- 1997: Volume 6, No. 4 Global Trading on the Internet

Internet-based trading is nothing new to the equities market. Major securities trading firms such as E-Schwab and E*Trade, are taking an increasing share of the market from the traditional retail brokerage houses. This has been well-publicized in numerous articles in the Wall Street Journal, and Forbes and Fortune magazines. However, what is not so well-publicized is the monstrous growth of the spot foreign exchange market and the increasing relevance of the internet as an essential trading vehicle.

According to the International Bank for Settlements, the spot forex market is a .5 trillion a day marketplace, an impressive figure even by New York Stock Exchange standards. The NYSE reported a record daily average trading volume of 347 million shares as of December 27, 1995. It would require between eight to 10 weeks of such trading volume on the NYSE to match a single day's trading activity on the spot forex market. The volume of currency futures and options traded in the United States is approximately billion daily, by comparison. This is the most liquid market in the world. Moreover, with the growth of speculation in exotic currencies, Bank of America in 1997, forecasted growth in the interbank currency market to trillion a day in trading volume, over the next decade!

The international arena of forex is almost exclusively controlled by the interbank system, which accounts for over 80 percent of all currency transactions, according to the Federal Reserve Bank. Barclays Bank, Bayerische Vereinbank and Merrill Lynch are among major financial institutions who have beefed up their forex trading desks, by as much as 300 percent, since the 1992 European ERM (Exchange Rate Mechanism) debacle. George Soros, probably the best known trader in forex today, reported annual earnings from spot forex trading greater than McDonalds Corporation's total revenues for the fiscal year of 1996!

It has been estimated by Greenwich Associates of London, that over 95 percent of each day's volume is due to speculation by large banks, multinational corporations, financial cartels, global money managers, registered dealers, international money-brokers, futures and options traders, right the way down to private individuals. The remaining five percent are genuine transactions for physical exchange and delivery of currency for non-speculative purposes. This category of participants includes import/export companies, bona fide hedgers in futures and options markets, international travellers, buyers of international money orders, and commercial enterprises that use currencies in their day-to-day operations. Almost 75 percent of all forex traded is transacted in four major currencies. In 1993, Greenwich Associates, tracked currency levels at 28 percent Deutschemark, 23 percent Japanese Yen, 13 percent Swiss Franc, and 9 percent British Pound.

Market-Maker vs. Clearing Firm

The emergence of the Internet has created opportunities in spot forex never conceived possible. Traditional phone-based methods of order execution have given way to a host of internet-based companies offering forex services. This trend has been growing since late 1994 when E-FOREX, formerly International Financial & Trading Network, released the first real-time, internet-based Global Currency Exchange for the Spot Forex Market called Infinex2000. Other companies like CMC and Money Garden, among a host of newcomers to the forex arena, have since built electronic or semi-electronic systems to transact forex.

Forex order execution systems are essentially divided into two categories: fully electronic clearing systems or semi-electronic market-maker systems. E-FOREX has software trading systems for both categories, whereas CMC and Money Garden supply trading software for the latter category only. Other companies are building systems to compete in this virgin territory, but so far none have released products.

E-FOREX, operates the first and only fully electronic Internet-based clearing system. The system clears an average of 10,000 lots (or contracts) per month, and is growing at approximately 20 percent monthly. Built upon a UNIX platform for speed and scaleability, Infinex2000 Global Currency Exchange employs multiple servers and satellites with built-in data and function redundancy, providing near instantaneous and fully-duplicated back-up to each other in the event of system failure on the lead server or satellite. Interbank dealing prices are fed into the servers, from interbank channels (participating banks, hedge funds or large financial institutions) via satellite links and leased line connections.

The market-maker systems operate on a front-end electronic interface which connects to human operators, who monitor incoming orders and offer their own prices according to market conditions, and relay order confirmation through electronic mail. The market-maker model must have a manual back-end since its mode of business is centered around the company's ability to make market prices that favors itself, thereby reducing its own exposure to market risk.

Typically, due to the obvious loss of advantage in speed of order execution compared with a fully electronic clearing system, market-maker systems often offer alternative features such as concentrated software development in the area of technical tools, charting capability and analytical comments. Alternatively, they may also offer more exotic currencies and cross-rates, in addition to the four major currencies. Whether these additional enhancements adequately compensate for slower execution speed and price slippage against the clearing system, is still a point of debate among users of both types of systems.

The fully electronic system incorporates the power of a full-service brokerage in a personal computer. The advantage it offers in speed, accuracy and convenience of order execution over conventional broker-based phone order systems, makes it an indispensable tool for the knowledgeable private investor. These individual traders can literally compete at the interbank level with the large institutions by virtue of having access to a level playing field, and anonymity to boot.

Electronic vs. Phone-Based

Traders access the Interbank prices via E-FOREX's Infinex2000 SpotFX trading station. This proprietary software system allows traders to execute orders with point-and-click ease. Order confirmation is virtually instantaneous, involving minimal slippage. The schematic below illustrates a comparison of a traditional phone-based order execution system against an electronic order execution system.

Obviously, removing the retail broker and trading desk, saves both time and money (broker fees), while eliminating out-trades. Traders must now assume liability for their own actions and have no broker or proxy order placement service to blame for errors committed in placing trades. Disputes regarding currency, price and direction (long or short) have no avenue for debate.

Moreover, the face of transaction costs has undergone a major overhaul with brokerless trading systems, much in the way E*Trade and E-Schwab, have changed the face of discount stock trading. Typically, they charge .95 per 500 shares bought or sold through their system. In forex, it is not unusual for clients to be charged pips or points instead of a specific round-turn fee in internet-based forex transactions. Typically, each transaction is charged by pips round-turn either from the spread or the rollover of the forex transaction from one trading day to the next.

Figure 1

Security

The biggest concern for all users of these systems is security. With reference to recent publicity over breaking the Data Encryption Standard (DES) of 40-bit encryption keys, fears are that breaking the new 56-bit standard, that is being proposed to Congress, will only be a matter of time. However, more than 10,000 computers were used in a highly coordinated and contrived worldwide effort by scholastic institutions and software engineers to break the DES. Hence, the fear is somewhat exaggerated and artificial.

Moreover, such technology is still not available legally for export to non-US customers. Such is the case with RSA, whose 128-bit encryption key is the most sophisticated available, dwarfing the as of yet unbreakable 56-bit standard-to-be. E-FOREX's security measures deploy an RSA-based encryption tunnel in addition to other proprietary security measures. Market-maker systems, with only a partial electronic interface, have less fear of attack on their partially human-based systems, and deploy lesser encryption algorithms to do the job.

Corollary

As we move towards a fully integrated electronic marketplace, companies like E-FOREX, will secure an increasing market share by evolving their business model to provide fully-customized back-office systems for brokerage houses, corporate hedgers and even small banks, much in the way GMI or Rolfe and Nolan provide these services for the futures industry.

While the internet-based electronic forex system helps sharpen the private investor's trading skills, E-FOREX offers a sophisticated array of licensing options, in terms of customization, multiple-account capability and back-office functions. Newly established brokerages, offering value-added services at the retail level, can kick-start their own forex programme with minimal effort, by licensing E-FOREX Market Manager 2.0 as a broker-dealer system. More experienced forex broker-dealers will want to include add-on modules, Rate-maker 1.5 and Omnibus Accountant 1.0, to create the complete market-maker system. Even individual traders and brokers, managing accounts for private investors, now have easy access to the E-FOREX SpotFx 2.0 back-office reports and segregated accounting for Affiliated Brokers, with virtually no capital outlay. The evolution of the portable brokerage is literally an internet hop away.

The company that truly stamps its mark in this electronic forex arena will eventually surpass the clearing volume of even some of the largest brokers. The growth of spot forex is a given. The rate at which it will grow will largely depend on the technological innovation of these power-brokers of the 21st Century.

John C. Ebert is a former forex broker/trader and commodity futures operations manager. He currently works in international sales at E-FOREX, a spot forex clearing firm, that provides customized electronic forex clearing and trading software solutions for brokers, institutional traders and private investors. E-FOREX, is the only internet-based, non-marketmaker system available in the electronic marketplace. John, is also a series 3 commodity futures trainer, with American Financial Services. For more information, please call (415) 583-4528 or refer to this issue's advertisement.