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John Sandman
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Searching for Liquidity in Fragmented FX Pools

As FX ECNs and bank desks compete for buy-side order flow in an increasingly fragmented foreign exchange marketplace, asset managers are using algorithms as well as voice brokers to fill orders.

The foreign exchange market comprises a $4 trillion-a-day business. But despite expanding volume and the growing popularity of FX algorithmic strategies, finding liquidity can be an increasingly chaotic process for the buy side. The presence of multiple foreign exchange trading venues continues to fragment the market, creating a moving target for buy-side firms.

To fill FX orders, fund managers can connect to an FX electronic communications network (ECN) or phone a forex bank with large, complex trades. Meanwhile, active traders -- a catchall term for the electronic market that includes prop shops, high-frequency traders, hedge funds and stat arb firms -- often rely on algorithmic strategies.

"The buy side trades foreign exchange based on what's important to them," says Dan Torrey, head of North American sales for ICAP's electronic FX platform, EBS, explaining firms' liquidity sourcing decisions. "Is it speed? Is it certainty of execution? Is it getting the full side versus a partial fill? Is it nominal price or the whole transaction cost? Is it all of the above?"

According to a recent report from Boston-based Aite Group, the FX ECN landscape is dominated by five major markets: ICAP's EBS platform, which controls 24 percent of the market; Thomson Reuters, which has a 22 percent market share; Currenex (21 percent market share); CME Group (16 percent); and FXall (12 percent). ICAP and the Hotspot ECN, which has 4 percent of the FX ECN market, concentrate on OTC spot forex, the fastest growing and largest part of the foreign exchange market.

But while the ECNs helped pioneer electronic FX trading, forex banks still control a large part of the market, and they are playing the automation game, too. They've deployed real-time internalization systems to match diverse customer flows against their own proprietary trading desks, and they have developed in-house pricing engines to automatically manage their risk books. According to Sang Lee, managing partner of Aite Group, "Most of the global FX banks either acquired or developed robust low-latency FX prop desks to compete in the marketplace and account for a significant percentage of the overall high-frequency market share."

Voice Brokerage: Not Dead Yet

Further, "Many of the larger deals within the interbank trading community and the traditional buy side are still done by voice instead of on an ECN," contends Chip Lowry, senior managing director and COO for eExchange, a division of State Street Global Markets that provides advanced trading solutions for a variety of markets (including FX) and operates the Currenex and FX Connect ECNs. But, he adds, while voice trading remains strong, "Institutional managers may still use an ECN to send the underlying allocations," and the overall trend is moving toward greater e-trading.

ICAP's Torrey indicates that fund managers prefer to call up a voice broker when they need to trade large orders. And, while voice brokers have virtually vanished from actively traded crosses, they still service the more illiquid currencies.

To compete with the banks for market share, the FX ECNs are catering to the needs of different customer groups. "We always look at the market by segment -- corporate customers, for example, aren't typically looking to trade for alpha; they're looking to hedge, and they're more concerned with control and compliance," says Mark Warms, London-based general manager of European operations for FXall, one of the early FX ECNs.

"On the other hand," Warms continues, "we do have corporate and asset managers that have alpha trading strategies and use products aimed at institutional active trading clients. A stat arb or a hedge fund has algo strategies with specialized needs. Our job is to figure out those needs and how to best meet them."

Complicating matters for the ECNs, there's little incentive for the buy side to remain loyal to any one electronic platform, explains an industry source who spoke on the condition of anonymity, adding that best price and best execution trump other concerns when selecting a venue. "The buy-side trader won't want to be limited to one venue -- they'll want to be everywhere," he says. "And why wouldn't they?"

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