Foreign exchange: the democratisation of forex trading

Currency trading, known as foreign exchange trading or forex, was once the territory of a select few.

But a technological revolution, access to better information, lower trading costs and greater transparency have all helped bring greater numbers of traders to the global foreign exchange market.

Foreign exchange, also known as FX, was never meant to be regarded as an investment asset.

What changed along the way to it becoming the truly global market it is? At $5tn in daily turnover, the FX market has no equal in size or liquidity, but can foreign exchange truly be regarded as an asset?  

It's an important consideration when looking at how the market became democratised – open to all.

In the forex club

Even as recently as 20 years ago, forex trade was carried out by a relatively small number of institutional players.

It's prime function, at the most basic level, was the transfer of cash across national borders between counterparties, usually to fund business capital expenditure, cross border deals and other international transactions.

This process has traditionally been carried out by banks and other institutions, but once a bank learns how to profit from a process, it engineers ways of manufacturing revenue streams very quickly.

Banks charged commission for small transfers – perhaps for foreign trips.

For larger transactions – such as converting a few million pounds into the equivalent amount of dollars for cross border business – traders found they could extract profit from the exchange rate alone.

Foreign exchange started as just the transfer of cash across national borders - Source: Shutterstock

"It's no longer just about making people's money move," says Roger Rutherford chief operating officer at ParFX.

"There is a profit that can be extracted from this. Those FX desks that were just there to move money started to make a revenue line so they built out spot desks."

He adds: "So from a historical perspective I think FX became an asset class in its own right pretty quickly."

Gaining access to FX

Forex-based derivatives were available, but required specialist knowledge and trading in these instruments were mostly limited to financial and corporate counterparties looking to use them to hedge currency exposures.

And before the widespread use of retail trading platforms, large amounts of initial margin were required to proceed.

Yet it was in these over-the-counter products that private investors could get a first taste of a market hitherto closed to them.

Growth also in forex-related mutual funds and exchange traded funds helped private investors get a first taste of currency markets.

The financial crisis

It's impossible to discuss the development of any market without noting the impact of the financial crisis on it.

With interest rates reduced to historic lows around the world, long-term investors were no longer able to find yield in the fixed income markets.

The financial crisis brought more investors to FX markets in search of yield - Source: Shutterstock

"It made sense for people to look at what was already a large and liquid market, and look at the opportunity for yield that was not being found in other asset classes," says David Campbell, head of capital markets strategy at Broadridge.

Volatility increased and wiped out profits in many of the riskier trading strategies, such as the carry trade, where currencies in countries with low interest rates are sold to fund purchases of higher yielding currencies.

Instead, volatility itself became a much more prevalent strategy. Hedging also became an important strategy – not just for portfolio management – but across industry where exposure to international trade meant exposure to volatile currency moves that could eat into corporate profits.

“The investment returns of the FX asset class do not correlate heavily with stocks or bonds so it can be a useful alternative investment,” says Curtis Pfeiffer, chief business officer at Pragma Securities.

Machine-driven forex

The biggest transformation in the last dozen years or so, has been the rise of retail trading platforms.

Other financial instruments have grown too. Massive growth in exchange traded funds (ETFs) has enabled more people than ever to include foreign exchange in their portfolios, while hedge funds and mutual funds have offered currency exposure too.

But the rising popularity of spread-betting, online CFD trading and other forms of public access trading, have truly democratised the asset class of foreign exchange, attracting large numbers of private investors.

A typical array of forex trading screens: prices and chart analysis are among the tools used by traders - Source: Max Pixel

"Technology has allowed the market to become more accessible and through this the spreads have narrowed. Regulators have become more involved and this had led to greater transparency,” says Brendan Clarke, director of capital markets and wealth management at CapGemini.

These greater levels of transparency have enabled a wider disclosure of useful data and information that would not have been available to private traders a couple of decades ago.

This makes it easier than ever to trade forex, but does it make it any safer?

Not necessarily, and the growth of forex as an asset class has attracted the attention of regulators, who have already made several moves to make the market even more transparent.

Setting up clearing houses to ensure, not just the smooth and efficient trading of derivative products, but also transparency in pricing was a major step.

Growth in private investors

In its most recent major report into the currency market in 2016, the Bank for International Settlements (BIS) noted that although the daily turnover in the currency market had dipped to $5.1tn from $5.4tn in 2013, the fastest rate of growth was in the “new technology, non-bankplayers”.

As the volume and variety of products that help private investors gain access to forex trading increase, so too will the numbers of investors looking to tap into the world’s most liquid market.

There are, of course, many things that could derail the process.

Trading scandals within foreign exchange have been very public and do much reputational damage to the professional industry.

Meanwhile, black swan events such as the Swiss National Bank suddenly and unexpectedly removing its peg to the euro in 2015 caused many people to lose a lot of money.

"No one wants to have too many Swiss National Bank surprises – they can turn investors away because of the extreme volatility," says Curtis Pfeiffer.

Whatever happens, as FX grows as an asset class, investors will be looking for the next innovation that promises to maximise returns and lower trading costs.

Already the fintech boffins are developing transaction cost analysis tools and machine-learning capabilities that have market transforming potential.

The democratisation and development of FX as an asset class moves on.