The $4 trillion question: What explains FX growth since the 2007 survey?
by Michael R King and Dagfinn Rime, via VoxEU.org
23 December 2010
Daily average foreign exchange market turnover reached $4 trillion in April 2010, 20% higher than in 2007. This column describes how recent growth is largely due to the increased trading activity of “other financial institutions”, which include high-frequency traders, banks trading as clients of the biggest dealers, and online trading by retail investors.
In April this year, 53 central banks and monetary authorities participated in the eighth Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity (BIS 2010). The 2010 Triennial shows a 20% increase in global foreign exchange (FX) market activity over the past three years, bringing average daily turnover to $4 trillion (Table 1 and Figure 1, left panel). The data show that 85% of the growth in FX market turnover since 2007 reflects the increased trading activity of “other financial institutions” – a broad category that includes smaller banks, mutual funds, pension funds, hedge funds, and other financial institutions. For the first time, activity by other financial institutions surpassed transactions between reporting dealers (i.e. inter-dealer trades), reflecting a trend that has been evident over the past decade (Figure 1, centre panel).
Figure 1.
Table 1.
Given that most of the growth in FX market activity since 2007 is due to increased trading by other financial institutions, the $4 trillion dollar question is: Which financial institutions are behind this growth? The Triennial data do not break down trades within this category of counterparty. Discussions with market participants, data from regional FX surveys and an analysis of the currency composition and location of trading activity provide some useful clues. Taken together, they suggest the increased turnover is driven by:
- greater activity of high-frequency traders;
- more trading by smaller banks that are increasingly becoming clients of the top dealers for the major currency pairs; and
- the emergence of retail investors (both individuals and smaller institutions) as a significant category of FX market participants.
This column based on our recent research (King and Rime 2010) explores the contribution of each of these customer types to the growth of global FX turnover.
Increase in FX market turnover driven by algorithmic trading
An important structural change enabling increased FX trading by these customers is the spread of electronic execution methods. The investment in electronic execution methods has paved the way for the growth of algorithmic trading. In algorithmic trading, investors connect their computers directly with trading systems known as electronic communication networks. Examples of such electronic networks in FX markets are electronic broking systems (such as EBS and Thomson Reuters Matching), multi-bank trading systems (such as Currenex, FXall and Hotspot FX) and single-bank trading systems (such as BARX from Barclays, Velocity from Citigroup, and Autobahn from Deutsche Bank). A computer algorithm then monitors price quotes collected from different ECNs and places orders without human intervention.
