In a speech made before the recent FX Market Structure Conference, Michelle Neal, the Head of the Federal Reserve Bank of New York’s Markets Group, provided some of her personal views about the dynamics of FX trading, the types of entities that conduct FX transactions, and the impact that technological innovations, including algorithmic trading are having on the market. After talking a little about the critical role The New York Fed plays in helping to stabilise the economy and financial markets, Neal went on to outline three aspects of the evolving landscape: Shifting trading dynamics, greater participation of nonbank financial institutions and modernisation and innovation.
Neal started out by looking at the market’s size and scope. “Trading activity in the FX market continues to increase, with about $7.5 trillion in total daily turnover – equivalent to approximately one quarter of the annual U.S. gross domestic product. The dollar is on one leg of almost 90 percent of all spot and derivative FX transactions, reflecting its preeminent global role. About half of aggregate daily volume is comprised of FX swaps, and just over a quarter is in FX spot transactions. Approximately 40 percent of total FX transactions take place in the U.K., and another 20 percent of trades occur here in the U.S. In addition, certain jurisdictions within Asia, such as Singapore and Hong Kong, are seeing significant growth in trading volumes,” she said. Although noting that FX trading occurs within an increasingly decentralised ecosystem Neal pointed out that “the primary platforms remain a significant source of price discovery, especially during times of elevated volatility. The primary platforms are also important in generating the rates that serve as reference to price many derivative contracts.”
She then went on to talk about how the FX landscape has evolved from being mostly bank-dominated to one where nonbank financial institutions are playing a more prominent role.
“Although NBFIs are not expected to supplant traditional banks anytime soon, an open question is whether their growth should be viewed as a challenge for bank dealer or as a complement to them”, says Neal. “Key watch points related to the growing role of NBFIs include their potential impact on liquidity conditions, price discovery, and market fragmentation.”
Before concluding her remarks by outlining how The New York Fed engages with market participants and other central banks and why this is a critical part of its job, Neal stressed how “technological innovations are driving the biggest and most impactful changes in the market. The electronification of the market has affected how trading occurs. For example, transactions made over the phone have become less common, while algorithmic trading has become more popular says Neal This has reduced average trade sizes, since large orders are now segmented into numerous smaller transactions. Artificial intelligence has also made automated trading strategies more sophisticated. There is also a perception of increased bouts of sudden pullbacks in liquidity, exacerbating price movements that can lead to flash events, a phenomenon that has occurred in major currency pairs in recent years. Market participants are also relying more on technology to reduce their market impact which,” says Neal, “is making it easier for certain dealers to internalise more flow by offsetting buy and sell orders and for buyside firms to utilize more sophisticated execution algorithms. Algorithms and liquidity aggregator platforms also help connect the different lakes via “rivers” that support price discovery.”
“While innovation occurs in every financial market, the FX market is typically at the forefront of developments and potentially due to a robust liquidity environment, it tends to be a testing ground for modernisation,” stated Neal.
The full speech is available here: https://www.newyorkfed.org/newsevents/speeches/2024/nea241119
