Between 2007 and 2010, Canadian turnover across all foreign exchange (FX) instruments declined by 3%, despite FX turnover in global markets increasing by 20% over the same three-year period (Table 1). When adjusting for movements in exchange rates, the picture is even worse with the decline in Canadian FX markets reaching 14%. What is going on?
This article explores this issue using data collected in the 2010 Triennial Central Bank Survey. The drop in the headline numbers for Canadian FX turnover may provide a deceptive picture, as they are partly explained by changes in what instruments are being traded and how FX markets operate. Investments in electronic trading have improved the efficiency and lowered the cost of FX trading, while increasing competition among FX dealers. These IT investments are increasingly the key to FX market growth, with the top FX dealers spending heavily in recent years to build their franchises and capture market share. Canadian banks may be falling behind in this FX market arms race, similar to regional banks in other countries, with global FX activity increasingly concentrated in a few key financial centres.
Fall in Canadian FX turnover with lower trading by dealers
Between 1998 and 2010, daily average FX turnover in Canada grew by 63%, or an annual rate of 4.2% per year (Table 1). Trading activity across all FX instruments – spot transactions, outright forwards, FX swaps and other instruments – totalled US$61.9 billion in 2010, a decline from the peak of US$64.0 billion reached in 2007 (Figure 1). Over this same period, the Canadian dollar (CAD) appreciated from around US$0.70 (C$1.43 per USD) to parity against the US dollar. When this appreciation is taken into account, FX turnover in Canada grew by only 1.1% per year, peaking in 2004 before declining in both the 2007 and 2010 surveys.
When FX dealers located in Canada report their activity in the Triennial survey, they break down their trades into three categories: trades with other FX dealers, trades with other financial institutions, and trades with corporations and governments. Table 1 and Figure 2 show how activity with these three counterparty types has evolved over time. Activity between FX dealers (ie interdealer trading) has declined steadily since 2004, while trades between FX dealers and their financial customers have increased. Despite the falling share, interdealer trading still represents more than half of turnover in Canadian FX markets. Trading activity by corporations and governments represents a declining share of activity in 2010, and fell by 14% relative to 2007 levels.
Rebound in spot and forwards offset by decline in FX swaps
When looking at activity in individual FX instruments, the source of the drop in Canadian activity becomes apparent. (For a description of these FX instruments, see our FX Glossary). After declining sharply in 2007, daily average spot trading in 2010 rebounded to US$18.3 billion – a level last seen in 2004 (Table 1). Trading in outright forward contracts, where a price is agreed today but the currency is exchanged on a future date, has also grown steadily. Forwards are often used for hedging future currency transactions where the date and amount are known.
The source of the fall in Canadian FX activity is FX swaps, which represent more than half of all FX activity in Canada. In April 2010, daily average turnover in this instrument equalled US$33.9 billion. Like repos in the fixed income markets, FX swaps are used primarily for overnight cash management by banks and other financial institutions. Around 70% of FX swaps have a maturity of one week or shorter, with almost all the remaining Canadian activity less than one year in maturity. Canadian FX swap volume in 2010 was 19% lower than the activity seen in 2007. While activity in other FX instruments (such as currency options and currency swaps) also declined by a similar amount, the volumes traded in these other instruments on a typical day are relatively small.
Electronic trading transforming FX markets
What explains these different patterns of activity? These trends may all be linked to the changing structure of FX markets, both in Canada and abroad.
The falling share of activity among FX dealers appears to be explained by more efficient electronic trading. FX dealers are internalising a greater share of their customer trades – a trend that is taking place globally. Internalization is made possible by banks’ heavy investment in their IT infrastructure and electronic trading systems. When more customer trades are crossed on the bank’s own books, fewer trades need to be hedged in the interdealer markets leading to lower activity in this market segment.
The rise in spot FX turnover also reflects the growth of electronic trading. Similar to developments in equity markets, electronic trading has lowered FX trading costs and supported the entry of new participants. Electronic trading, for example, has fuelled the growth of algorithmic (or algo) trading where streaming prices are monitored by a computer algorithm that decides when and how to submit a trade. Algo trading is used by a wide variety of financial institutions. FX dealers use algorithms to match customer trades or to clear inventory positions efficiently. Hedge funds and proprietary trading desks use algorithms to engage in macro bets, statistical arbitrage or other forms of technical trading. And institutional investors are increasingly using algorithms to break up trades and reduce their price impact. Increased electronic trading may also explain the rising share of trading between FX dealers and their financial customers.
Implications for the competitiveness of Canadian FX dealers
Where does this leave the Canadian banks? And how are these changes affecting the levels of competition in Canadian FX markets?
The good news for the Canadian banks is that the five largest institutions continue to dominate the domestic FX market, as shown in Figure 3. Onshore competition from other FX dealers has been declining, with the number of Canadian-based FX dealers that participate in the Triennial survey falling from 36 in 1998 to only 16 in 2010. The Canadian banks also continue to dominate trading in the Canadian dollar.
It would be wrong to conclude that competition has decreased, however, as offshore competition for Canadian business has increased. The growth of electronic trading means that customers based in Canada can easily trade with banks located abroad. All the top FX dealers have launched proprietary trading systems for their customers, such as Barclay’s BARX, Citigroup’s Velocity, Deutsche Bank’s Autobahn or UBS’s FX Trader Plus. These bank-sponsored trading platforms compete with a number of third-party FX trading venues led by Currenex, EBS, FXall, Hotspot, and Thomson Reuters, among many others. These electronic venues offer low transaction costs and guaranteed liquidity, and are attracting a greater share of global FX business.
While there is very little data to draw hard conclusions, market reports suggest that the top global FX dealers are pulling away from the rest of the pack. As the IT gap widens, regional champions such as the Canadian banks are increasingly playing a hybrid role. They are becoming clients of the global FX dealers for the major currency pairs, while continuing to make markets for customers in local currencies. This specialisation allows the Canadian banks to profit from their customer relationships and comparative advantage in the provision of credit, while freeing them from the heavy investment required to compete in the low-margin business of market making for the major currencies. It remains to be seen whether this FX business model will last, or whether one or more of the Canadian banks will make a push to join the top FX dealers globally.
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Table 1: Daily average FX turnover in Canada reported by instrument
(US $ in billions)
1998 | 2001 | 2004 | 2007 | 2010 | % Change | Annual growth 1998-2010 | |
| TOTAL as reported | 37.9 | 44.2 | 59.3 | 64.0 | 61.9 | -3% | 4.2% |
| TOTAL at 2010 exchange rates | 54.0 | 68.6 | 79.2 | 72.3 | 61.9 | -14% | 1.1% |
| By counterparty: | |||||||
| With other FX dealers | 26.7 | 27.9 | 37.7 | 35.5 | 33.7 | -5% | 2.0% |
| With other financial institutions | 6.3 | 10.4 | 15.7 | 22.2 | 22.8 | 2% | 11.3% |
| With corporations and governments | 4.9 | 6.0 | 5.9 | 6.3 | 5.4 | -14% | 0.7% |
| By instrument: | |||||||
| Spot | 10.8 | 10.9 | 18.4 | 13.7 | 18.3 | 34% | 4.5% |
| Outright forwards | 1.4 | 2.3 | 4.0 | 4.3 | 6.3 | 46% | 13.1% |
| FX swaps | 24.6 | 28.5 | 31.6 | 41.9 | 33.9 | -19% | 2.7% |
| Other instruments | 1.1 | 2.6 | 5.4 | 4.2 | 3.5 | -17% | 9.7% |
Source: BIS
