreign exchange (known as an over-the-counter product) and products traded on exchange (such as equities), where such transparency is taken for granted. It’s the difference between looking at the outside world through a letterbox or a glass door. The latter gives you a lot more faith about what lies beyond.

With the ECN model, the role and requirements of the broker change. In contrast to a market-maker, the broker acts as the intermediary to the trade, rather than the counterparty. Foreign exchange markets deliver natural advantages to the trader, primarily anonymity with whomever they are trading. It’s often said that markets are driven by fear and greed and, in most cases, participants prefer not to reveal whether they are bearish or bullish. There are exceptions to this rule in the institutional field, but even there key players prefer to trade under the cloak of anonymity most of the time.

The risk factor
There is sometimes a perception that ECN trading is only for the experienced, higher-volume traders. As always with trading, it boils down to what you are most comfortable with. ECN trading is instant – you won’t receive re-quotes. A re-quote occurs when a market-maker will not fill your order at the price you chose, usually owing to fast-moving markets. The counter-balance to this for ECN traders is that they may not always get the price they see, and it is the same with any exit levels (be they stop-loss or take-profit), or pending orders they set.

No ECN provider can guarantee an exact price on these, and market-makers should look to fill as best they can, even if they take some slippage between the market price and the price given to the client. It’s the same when queuing for the last chocolate chip shortbread with your morning coffee. You may see it behind the counter, but who’s to say it will still be there when you get to the front of the queue (you may have to settle for one without chocolate chips). Granted, we’re talking milliseconds in foreign exchange, rather than a few minutes in a coffee shop, but the principle is the same.

In general though, ECN accounts will offer less leverage than ones built around a market-maker model, in part due to the scenario outlined above. The ECN broker has no control over execution prices and so is likely to be more cautious in the leverage offered, ultimately to protect the client. For this reason, opening deposits required will generally be higher because more capital will be needed for any given position in the market.

Knowledge is power
It’s not only technology that has supported the growth in foreign exchange trading in both the institutional and retail fields in recent years. The other major factor that’s been apparent is the increased cross-correlation between many different financial assets. The mantra that has dominated the market chatter has been ‘risk-on, risk-off’. Bonds, equities, metals, credit and some aspects of foreign exchange (e.g. high-yielding currencies) have been caught in the ebb and flow of global risk appetite. In the first two months of 2012, as sentiment improved, stocks took off (the S&P 500 up 8.6 percent) and credit markets rallied, as did high-yielding currencies. This has changed the whole approach to investing, diminishing the risk-adjusted returns from diversification between different asset classes.
A couple of anecdotal stories also highlight this shift. Speaking to a senior banker earlier this year, he recalled how, before the crisis, the divisional heads at major asset managers (of credit, fixed income, equities etc) may have met once a quarter to discuss markets. Each was pretty much disinterested in what was going on in the other sectors, confident that they were on top of the micro factors that were relevant for their respective asset class. Now they meet as frequently as once a week.

Elsewhere, the London-based head of an Asian equities fund has said the first thing he looks at in the morning was not the latest Asian economic data or corporate results, but the moves on Spanish and Italian bond yields. Five years ago, someone in a similar position would have struggled to find these on their news terminal and, in some cases, even on a map. How times have changed.

Yen and yang
So how has foreign exchange managed to be caught up in this development but rise above it? The best illustration is the fortunes of AUD/JPY. The yen, with near zero interest rates, has been one of the primary carry currencies where investors have borrowed. The Australian dollar, with its comparatively high interest rates and strong link to China, has been one of the primary destinations for those wanting exposure to the global business cycle. The result has been a rollercoaster, but one strongly correlated with equities, and other asset classes. Even this has proven to be a tougher ride recently, as the Australian central bank has started cutting interest rates and the world has become increasingly nervous regarding the state of the Chinese economy.

Yet these developments, together with those on the technology side, have helped deliver strong growth in funds trading algorithmic strategies in foreign exchange. Put simply, these are strategies that scan currency pairs for key patterns and execute trades accordingly, with the programs calibrated based on years of data. Trades can be open and closed in seconds. They may stretch to hours, and more rarely days. The aim is to generate returns that are uncorrelated, not only with other markets, but also with broader macro themes such as the carry example outlined above. Expect to hear a lot more about these types of strategies and funds in the coming years, together with more ways to make them accessible to retail investors.

Tricks of the trade
The improved pricing and liquidity – previously only available to institutions – now offers significant risk and reward opportunities to all retail traders, allowing them to profit from the continuing growth of the Forex market. FxPro offers unlimited free demo accounts to traders wanting to test out their strategies in advance and it is a useful tool for both beginners and those with more experience as a way to familiarise themselves with the platform.

Expert advisors, also known as robots, are popular with retail traders. Robots are programs which trade with pre-set rules and can be adapted to FxPro’s cTrader platform using the cAlgo (algorithmic) language, which lets traders build robots and custom technical indicators and work together with a larger pool of collaborators.

Rule-based trading using similar liquidity-pooling platforms to ECNs has become increasingly common in the institutional space as well, which has lead to further technological advancements of benefit to retail traders.

As a result of this, in the years to come, retail forex traders should see better and better opportunities, liquidity, technology and pricing.