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The Hedge Fund Effect: How Hedge Funds Are Changing Electronic FX Trading

Date: Friday, October 27, 2006
Author: Bryan Hunter, FXMarketSpace

In the last five years, hedge funds have had an enormous impact on all of the world's financial markets, but their influence has perhaps been felt most by the largest market, the $2 trillion-a-day foreign exchange market. Today, trading by hedge funds and other asset managers is the fastest growing component of the FX market with a compound annual growth rate of 21%. According to the latest Bank of International Settlements survey, approximately a third of average daily volume came from hedge funds and money managers in 2004, up 20% from 10 years earlier.

This impressive growth rate is estimated to accelerate as the market begins to shift away from more traditional methods of FX trading to electronic trading platforms that are far better equipped to meet hedge funds' needs. Specific demands coming from hedge funds are helping to drive the evolution toward electronic trading and create a solution to address the inefficiencies increasingly associated with the over-the-counter FX market. Tower Group, a leading research and consulting firm, recently said in a report that hedge funds will continue to be the driving force for technology innovation in the FX marketplace. In today's environment, hedge funds need to trade on platforms that offer them complete anonymity, transparency, electronic best execution, speed and direct access. In the traditional interbank FX market, these attributes were in short supply.

As trading platforms have evolved from single-bank platforms, dependent on bilateral customer relationships, to today's more open platforms, it is now possible to trade with a greater degree of anonymity. How truly anonymous trading is varies from platform to platform. Due to the bilateral nature of the traditional FX market, a number of platforms continue to give up names post-trade to allow trades to be settled. Full trade anonymity will finally come to the FX market next year when FXMarketSpace will launch the first electronic trading platform to use the central counterparty model and provide a solution to a problem that has previously been a deterrent for many buy-side firms.

FX trading has increasingly mirrored the practices that traditionally have been used in equities, such as algorithmic trading. This technique of placing very specific buy or sell orders into a quantitative model that then automatically generates the timing and size of orders based on certain goals and parameters, is one way traders seek to optimize performance. Electronic trading has enabled the application of algorithmic trading techniques to become prevalent in foreign exchange. This has helped to enhance execution and pricing of transactions and accommodate the higher-frequency, algorithmic trading style preferred by many hedge funds.

When it comes to electronic trading platforms, some of them lack the robust technology needed to support model-based "black box" trading in the FX market. The interbank market relies on Graphical User Interface (GUI) for its electronic trading needs and so GUI is the most commonly offered access mode. High frequency, model-based traders use an Application Programming Interface (API) as their point of access. Because hedge funds employ multiple trading strategies, they want to be able to execute them on a single platform and need one that offers both GUI and API access. Electronic platforms also need to offer API and GUI traders a level playing field, which allows them to trade by the same set of rules. Some platforms impose different sets of rules for API traders, such as limiting API traders to a certain order size. FXMarketSpace has been designed to meet the needs of both GUI and API users as well as traders who want to access the market through an independent software vendor.

As the FX market has grown in size and become increasingly complex, so has the requirement for quality data that allows hedge funds to have a clear view of the market. This goes beyond price transparency—traders want more detailed information such as knowing what quantities are available, the depth of the book and detailed time and sales data, which they can then use to formulate their strategies. Electronic trading platforms have sought to address this and the quality of information in the market place has improved.

As hedge funds continue to be the catalyst for electronic FX trading trends, the market will need to evolve and keep pace with their needs. The emergence of the more sophisticated electronic trading platforms will help hedge funds to become even more active in FX markets. The result for all market participants will be a more dynamic, liquid and efficient FX market.

Bryan Hunter is the chief operating officer of FXMarketspace.