HFT in FX provides challenges as well as opportunities

As profitability in equities has declined in recent years, firms have been increasingly looking to other asset classes to boost their profitability. This need to improve the bottom line has precipitated a move by HFT firms into the FX sector.

The FX market has grown to an average daily volume of more than $4.5 trillion in 2010 from $1.5 trillion in 2001, according to the Aite group, which also estimated that high-frequency FX trading strategies accounted for more than 40 percent of all FX trading volume by the end of 2012.

Growth in electronic trading and the increasing adoption of high frequency trading means that the FX sector will continue to flourish. This heightened activity is spurring players in the sector to provide increased transparency levels, and add lower latency and cost-effective trading as part of their offerings.

FX is a natural fit for HFT. It’s traded over the counter and no one bank controls a substantial percentage of the market, although the top 10 global banks control more than 77 percent of the market.

But there are numerous challenges to using HFT in the FX market. Over the years, the market has become extremely fragmented, with two primary markets, dozens of ECNs and multi-dealer platforms, and 10 to 15 critical single-bank platforms. For example, most Tier 1 and top Tier 2 players routinely connect to over a dozen different liquidity providers. In addition, FX markets are much larger, more international, and deeper than equity markets and comprise a widely divergent range of players—retail, corporate, institutional and sovereign wealth funds.

Another complication is that banks have to manage their risk, which means they need to keep a careful eye on order flow. Banks may widen spreads or even stop publishing prices to a particular customer if they get a whiff of overly aggressive trading practices. If an HFT firm wants to compete effectively in the FX market, it will need to develop flexible technology that respects relationships with the banks and allows them to effectively hedge their risk. If firms play by the rules, they will be rewarded in the form of better prices and deeper liquidity.

HFT in the FX space requires substantial investment in technology and infrastructure. For companies that are willing to make these investments, there are myriad opportunities to be explored. I’ll be discussing this further at the Forex Magnates London summit tomorrow. Follow @forexmagnates to track the debate.