Retail, hedge funds fuel forex growth

In the past few years, forex trading has moved into the mainstream, a big step for an asset class long viewed as a peripheral market for retail traders. Now, along with its traditional base of banks and big institutional users, the currency market is attracting growing numbers of hedge funds, money managers, corporations, and retail traders, both in the spot forex market and on several exchanges that offer currency futures and options contracts.

Exchange-traded currency futures contracts are offered by the Chicago Mercantile Exchange (CME) and the New York Board of Trade (NYBOT), who will soon be joined by the Philadelphia Stock Exchange (PHLX), which plans to launch currency options and futures in the fourth quarter.

The growth in spot forex, which trades more than $2 trillion per day globally, is because of a number of factors, but none more important than the proliferation of electronic trading systems that have opened the market to more users than ever. Electronic platforms are improving functionality, which also invites more sophisticated and high-volume traders.

“The growth in forex trading has been fantastic,” says Glenn Stevens, managing director of Gain Capital in New York. “A lot of it has to do with the basics of this industry that make it a very appealing marketplace. The other reason is that other markets haven’t been so appealing to trade, given the trends that are not there in equities, the dot-com bust, and the low interest rate environment that we’ve had for such a long time globally.

“These factors provided a great opportunity for a larger set of people to trade forex directly,” he continues. “Retail and institutional users now look at FX as an alternative asset class.”

The hedge-fund boom has particularly fed forex growth. “When you look at the overall market, you have to look at hedge funds as the most active and fastest growing segment,” says Harrell Smith, manager of securities and investments practice for Celent in New York. “The number of forex-based hedge funds have increased over the past several years. And hedge funds have been at the forefront of automated trading.”

Hedge funds and other institutions looking to protect currency risk are finding a variety of ways to integrate forex futures into their portfolios. Firms are now utilizing more sophisticated strategies to lock in currency rates.

Richard Chappetto, director of business development at Peregrine Financial Group in Chicago, echoed the comments of many in the forex space about hedge fund activity, which continues to rise significantly as spot forex and currency futures markets offer faster and more sophisticated trading functionality. This is the customer base most exchanges and brokers are looking to attract.

“I see more hedge funds moving at least a portion of their portfolios into this space,” Chappetto says. “It gives them the liquidity and volatility they need. And the currencies trend well, which is something these traders really like.”

As more participants join in, Chappetto believes this year will become a historical milestone for the asset class. “When we look back five years from now, we’ll say ‘that’s when it really started,’” Chappetto says.

The recent growth in the space has spurred renewed efforts by derivatives exchanges to put more focus on currency futures and options. The leading exchange in currency futures is the CME, where volume has migrated from the floor to its Globex trading platform over the past five years and posted impressive volume gains. Today, roughly 85 percent of the exchange’s currency volume is electronically traded, up from 61 percent in 2003 and just less than 30 percent in 2001, when the CME began trading FX futures electronically during floor trading hours.

“The growth in the breadth of players in foreign exchange is probably one of the bigger changes in the market,” says Rick Sears, managing director, CME foreign exchange. “The emergence of prop traders,who consider themselves to be as good as the big banks when it comes to market making, has been another reason why we’re growing.”

To help expand that diversity, CME began offering a fee incentive program last November to commodity trading advisors and hedge funds active in forex. The move was spurred in part by competition from the likes of Eurex U.S., which entered the forex space last September with six currency pairs on its 23-hour-per-day trading engine and lower exchange fees. Eurex U.S. added eight more forex contracts in January, although it has failed to attract volume. The CME also has been able to further integrate with the OTC market by listing its forex futures contracts on the Reuters 3000 platform and forging a joint venture called FX MarketSpace to trade and clear forex spot and forwards.

While the CME is the clear leader in forex futures, it is not the only player. The NYBOT has a slate of currency and cross-rate futures, with volume concentrated in the U.S. dollar index (DX) futures contract.

The NYBOT will try to pump more life into its forex products when it begins listing financial futures contracts on the Chicago Board of Trade’s eCBOT electronic trading platform in November.

Meanwhile, Eurex U.S. has gained an equity partner in Man Financial. The agreement could leverage the exchange’s sizeable distribution network and expand its forex futures platform.

Finally, the PHLX announced it will launch options on the U.S. dollar/euro and U.S. dollar/British pound in the fourth quarter, along with matching futures contracts on its subsidiary exchange, the Philadelphia Board of Trade.