A major structural change in the foreign exchange market occurred in April 1992 when Reuters, the news company that supplies the foreign exchange market with the screen quotations used in telephone trading, introduced a new service that added automatic execution to the process, thereby creating a genuine screen-based market. Other quote vendors, such as EBS, Telerate, and Quotron, introduced their own automatic systems. These electronic trading systems offer automated matching. Traders enter buy and sell orders directly into their terminals on an anonymous basis, and these prices are visible to all market participants. Another trader, anywhere in the world, can execute a trade by simply hitting two buttons.
The introduction of automated trading has reduced the cost of trading, partly by eliminating foreign exchange brokers and partly by reducing the number of transactions traders had to engage in to obtain information on market prices. The new systems replicate the order matching and the anonymity that brokers offer, and they do it more cheaply. For example, small banks can now deal directly with one another instead of having to channel trades through larger ones. At the same time, automated systems threaten the oligopoly of information that has underpinned the profits of those who now do most foreign exchange business. These new systems gather and publish information on the prices and quantities of currencies as they are actually traded, thereby revealing details of currency trades that until now the traders have profitably kept to themselves. Such comparisons are facilitated by new Internet-based foreign exchange systems designed to help users reduce costs by allowing them to compare rates offered by a range of banks. The largest such system, FXall, teams some of the biggest participants in the foreign exchange market—including J.P Morgan Chase, Citigroup, Goldman Sachs, Deutsche Bank, CSFB, UBS Warburg, Morgan Stanley, and Bank of America—to offer a range of foreign exchange services over the Internet.
The key to the widespread use of computerized foreign currency trading systems is liquidity, as measured by the difference between the rates at which dealers can buy and sell currencies. Liquidity, in turn, requires reaching a critical mass of users. If enough dealers are putting their prices into the system, then users have greater assurance that the system will provide them with the best prices available. That critical mass has been achieved. According to the Bank for International Settlements, in 2000, 85% to 95% of interbank trading in the major currencies was conducted using electronic brokers.2
2 See BIS 71st Annual Report, p. 99.
The foreign exchange market is by far the largest financial market in the world. A survey of the world’s central banks by the Bank for International Settlements placed the average foreign exchange trading volume in 2007 at $3.2 trillion daily, or $800 trillion a year.3 This figure compares with an average daily trading volume of about $85 billion on the New York Stock Exchange and is 10 times the average daily turnover of global equity markets. As another benchmark, the U.S. gross domestic product was about $14 trillion in 2007.
After peaking in 1998, foreign currency trading volumes fell, largely because the replacement of 12 European currencies with the euro, combined with the rise of electronic trading, greatly reduced the number of currency transactions. This trend reversed itself after 2001 for a variety of reasons, including investors’ growing interest in foreign exchange as an asset class alternative to equity and fixed income, the more active role of asset managers, and the growing importance of hedge funds.
According to data from the 2007 triennial survey by the Bank for International Settlements, London is by far the world’s largest currency trading market, with daily turnover in 2007 estimated at $1.359 trillion, more than that of the next three markets—New York at $664 billion, Zurich at $242 billion, and Tokyo at $238 billion—combined.4 Exhibit 7.4a shows that the eight biggest financial centers have seen trading volume rise by an average of 65% since the last BIS survey was conducted in 2004, even faster than the average increase of 57% between 1998 and 2001. These data are consistent with the fact that foreign exchange trading has historically outpaced the growth of international trade and the world’s output of goods and services. The explosive growth in currency trading since 1973—daily volume was estimated at $10 billion in 1973 (see Exhibit 7.4b)—has been attributed to the growing integration of the world’s economies and financial markets, as well as a growing desire among companies and financial institutions to manage their currency risk exposure more actively. Dollar/DM trades used to be the most common, but with the replacement of the DM and 11 other currencies with the euro, dollar/euro trades have the biggest market share (27%) with dollar/yen trades at 13% and dollar/sterling trades at 12%.