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Electronic foreign exchange trading struggles to keep pace with market surge

Electronic foreign exchange trading volumes increased by 21 per cent from 2006 to 2007, but this was not enough to keep pace with the surge in global foreign exchange markets last year - a sign that the electronic trading business could be entering a phase of more mature development, according to a new report from Greenwich Associates.

By almost any standard, last year was a good one for electronic trading systems, the firm says. In addition to the overall increase in trading business, e-trading systems continued to attract new users, especially among the world's most active foreign exchange traders.

According to Greenwich Associates' 2008 Global Foreign Exchange Research Study, market-wide foreign exchange trading volumes jumped 36 per cent last year, however, causing the global share of forex trading executed electronically to shrink from 50 per cent in 2006 to 43 per cent.

Greenwich Associates tracks foreign exchange trading volume among end-use customers; figures quoted in this report exclude inter-bank transactions and volume generated by other sources. Its says that until last year, electronic trading systems were gaining new users and new business from foreign exchange market participants around the world at a relatively consistent pace.

Electronic trading accounted for 20 per cent of global volume in 2003 and 30 per cent in 2005 before reaching 50 per cent last year, but the results of the latest study suggest that trading practices have begun to diverge among different types of user in different regions.

'This finding supports the notion that eFX is leaving behind its initial stage of dramatic, across-the-board growth and entering a more mature period in which market participants begin to self-sort into active or infrequent users of electronic trading systems based upon their needs and strategies,' says Greenwich consultant Peter D'Amario.

Worldwide electronic foreign exchange volumes rose to USD43trn in 2006-07 from USD35.5trn the previous year. Greenwich says this growth lagged the expansion in total trading volume in part because the boom in overall business was driven by increases in the trading of options and emerging market currencies, which are not particularly conducive to electronic trading.

The full story of why e-trading declined as a share of total foreign exchange trading as a whole last year, however, is much more complicated, the report's authors say. The share of market participants using electronic trading systems for at least a portion of their business increased from 53 to 55 per cent, a statistically significant increase in the context of the more than 1,700 companies and institutions participating in the research.

At the same time, the proportion of foreign exchange users telling Greenwich Associates that they have no plans to start trading electronically continues to shrink, from 36 per cent in 2006 to just a third last year.

'Among companies and institutions that are regularly in the market, it is becoming increasingly rare to find one that does not use e-trading systems for at least some part of their FX trading business,' says consultant Woody Canaday.

However, the study reveals a growing divergence in usage patterns between large, active traders, generally financial institutions, and accounts that generate relatively small amounts of annual trading volume. More than 80 per cent of the world's most active foreign exchange traders, those that trade more than USD50bn every year, use e-forex systems, up from 77 per cent in 2006.

However, usage rates decline with overall trading activity, and although the share of corporations reporting that they use electronic trading systems increased to 43 per cent from 40 per cent in 2006, usage remains far lower than among banks (90 per cent), hedge funds (65 per cent) and fund and pension fund managers (55 per cent).

'Our research reveals a significant spike in e-FX usage among fund managers and pension funds, which see electronic systems as a means of documenting best execution in keeping with stricter demands from regulators,' says Greenwich's Frank Feenstra.

On a regional basis, electronic foreign exchange usage patterns seem less influenced by differences in trading strategies and more driven by cultural preferences and the state of development of e-trading systems in terms of technology and liquidity.

E-trading providers have the highest level of market penetration in the US, where more than two-thirds of foreign exchange market participants trade electronically, up from 61 per cent in 2006, while in Europe the proportion has grown from 60 to 63 per cent. By contrast, electronic foreign exchange use fell from 52 to 46 per cent among Asian participants.

'Our research points to something of a digital divide between FX markets in Japan and the rest of the world,' says consultant Tim Sangston. 'Although the share of FX users trading electronically in Japan did increase year-on-year, only 36 per cent of market participants there say they use e-FX systems.'

Greenwich Associates is an international research-based consulting firm in institutional financial services, specialising in providing benchmark information on best practices and market intelligence on overall trends. Based in Stamford, Connecticut, with offices in London, Toronto, Tokyo and Singapore, the firm offers more than 100 research-based consulting programmes to more than 250 global financial services clients.

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