Analysis of forex industry by sander kausDocument Transcript
ANALYSIS OF THE RETAIL FOREX TRADING INDUSRTY<br />Executive summary<br />This report is analysing forex retail trading industry. Defining the industry is based on market participants’ segmentation and on BIS stats collected from 54 central banks and monetary authorities. Industry-specific factors, threats and attractiveness are assessed through five forces analysis (Porter). Broad environmental influences and market development evaluation analysis for next five years is conducted through PESTEL framework (OUP). <br />In conclusion the analysis shows that retail forex market is continuously attractive market over next five years when:<br />
Targeting high trading volumes and/or
Differentiating through additional knowledgeable trading services and/or
Providing profitable proprietary trading to customers.
Defining the forex industry <br />Forex is an acronym for foreign exchange, a market (called also FX or spot market) where currencies can be exchanged in order to do business internationally (Martinez). <br />Forex market is the biggest financial market in the world – it is about 10 to 15 times the size of daily trading volume on all world’s stock markets combined (Galant and Dolan). According to the most recent available data of Bank of International Settlements (BIS) the traditional foreign exchange markets (spot transactions, outright forwards, foreign exchange swaps) daily turnover amounts to $3.2 trillion. This report focuses on spot market, as the forwards and swaps are foreign exchange derivatives and therefore differently regulated, different in characteristics of market players and customers. <br />Table 1 presents the turnover of forex markets, whereas spot trading represents a turnover of ca $1 trillion per day. <br />Table 1. Daily turnover of global forex markets (BIS).<br />According to BIS survey the retail trading market forms a 57% of FX trading spot market – a daily turnover of $570 billion. Forex retail trading firms are market players who provide currency traders with access to an open trading platform that allows them to buy and sell foreign currencies (Olsen).<br />Beside high trading volume there are two main features that distinguish forex markets from other financial and currency markets (Cabrera): <br />
Speculation accounts for most of the volume;
Transparency is low.
Galant and Dolan estimate that upwards of 90% of FX trading volume is based solely on speculation. The markets speculative nature comes from a zero-sum game logic: there is a corresponding loser for every winner. ‘Forex market makers don’t care about the absolute value of any currency – their primary concern is the relative value that will result in a trade’ (Olsen). <br />As a globally open market with no central market place it is very hard to control and regulate the market. Therefore the transparency of pricing, profitability, supply and demand is low. Appell describes that the profit making in forex market is one of the worst kept secrets. In retail trading the profits are mainly produced over the spread of the trade, which in average is 0.03% from the volume of a trade (Salcedo). Based on the latter and BIS stats the estimated profit of providing spot trading should amount to $62.7 billion a year. Some proof to this calculus can be found from U.S. government sources whereas ‘currency trading has been the richest source of trading revenue for U. S. banks over the past 12 years, accounting for $2.1 billion of the $5.2 billion total trading revenue in the second quarter of 2009’ (Appell).<br />Identifying and segmenting the participants<br />Forex market has no central marketplace and is best described as a decentralized multiple-dealer market (NFA). There is no physical location where dealers meet with traders nor there is a screen that consolidates all executable quotes in the market (Cabrera). The current market participants are (Cabrera, Olsen):<br />
Governments and Central Banks – implementing monetary and economic policies (non profit oriented)
Banks and Investment Banks – providing services for their commercial customers or trading own accounts (proprietary trading);
Hedge Funds – leverage and diversify their investments;
Businesses – international trade;
Individuals and SME-s – trade currencies for purchases or speculation.
Their interrelation is described in Chart 1.<br />Chart 1. Forex market participants and their interrelation (Olsen)<br />Five Forces Analysis<br />Porters five forces analysis is conducted in order to assess the attractiveness and threats of the industry (Porter). <br />Threat of new entrants is high, because the market is unregulated, growing and commoditised. ‘In recent five years retail electronic trading in the FX spot markets has been exploding with newcomers’ (Cabrera). <br />‘The great divide between the “big banks / investment banks” as whole sellers and the “retail brokers / market makers” is diminishing’ (Olsen). The competition is fierce and market is upward and backward integrating as large market players loosen their trading conditions (minimum trading amount) in order to attract more retail customers and small and vital players grow from retailers to interbank market participants. For example Citigroup has agreed to sell its LavaFX foreign-exchange trading platform to retail electronic platform FXall (American Banker). The process of concentration as global trend can be noticed also from BIS report provided in Table 2.<br /> <br />Table 2. Global concentration of forex industry (BIS)<br />The consolidation is related to economies of scale where profitability from providing trading platforms is related to large volumes.<br />The power of suppliers and buyers is very low as ‘forex market has no central marketplace’ (NFA). Trading takes place in a number of well accessible interconnected markets, volumes are high and trading facilities are automated. ‘Even very large currency traders and institutions are rarely able to single-handedly drive the direction of market or prices’ (Olsen). Spot trading has high growing interest for newcomers because it is accessible to everyone, is related to liquidity and offers plain cost (spreads) on trading (Olsen).<br />The threat of substitutes is high. As driven from speculation all other financial trading systems are potential substitutes. Market participants have responded to this threat by providing low entry and exit cost, high liquidity and value adding professional on-line trading advice. <br />Competitive rivalry is very high among market participants. The similarity in commoditized trading platforms has resulted in high cost competition. Differentiation between competitors is provided through additional value adding services like market analysis, trading assistance, trading hints etc in order to provide winning and profitable trading strategies for customers. Many market players have started proprietary trading – deciding and making trades on behalf of their customers. <br />Summarising the analysis of five forces one can notice that the industry is attractive because of its growth and high liquidity. Open, unregulated and easily accessible market has led to fierce cost competition. Differentiation comes from additional value adding knowledgeable services with an aim to provide higher profitability for customers’ trades or customers’ capital under proprietary trading. <br />Strategic analysis through PESTEL framework<br />In order to externally and strategically analyse the attractiveness of forex retail trading market and its different macro environmental factors an analysis based on PESTEL framework was conducted for understanding market movements, business potential and further directions for operations.<br />At odds the forex market is equally positively affected through political, environmental and economic factors over large and abrupt changes. Abruptness and uncertainty create volatility thus rapid movements on currency markets which attracts speculative capital. For example in contrary to expectations the ongoing crisis has fuelled the market.<br />Political factors. In general FX markets are lightly political because developed nations want to release restrictions on the flow of global capital (Galant and Dolan). For example after China relaxed forex controls in 2005 (Country Commerce: 85), the daily average trade of Renminbi 9-folded during 18 months (BIS). Because of its global size local political factors usually have little long term impact to the market. For example if UK would join euro zone then the global forex trade would decline only 2% (BIS). I think in next five years the political intervention to the forex market fundamentals will continually diminish.<br />Economic factors. Forex market is global, borderless and liquid financial market that operates 24 hours a day (NFA). According to Keynes macroeconomic uncertainty (crises) lead people to stay or invest in more liquid instruments (Skidelsky). Because of its high liquidity, growth and profit potential, easy entry and exit I think forex retail market is continuously attractive market in next five years. Fierce cost competition will be opposed with value adding knowledgeable trading services with an aim to attract customers over higher profit potential. As a zero-sum game, trading needs discipline and comprehensive market context analysis and therefore the service of proprietary trading will have significant role in growth potential. <br />Social factors. Retail forex trades are not guaranteed by a clearing organisation and forex arena has not been the safest for participants (Salcedo). Over the last few years, there has been a sharp rise in foreign currency scams (NFA). This ethical issue has alerted governments to regulate the market. Although in U.S. NFA tries to regulate it, the global openness has enabled them to regulate many but not all forex firms (NFA). Despite additional regulation will most probably appear in next five years, the ‘increased legitimacy and transparency should fuel forex’s continued growth’ (Salcedo). <br />Technological factors. Trading in the FX spot market is typically commission-free when done over electronic trading systems, and the spread has fallen dramatically over the last five years as a result of improved technology (Olsen). ‘Trading systems have been so far the collection of indicators and chart patterns that one examines to determine when to enter or exit a particular market’ (Jurgilas). <br />The speculative nature of the market is interested in relative movements of currencies. The latter depends on large amount of information and variables. Winners are those who can interpret them quicker and more accurately. I believe that in the future computerised analysing tools will play very significant role. The future of electronic trading systems is related to how quickly and in which quantity and quality information is interpreted in order to be winner in this zero-sum profit market. Better handling of information is vital in order to maintain and attract customers. <br />Legal factors. Forex has so far been largely unregulated marketplace (Olsen). I think low transparency and legitimacy will lead to additional regulation in order to protect newcomers and relatively small participants in forex trading industry. Especially it will take place in proprietary trading where traders collect customers’ money for speculation on behalf of customers over their own account. This trend will result in higher regulatory and capital need barriers to entry the market. For example in U.S. you have to apply for membership in NFA and obey their regulation in the market, e.g. net capital has to equal at least $20,000,000 (NFA).<br />In conclusion the PESTEL analysis shows that the market should stay attractive during next five years. The continued growth potential and fierce cost competition will lead to attaching value added services to trading systems. Proper information synthesis of the currency markets impacts customer profitability which will become the driver of scaling the volume of trading. Higher needs for comprehensive market knowledge and professional approach increase customers demand for proprietary service. The latter impacts more intense regulatory activity.<br />Sander Kaus <br />May 28th, 2010<br />References<br />American Banker. 1/5/2010, Vol. 175 (2).<br />Appell, D. Forex fees facing scrutiny. Pensions & Investments, 11/2/2009, Vol. 37, (22).<br />Bank of International Settlements. Triennial Central Bank Survey. Foreign exchange and derivatives market activity in 2007. Dec 2007.<br />Cabrera, J. 2009. Essays in market efficiency. City University of New York.<br />Country Commerce. China; 2010, p84-89<br />Galant, M., Dolan, B. 2007. Currency Trading For Dummies. Indiana: Wiley Publishing. http://mediaserver.fxstreet.com/Reports/7ca9c4ce-1c56-42f3-958f-236e341d243d/17935e1c-f791-43d3-90e0-cbef11cd3019.pdf, retrieved 20/05/2010.<br />http://www.bis.org/publ/rpfxf07t.pdf, retrieved 21/05/2010.<br />Jurgilas, M. 2007. Interbank markets under currency boards. University of Connecticut.<br />Kurov, A., Lasser, D. 2004. Price Dynamics in the Regular and E-Mini Futures Market. Journal of Financial & Quantitative Analysis, Jun2004, Vol. 39 (2).<br />Martinez, J. 2007. The 10 Essentials of Forex Trading. NY, USA: McGraw-Hill.<br />National Futures Association (NFA), http://www.nfa.futures.org/, retrieved 20/05/2010.<br />Olsen, R. 2009. Investing in Currency. <br />http://mediaserver.fxstreet.com/Reports/7ca9c4ce-1c56-42f3-958f-236e341d243d/17935e1c-f791-43d3-90e0-cbef11cd3019.pdf, retrieved 19/05/2010.<br />Oxford University Press (OUP), 2007. PESTEL analysis of the macro-environment, http://www.oup.com/uk/orc/bin/9780199296378/01student/additional/page_12.htm, retrieved 18/05/2010.<br />Porter, M. 2008. The Five Competitive Forces That Shape Strategy. Harvard Business Review, January 2008<br />Salcedo, Y. 2004. Forex FCM report. Futures, Apr2004, Vol. 33 (5).<br />Skidelsky, R. 2009. Keynes. The Return of the Master. London: Penguin Books <br />