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Sunday, July 26, 2009

Forex story: Only the strong survive

No sector has seen the revolutionary growth of forex, particularly retail forex. But along with unprecedented access to currency markets came sleazy practices and outright fraud. Revolutionary change is often followed by a more conservative period where the excesses of the prior period are brought in line. That appears to be what is happening in the booming retail forex market.
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In the "old" days, say 10-15 years ago, the foreign exchange market was the playground of big banks and multinational corporations. Few looked behind the curtain as the deep, liquid market was a closed club, fitted with direct dials to key bank players. But early on several large futures traders such as John W. Henry saw the beauty of trading these markets: long trends and tailored plays. The futures market had only a few currency contracts, but what if you wanted to trade the Russian ruble or New Zealand dollar or crosses? Soon the curtain cracked; firms were consolidating smaller orders to play in the trillion dollar market. And then, with the growth of electronic trading, the curtain opened wide. Foreign exchange no longer was some dark place where small traders feared to tread, in fact, a new "industry" was born to service their demand.

"We share backgrounds with a lot of people in the industry in the sense that we came from the more institutional markets background," explains Drew Niv, CEO and one of the original founders of FXCM, a pioneer online forex broker. "We started this in the late 90s, when day trading equities was really hot. In that field there were hundreds of firms and they had every advantage under the sun. Moving into that space would have been way too competitive, and coming from a wholesale market, we knew FX in the 90s was already what equities was aspiring to be. If you remember, Nasdaq was going to build an exchange in every time zone, and they were trying to do what FX already was, which is a liquid 24-hour market."

Todd Crossland, founder of InterbankFX, says his firm started as a proprietary trading firm. "The impetus was to trade our own personal funds and never have customers." He says they had various black box programs and were doing well, but they "were using different counterparties to trade with around the world and it became evident to me back in 2001 or so while trading with one of the other FCMs, it had a business model where they basically traded against [us] and made money when the customers lost. So we started to work with the large money center banks, multiple banks at one time, where there wouldn't be this inherent conflict of interest." Then in reviewing the competitive landscape, he decided to leverage their relationships with these banks "to offer real liquidity and great execution. We also wouldn't have the inherent conflicts of interest that our competitors had," Crossland says.

Gary Tilken, founder and sole shareholder of Global Forex Trading, says his firm was doing alot of currency futures brokerage when he saw day-trader and scalper customers getting frustrated due to exchange floor logistics. "It became very clear that we needed electronic trading, which was extremely new 10 years ago," he says. By licensing software that wove in bookkeeping, Tilken says his firm became a forex dealer, which solved alot of customer problems. One reason GFT developed the currency side of the business was "it was perfect for the retail trader, really any active trader," he says. "It was 24 hours a day, which was something of a disadvantage if you were trading futures, because [the exchanges] would close...and you weren't able to participate in the markets full time." This especially was a problem when the Federal Reserve would do something during off hours and only interbank traders could participate. "Those were significant disadvantages to trading futures," he says.

FXCM's Niv first worked at MG Financial, who were the first to offer retail foreign exchange in the United States, he says. But he left to expand into a bigger pool, tapping international players. "The world was very hungry for [retail forex trading]. When [I] traveled around and saw investment options overseas, FX [was] a much bigger portion of that pie, partially because other investment options are more limited and more expensive, and partially because (forex) is more common so (overseas customers) were not afraid of it," he explains.

For example, he highlights 1990s Japan with 0% interest rates. "Many banks started offering a checking account or a domestic currency in a savings account and a high-yielding currency, so [the customer] could take their ATM card and basically transfer money from a yen checking account to a dollar savings account. The customer was getting charged 1% - so 100 pips - to do that, which from a tourist perspective is cheap, but from a trader's perspecitive is criminally exorbitantly expensive. But people would do that two or three times a year and basically make whatever the prevailing U.S. interest rate was, and back then, we had a good one." Bringing down the spreads and offering internet access, transparency and leverage built their business and an industry, he says.

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