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International Financial Management December 15, 2006
Topic: Electronic Trading: Technological Comparisons and Special Considerations
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Electronic Trading: Technological Comparisons and Special Considerations. The Internet and Information Technology (IT) have been major forces in every aspect of our lives. These two have touched and altered the way that we go about our day-to-day lives, how we get information and even how we conduct business. Financial trading is no exception; it too has been changed by the connectedness, efficiencies, and wealth of information that the Internet and IT provide. In this paper I will discuss some of the historical background of foreign exchange (forex) trading how it developed, some of the pros and cons of the different models of electronic trading, as well as some of the pros and cons of electronic trading in general as compared to traditional trading. There are a few considerations that come in mind when one compares an electronic medium of exchange to a physical medium where two humans interact. There are definite pros and cons associated with electronic forex, when one compares electronic forex with conventional “open-outcry” systems that are in place now. The pros of electronic forex systems deal mostly with efficiency and improved capability over non-electronic, face-to-face systems of exchange. Electronic forex systems are not location based like traditional forex systems. One does not need to be at a specific place at a specific time in order to benefit from forex. Electronic forex systems can function twenty four hours a day, in many markets internationally. In contrast, traditional forex consists of national markets that do not necessarily speak to foreign markets and are only open for a specified amount of time per day. Additionally, because of their electronic nature, there is a noticeable reduction in errors, errors inherent in human-to-human communication. Electronic systems provide
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two more security features that are usually not inherent in traditional markets: auditing and monitoring. In traditional forex markets there is no audit trail per se, therefore deals might or might not be effectively executed, and there is little recourse, other that the good reputation of the bank. Electronic forex systems also provide monitoring services. Gallaugher provides us with an example of a rogue trader that worked for the Allied Irish Bank that managed to accumulate $619 million in losses before he was discovered. Electronic forex systems would be able to have prevented this abuse with their built-in safeguards. There are of course cons to electronic forex systems. The top three cons associated with electronic forex systems include system failure, reduction of margins, and delays in cancellation of execution of orders. First, reduction of dealer margins is the main non-technical downside of electronic forex systems. Reduction of dealer margins can result in fewer dealers entering into the market, which in turn might affect the quality of service provided by those dealers that remain. The two other downsides of electronic forex systems are a consequence of the system’s electronic nature. First, are inherent system failures such as power-loss, lack of expansion space, and computer crashes. Traditional forex methods are not troubled by power loss or system failure, and if there is a surge of orders, human counterparts can deal with a momentary spike in orders. In contrast, computers that might receive that spike in forex activity, might not be able to adequately process those orders, thus either not executing the orders that were submitted, or malfunctioning to the point that it also corrupts records from previous orders that were in the system. One last con is that there is a limitation of the system appears to be that there is a delay in the processing of
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cancellations of orders. This might discourage clients from submitting limit orders. Since there is money to be made in forex, $1.2 trillion turnover per day according to BIS1, there are three electronic trading mechanisms that have developed to help take advantage of these opportunities. These three are: Telephone trading, interdealer electronic banking, and electronic foreign exchange platforms (“eFX” according to Gallaugher). Furthermore, there are three types of eFX platforms: platforms owned by a single bank, platforms owned by banking consortia, and independent platforms. Each electronic trading mechanism, and respective sub platforms, has its advantages and disadvantages. The first system is actually the lowest tech electronic exchange type of the three: the telephone. Telephone trading does have definite advantages in that it brings the human element to the equation despite the fact that geographic distances might separate the two parties. It is shown that some buyers prefer to interact with a human, rather than a machine, when they are executing their trades, for this reason the telephone does have advantages over eFX and interdealer electronic brokering. This method providers the buyer with more information that the buyer receives using this method because there is a human being on the other end of the line that is able to assist the buyer, whereas with other forms of electronic trading the buyer will need to be more proactive in order to get additional information, and they need to know where to look for it. This of course is provided that this sort of information is available in the first place. Interdealer electronic brokering systems, as the name implies, is only used by dealers. This medium was introduced to promote speed, accuracy, and productivity among sell-side banks. There are two major systems: Reuters Dealing Service (RDS),
Bank of International Settlements Page 4 of 13
established in 1981 and revamped in the early 2000s, and Electronic Brokering Services (EBS), which was launched in 1993. Reuters was an immediate success as it reduced the average transaction time. Both RDS and EBS are the de facto systems. In the year 2000, 90% of interbank trading was conducted using these systems. Finally, there are, what Gallaugher calls, the eFX platforms which consists of three varieties: single-bank sponsored, consortium sponsored, and independent platforms. These eFX systems bring together not only sell-side, but also buy-side parties. In order for a forex system to be successful there are four interrelated forces that interact with one another: business models, network effect and liquidity, market segmentation, and technology. These three eFX platforms can be viewed and analyzed through the interaction of these four. Single-bank sponsored systems are owned and operated by one bank, however other banks can be part of this system. Members of the system compete for the business of the clients in this system with each other as well as the sponsoring bank. An example of this is system is State Street’s FX connect which was established in 1996 as part of their Global Link portal. FX connect provides spot, forward and swap transactions. Along with trades, State Street provides market research, volumes, price swings, and cross country flows to their asset managers and institutional clients. According to Gallaugher, by doing this State Street “demonstrates how synergies among IT enabled core business and monetizing information can generate a competitive resource that is difficult for rivals to match.” State Street here has an advantage over other platforms because they can use their other businesses to subsidize their non-core FX connect, if FX connect does not do well
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on its own. In terms of network effects, because of their established customer base, they can convince their clients to put pressure on their other banks to join FX connect, or risk losing their business. Through strategic alliances, such as the alliance with SunGard, State Street was able to have immediate access corporate forex market. Finally when considering market segmentation factor, FX connect focuses on institutions, which are smaller when compared to other segments such as the corporate segment. Due to the fact that institutions are responsible for the growth experienced in the past few years, the fact that they are specializing in a smaller segment is not a cause for concern. Another type of eFX is the independent platform eFX. These offer multibank platforms where the owner of the eFX platform does not function as a counterparty in the exchange. An example of this type of eFX is Currenex which was established in 2000. This model has strengths and weaknesses for the platform. Its strengths lie in the fact that the owner of the platform does not compete with banks that are sharing the platform. This strength also is able to get the attention of more clients because clients might be attracted to the fact that banking interests do not control the owners. The weakness is evident when you compare this platform with State Street’s FX connect. FX connect has access to information from State Street’s Global Link. This information is useful to clients and provides a value added to the State Street’s FX connect, however independent platforms like Currenex might not have access to this sort of information. The lack of an established bank to back up this endeavor is also a detriment to this eFX model because important factors such as brand awareness, trust and liquidity are not readily available. To combat these weaknesses, independents attempt to attract blue chip clients
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with aggressive pricing and equity stakes, then they leverage these brand name clients for the benefit of their own brand name. Currenex followed this tactic by having Nokia, MasterCard, Intel and Caterpillar on the buy side and Royal Dutch Shell on the sell side to prop it up and gain brand awareness and liquidity. The last type of eFX are Bank Consortia. Bank Consortia evolved after the Single-bank and Independent models had already been in use. They benefit from having already established liquidity, trust, and customer relationships. The problem with the bank consortia is that they are their own worse enemy. Banks are supposed to cooperate with one another, however they are also in competition with one another. As a result of this double edge sword bank consortia are a fragile entity. Spreads get narrower and profits for individual companies decrease in this model. There are two examples, Atriax2, which went under less than a year after it made its debut, and FXall3, which is owned by 13 banks. One last thing to consider with eFX platforms are standards and technological interoperability. Just like any business that is touched by IT, eFX platforms are dependent on the technological soundness and the widespread adoption of the technologies employed. Technological decisions that are not sound can not only raise the costs of implementation, support and learning, but they also raise a wall that prohibits easy adoption. Examples of such bad decision are the technologies used by CFOWeb and Atriax. These technologies were hard for bankers to integrate with their systems. When Atriax went belly up for example, only 20 banks had successfully integrated the Atriax
Members: Chase, Citibank, Deutsche Bank Members: Bank of America, Bank of New York, Bank of Tokyo – mitsubishi, BNP – Paribas, Credit Agricole, Indisuez, Credit Suisse, First Boston, Dresdner Kleinwort Benson, Goldman Sachs, HSBC, JP Morgan Chase, Stanley Dean Witter, Royal Bank of Canada, UBS, Royal Bank of Scotland, Warburg and Westpac banking corporation. Page 7 of 13
eFX platform with their own in-house technologies. When taking all things into consideration, Information Technology as a pervasive technology has marked everything in our lives, including forex. There are a number of ways that technology has impacted the field of forex, and in the process it created new models of doing business. There is no one perfect way of conducting electronic exchanges, as the eFX platforms have shown, however, as we see, they provide viable alternatives to traditional trading mechanisms.
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Exhibit 1: Source: Liu, S. Electronic Trading - New Methods in Financial Markets (2005)
Exhibit 2: Source: Liu, S. Electronic Trading - New Methods in Financial Markets (2005)
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Exhibit 3: Source: Gallaugher, J. and Mellville, N. Electronic Frontiers in Foreign Exchange Trading (2004)
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Exhibit 4: Source: Gallaugher, J. and Mellville, N. Electronic Frontiers in Foreign Exchange Trading (2004)
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Exhibit 5: Source: Gallaugher, J. and Mellville, N. Electronic Frontiers in Foreign Exchange Trading (2004)
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BIBLIOGRAPHY Gallaugher, J., & Melville, N. (2004). Electronic Frontiers in Foreign Exchange Tradingfrom http://portal.acm.org.eresources.lib.umb.edu/citation.cfm? id=1012037.1012040 Hawkins, J. (2002). E-Finance and Development: Policy Issues. http://www.bis.org: BIS. Retrieved November 5, 2006, from http://r0.unctad.org/ecommerce/event_docs/monterey/hawkins-bis-EFfD.pdf Hawkins, J. (2001). Electronic Finance and Monetary Policy. http://www.bis.org: BIS. Retrieved November 5, 2006, from http://www.bis.org/publ/bispap07k.pdf Jogani, A., & Fernandes, K. (2006). Arbitrage in India: Past, Present, and Future. Retrieved November 5, 2006, from http://www.iief.com/Research/CHAP4.PDF Liu, S. (2005). Electronic Trading (ET) New methods in Financial Markets. Retrieved November 5, 2006, from http://delivery.acm.org.eresources.lib.umb.edu/10.1145/1090000/1089729/p900liu.pdf? key1=1089729&key2=2876564611&coll=GUIDE&dl=GUIDE&CFID=7288363& CFTOKEN=55038787 Marossi, A. Z. (2006). Globalization of law and electronic commerce toward a consistent international regulatory framework. Retrieved November 5, 2006, from http://portal.acm.org.eresources.lib.umb.edu/citation.cfm? id=1151454.1151510&coll=portal&dl=ACM&CFID=15151515&CFTOKEN=618 4618 Reixach, A. A. (2001). The effects of information and communication technologies on the banking sector and the payment system. Unpublished PhD, Universitat de Girona Sato, S., & Hawkins, J. (2001). Electronic Finance: An overview of Issues. http://www.bis.org: BIS. Retrieved November 5, 2006, from http://www.bis.org/publ/bispap07a.pdf Sato, S., Hawkins, J., & Allen, H. (2001). Electronic Trading and its implications for financial systems. http://www.bis.org: BIS. Retrieved November 5, 2006, from http://www.bis.org/publ/bispap07d.pdf
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