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Foreign exchange trading; “Same as it ever was”. A market ripe for disruption

Ray McKenzie

When I first began trading FX in the age when dinosaurs roamed the earth, spot was traded through brokers and once in a while on the Reuters dealing system or via Telex. And of course direct over the phone. It took much prodding, begging and pleading to convince the brokers and the banks to allow Morgan Stanley (where I traded) to be allowed to use the broker market. Our argument was that we really were a customer and not a competitor because we were hedging client flow that the banks wouldn’t see anyway. To some extent that was true, but what the banks feared was also true. We were competitors and planning to edge our way into the lucrative world of quoting the big buy side firms in FX alongside Chemical Bank, First Chicago, LBI and others. Yes I am purposely naming banks that have since been swallowed up. We also wanted to take business away from our cousin JP Morgan and to get ahead of J. Aron/Goldman Sachs (where I learned to trade) who were growing quickly as well.

 In the late 90s and early 2000s electronic trading started to take off, but only in spot and with the CME currency futures which are essentially a proxy for spot . There have been attempts over the last few years to launch electronic market making and trading in forwards, swaps, NDFs etc in FX but there has been no uptake. Even though you can trade spot through 50 platforms and FX futures on CME, ICE, and Liffe, only about 5% of the total daily turnover in FX products is traded electronically or through exchanges. So we are essentially still trading 95% of the FX market today the same way we did when Flock of Seagulls ruled MTV. Forwards, Swaps, Options and NDFs are still basically traded over the phone, through brokers or through instant messages. Why is this so?

 With all the technological advances in trading everything from complex swaps, options and even intellectual property electronically and through exchanges, why is it that 95% of the FX market still trades in such an antiquated fashion? FX forwards are simple. FX options are no different than energy options. FX Swaps and NDFs are simple transactions. There are great electronic platforms that can transact daily futures products in flexible sizes and with flexible maturity dates. The technology exists today and the clearing mechanisms are safe and robust enough to handle all of the OTC FX trading transparently, safely and securely.

 After the near Armageddon that took place in 2008, and the ensuing creation of Dodd Frank, there was a great uproar from some in the FX community to clear everything through exchanges. Spot, Forwards, NDFs, swaps. I had a major bank beg me to clear forwards at the exchange I was working at because they were so afraid the business would disappear altogether.

 But today all is forgotten. There is a movement afoot to pretend the Bear Stearns, Lehman Brothers and AIG debacle never happened. Rip up Dodd Frank and lets go back to the status quo. The banks now have high frequency applications and can compete with the guys from Chicago. Get rid of the Volcker Rule. Never mind the FX benchmark manipulations. The world of FX doesn’t need to change. Lets keep things like they were in the 80s. If it ain’t broke don’t fix it.

 Well I say the time is now to disrupt the status quo in FX. As my good friend Yra Harris says, all markets need TLC. Transparency, Liquidity and Clearing. And FX is about 30 years behind the curve technologically in terms of how it should be traded.

 I envision a world where all FX products trade as futures on a regulated exchange. You could list the entire five year curve in the G 10 currencies and imply prices across the board, the same way as it is done in the Eurodollar futures market. There are expert market makers who would gladly quote these products and clearing houses who would gladly clear them. There are buy side customers who would trade them. You could do cross margining for spreads and swaps and spot and forwards. You could even set up auto spreading to trade FX forwards against other interest rate futures. The spreads would be tight and the liquidity would be excellent. You could cash settle or physically settle depending on what the customer needs. I predict that the volume from a listed set of FX futures across the curve could be larger than the volume today in the Eurodollar market. We are talking millions of contracts in average daily volume. All it will take is for an exchange to have the courage to finally open up the last non transparent and unregulated market in the world of finance. Who will step up to do this? Will it be one of the existing exchanges, or an upstart with Google technology financed by an AliBaba? Whoever does it will be a game changer and will profit greatly. I can’t wait for it to happen. And trust me, it will.

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