FX Poll 2005: The big get bigger - but is it for the best?

Deutsche Bank is the big winner in Euromoney's 2005 FX survey, which has a significantly larger sample size of $40 trillion this year. It not only outstripped UBS but increased its market share to more than 16%.

SOARING FOREIGN EXCHANGE trading volumes are being handled by ever fewer players. The barriers to entry for full-scale FX providers are getting higher, resulting in widening gaps in market share. Euromoney's 2005 foreign exchange survey has confirmed that this trend is showing no signs of abating. Volume and market share are crucial for banks that want to make big profits in a market with highly compressed spreads. "The name of the game in foreign exchange is to be one of the consolidators, which is arguably the top five or six," says Stuart Gulliver, co-head of corporate and investment banking at HSBC. "The market is tiering itself, so that a smaller number of banks are doing more volumes."

Deutsche Bank clinched top position this year with a market share of 16.72%, a 4.36% rise on UBS's winning score of 12.36% in 2004. UBS slipped to second place this year but still managed to increase its market share to 12.47%. Such figures not only show that the banks at the top of the industry are aggressively fighting for market share, but also that they are gaining it rapidly.

So what is your future as an FX provider if you are not determined to elbow your way into these top-slot positions?

White labelling is one answer. It now dominates the e-FX landscape and has emerged as a lucrative solution for smaller institutions that don't want to be lumbered with the burdensome costs of running a full-scale FX operation. Both Deutsche Bank and UBS have been dominant players in this area, which would account for both banks snatching a significant bulk of the business in the non-market-making banks category, 22.85% and 20.64% respectively. This compares with third-placed HSBC's share of 6.96%. UBS currently has electronic dealing relationships with more than 1,000 banks. "There are two parts to the FX business – manufacturing and distribution," says Fabian Shey, global head of FX distribution at UBS. "You don't have to be in both to be profitable. In fact, it's tough to be in the manufacturing business if you want to be a niche player in the distribution business. We took a strategic decision to invest in electronic dealing in 1999, so we can offer our services to help other banks grow their FX businesses."

E-commerce investment

Barclays Capital, which moved from seventh  to fifth position this year with a market share of 5.85%, compared with 4.08% in 2004, attributes much of its growth to continuing investment in e-commerce, the expansion of client coverage across client types and regions, and the building out of its FX derivatives product. It cites white labelling as an important part of  its business. "We've had this product for a number of years already," says James Van den Heule, director at Barclays Capital in London. "It's certainly something that we will continue to grow going forward."

White labelling is a complicated area of FX – it means different things to different people. "There are many variations of white labelling," says Robert Valdes-Rodriguez, global head of FX sales and marketing at ABN Amro. "A smaller institution may come to us for just back-office services or alternatively they may require prices and liquidity." Either way, there is no doubt that industry consolidation will have an impact on the types of institutions considering white labelling. "You'd be surprised by the conversations we have had across the board in terms of the size of institutions that would like to form partnerships," says Jim Turley, global head of FX and commodities at Deutsche Bank.

Given that the big banks at the top of the liquidity spectrum are now consolidating greater market share, the future holds some questions for the middle-tier banks that aren't big enough today to compete directly in terms of market share but at the same time aren't small enough to be clients. "There are a bunch of banks for whom the results of the survey will be a watershed," adds Turley. "The question now is, are they going to go right or left?"

One FX banker argues that the future of an FX provider will largely depend on its market capitalization. "Take RBS for example," he says. "They are on a huge growth strategy to get themselves into the top six. They can do this because they have a large market cap and therefore a strong balance sheet to invest in this business. If you look at the overall profitability of a bank, you can work backwards and ask, can they afford to do it?" Despite RBS moving down two places to eleventh this year, it did increase its overall market share to 3.62%, from 3.51% in 2004. Over the past couple of years RBS has shown a huge commitment to investing in e-commerce and has been quick to offer its clients a price benchmarking product. RBS FiX provides its clients extra levels of price transparency, which is particularly useful for institutions in a tight regulatory environment.

But what is the minimum size requirement for a major player? "It's hard to draw a line, but let's just say the top 10 to 15 banks are seriously battling it out for market share," says ABN Amro's Valdes-Rodriguez. "I think it will depend on how the top players adjust their strategies in this consolidating environment." 

Ivan Ritossa, managing director and global head of FX at Barclays Capital, does not buy the view that any institution that has a market share of say less than 2% or 3% will lose relevance in the market. "There is not necessarily a correlation between market share and revenue; different banks operate different business models," he says. So banks with a smaller market share may take on white labelling relationships, in whatever form, but they won't disappear from the interbank market nor from the perspective of their clients.

Andrew Brown, head of FX for Europe and the Middle East at HSBC, concurs. "You'll end up getting people who are specialists in their own currency pair," he says. "There will be a hybrid approach from the banks in the middle; they will take liquidity where it's beneficial to them and then they will remain a dominant provider in their domestic currency pair."

But David Puth, global head of FX at JPMorgan, argues that client demand has become so sophisticated now, some niche players may find it difficult. "There is still a role for specialization but, even then, it will be hard to compete because clients like having one-stop shops where they can have access to everything," he says.

Despite the synergies that white labelling brings to both sides of the agreement, it does mean loss of jobs. "If you are running a desk in a small dealing room in Denmark, and you decide to white label, then all your traders have lost their jobs," says HSBC's Gulliver. "If an institution white labels our pricing engines, for instance, then it only needs sales people, no traders or risk managers. White labelling means a significant redundancy programme for any bank taking it on."

Information shortfalls

Sector consolidation will also mean that banks further down the liquidity spectrum will find it harder to obtain valuable trading information. Pricing in the FX business is now so commoditized that there is hardly any margin left to compress. "Among the tier-one banks, everyone is going to be making a brilliant price, and this group is capable of pricing huge transactions with very tight spreads immediately in all market conditions," says HSBC's Gulliver. "You need to have big volumes, good dealers and ensure that you are getting enough flow from both sides of the market. You will make money from the information about the short-term direction of the market that your market share can give you. It becomes much harder for the people down the list to get this information. Additionally, the more you deal electronically with people, the more you can interrogate that data."

Banks that have a greater market share can offer their clients valuable insights into where flows are going. Online research and analytics are big selling points for clients, particularly for the growing number of hedge funds now trading FX. "Different clients want different things from their service providers," says Mike Powell, treasurer and head of global markets for Europe at HSBC. "For hedge funds it's all about trading ideas and how to execute them, so it's important to give them access to information." HSBC aims to target all client segments and it makes no bones about the fact that two years ago it didn't have a particularly strong hedge fund capability. Since 2003, HSBC has been running its FX business globally and has gained greater hedge fund business through its strong cross-border presence.

Research and analytics is a highly competitive part of FX and clients can now access tools that give them the latest forecasts, trade recommendations and research. Deutsche Bank was ranked first this year for its economic and quantitative research and Citigroup remained top for technical research.

If you can't get big, get smart

Despite the hurdles that mid-tier banks are now faced with, there are a number of strategic options available to secure longevity as a profitable FX provider. "If you go back a few years, it was all about the big getting bigger," says Deutsche's Turley. "This is still true but some have just got smarter. If a bank picks which piece it wants to do out of product delivery, risk management and processing and then chooses wisely in terms of partners, then it will be around for a very long time." One senior FX banker notes that one way small to mid-tier banks can ensure survival is by putting a price on the free liquidity they receive from banks higher up in the liquidity spectrum and offering it to a number of less creditworthy clients that wouldn't be able to access such good liquidity directly from tier-one banks.

To this end, several banks have already overhauled their structures in order to establish a more profitable model for their FX operations. Commerzbank used to be a major player in FX but is now thirty-ninth with a market share of 0.17% in Euromoney's poll. However, it began streamlining its FX trading operations towards the end of 2004. It has since increased its focus on mid-caps and corporate clients and now offers a seamless trading operation out of Frankfurt. This year the bank ranked third for "who is best in Frankfurt".

"The FX market is certainly consolidating, so this is why it is important that mid-tier and smaller players focus on their competitive strengths," says Klaus Hoffmann, head of FX trading at Commerzbank. "We think that mid-tier banks will have to focus on their customer base and offer a specialized service to those customers."

In any case, there are valid reasons for customers to consider putting business through a niche player. "The advantage of niche players is their deep understanding of their local markets and customers, which allows them to provide an excellent specialized service," Hoffmann adds. In the past, Commerzbank tried to play a big role in all market segments without having the size to compete with the top 10 banks. It has now chosen a more focused approach and expects to be able to gain a significant market share in its home market, particularly focusing on the options and warrants markets.

But with a shrinking number of market-makers, some FX observers believe that the industry is becoming impracticably top heavy. They argue that banks at the top of this game are pumping out too many prices to too many people. In effect, there is more liquidity being shown on the screens than is readily available to the banks through client transactions, so the concentration of liquidity among a smaller group of banks has logically to exacerbate this.

Less liquid, more volatile

Richard Olsen, chairman and co-founder of Oanda, a futures commission merchant (FCM), which offers FX trading and information services over the internet, believes that liquidity is the most important issue in FX because it affects everyone in the global economy. "Consolidation in the foreign exchange market means that there are fewer market-makers to sell currencies," he says. "With the absence of a substantial number of market-makers, this will move prices. An increase in price volatility will be a direct result of consolidation in the industry." He argues that if these "consolidators" are going to take on more volumes, they must also increase their risk capital. "Five years ago, the total risk capital was $5 billion, but it is now around $2 billion," he says. "So there is a case that banks aren't offering enough liquidity to cushion the in and out flows of the buy and sell orders of their customers. In other words, if market share is consolidating among a smaller number of banks, they must proportionately increase their amount of risk capital."

Banks concede that liquidity is an important issue, and when asked what they consider to be the most important factor for customers, liquidity was a unanimous answer. "There's a lot of liquidity in the market right now but it's absolutely true that if banks all got hit on the same prices at any one time, there could be a substantial dip in the market," says JPMorgan's Puth. "Such scenarios mean that market makers should keep their methods of dealing open, so that a client can choose whether to trade over the phone, on a single-bank trading platform or a multi-dealer platform. Electronic trading does not always enable clients to be assured of liquidity they are getting, so it's vital to have other means available as well."

Mitigating risk

Portfolio manager Adrian Cunningham at BCS Asset Management says that banks are looking to differentiate themselves in this competitive market and "they do try to step up to the plate in the provision of liquidity. While they can never categorically guarantee liquidity at a given price, most now offer pricing grids to provide indicative spreads to counterparties. As a result, there is a confidence in trading in various sizes that may not have been in existence a few years ago." JPMorgan says it has come  up with different ways to mitigate risk such as CLS or establishing more productive credit agreements with clients. Stephen Kemp, global head of FX at Merrill Lynch, agrees that "it is essential for banks to continue to invest in their risk management tools, especially for business transacted on e-platforms". Turley also says that there are enough market makers of sufficient size to take on these volumes and actually help the market rather than hinder it. "When we decided to become a wholesale player in FX, we noticed that it wasn't just about product delivery," says Turley. "It is also about being able to match that in terms of your risk management capability and your processing capability. If you can't scale up all three at the same time, you're going to get into trouble. There's no point having masses of deals coming in if you can't risk manage or process them."

But good risk management comes at a price, and banks have had to plough a huge amount of money into their risk-management systems. "When we moved into the e-commerce space, we made a conscious decision to develop in house," says Vince O'Sullivan, director in FX at Barclays Capital. "Initially this was quite expensive but it has enabled us to react quickly to a rapidly changing market." 

The market has experienced some significant price moves but Gulliver argues that "historically there have been some players that have bullied the market but they quickly worked out that they have to look after the market-making banks. You have to look after the people that give you access to the marketplace – if you beat them up, then the day you need to get out of position quickly they won't quote you. The market has a tremendous self-correcting mechanism."

This rapidly evolving market doesn't stop for anyone. Consolidation is here to stay, so institutions will have to be quick to work out what model is best for them. "The winning formula is pick your strategy, whether it be specific or not, and as long as it's profitable, then that's OK," says Barcap's Ritossa. But as the heavy-hitters at the top consolidate more market share, it will be critical that they adapt their FX operations in line with this growth.