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Online Forex Trading: The Fintech-FX Connection

By Frances Coppola

Until the 1990s, forex trading was exclusively the province of banks and dealers. But the advent of the internet and the rise of online trading platforms enabled corporations and individuals to trade forex online. Now, the online forex trading market is big business.

From Telephones to the Internet: How Forex Trading Went Online

 

In the 1980s, forex trading was done over the telephone.

 

Businesses and individuals wishing to trade currencies would call a forex dealer (usually a bank) and ask for current exchange rate quotes for the currency pair in which they were interested. In any currency pair, the transaction currency, also known as the “quote” or “counter” currency, is the first currency in the pair: the second currency, against which the first is quoted, is the “base” currency. So, for example, a U.S. customer with dollars in hand who wished to buy or sell British pounds would ask for quotes for GBPUSD. In this example, GBP is the transaction currency and USD the base currency.

 

The dealer would quote two exchange rates – the “bid,” which is the price at which he would buy the base currency, and the “ask,” which is the price at which he would sell the base currency. The difference between the two is known as the “spread,” and represents the dealer’s return from trading, since he makes money by selling high and bidding low. Based on these quotes, the customer would decide whether to buy the base currency of the pair, sell it, or “pass” without trading. Confirmation of a forex trade involved the physical exchange of paperwork, a cumbersome process prone to human error.1

 

Forex dealers either called each other directly or placed orders with a voice broker. The voice brokers shouted the best available bid and ask prices into open multi-party phone lines that ended in small speakers known as “squawk boxes” on the desks of each dealer. Dealers relied on each other for market information and would call each other for quotations. They also passed on unwanted currency inventory to each other, a process known as “hot potato trading.” Over half of all forex trading was between dealers.2

 

But from the late 1980s onwards, technology radically transformed forex trading. By the end of the 1990s, telephones and paperwork had become largely obsolete in inter-dealer forex trading, replaced by online forex trading platforms and electronic settlement.3

 

Reuters introduced the first system to record inter-dealer trades in 1987, partnering it with an information screen that displayed current price quotations. But a much bigger change happened in 1992, when Reuters introduced the first automated electronic brokerage system. Suddenly, dealers around the world could quote prices and trade with each other anonymously, with automated credit checks and confirmation. Competing systems quickly appeared, and soon electronic trading dominated the inter-dealer market in major currencies. The share of electronic trading in the forex market rose from 2 percent in 1993 to almost 20 percent in 2001.4

 

Because electronic online forex trading revealed price quotations worldwide in real time, dealers could no longer bid up or down prices to increase their profits, so bid-ask spreads narrowed in the inter-dealer market. However, spreads were much wider for customers – reportedly, up to 20 times as wide as for dealers5 – because they still had to telephone dealers and ask for quotes.

 

How Online Forex Trading Empowered Forex Customers

 

As the 20th century drew to a close, independent financial firms (not banks) started to introduce online forex trading platforms for end users. Currenex, launched in 1999, ended the chore of obtaining competitive exchange rate quotes by telephoning individual banks: instead, customers could send a “request-for-quote” to many forex dealers simultaneously. The dealers were required to respond within a few seconds, and end-customers would then trade with the dealer of their choice.6

 

But the real revolution was the introduction of online platforms that allowed customers to place limit orders. A limit order is an instruction to buy or sell a currency at a specified price or better.7 Enabling customers to place limit orders meant they could trade forex online anonymously, bypassing dealers. When customers were no longer dependent on dealers, bid-ask spreads started to reduce, resulting in better forex prices for businesses and individuals.8

 

Once customers could use online multi-bank platforms to place their own orders and manage their own positions, they didn’t need to develop relationships with individual banks. Banks responded to this threat by developing proprietary online forex trading platforms for their own customers.

 

The introduction of both single-bank and independent multi-bank online forex trading platforms fundamentally changed the relationship between customers and dealers. Now, dealers and their customers use the same platforms; dealers provide a stream of market price information from their trading activity, and customers use that information to decide when to execute their own trades.

 

The Online Retail Forex Trading Explosion

 

In the 1990s, retail investors – small businesses and individuals – could not trade forex directly. Forex trading can require substantial liquidity, which is usually obtained via a line of credit at a major bank. Retail investors typically lacked the creditworthiness to be granted a sufficiently large line of credit, so were forced to use forex brokers and dealers. They therefore often paid significantly more for forex transactions than large corporations and financial institutions that could access the market directly.

 

But the introduction of retail aggregator platforms at the start of the 21st century changed all that. Retail aggregator platforms enabled small businesses and individuals to trade forex actively, rather than being dependent on brokers and dealers.

 

Retail aggregator platforms aggregate forex trades from multiple small traders and lay them off in the inter-dealer market. Dealers, in turn, provide liquidity to the aggregators. The retail investors themselves are unaware of the aggregation: what they see is a sophisticated online forex trading platform providing real-time prices, margin (credit) accounts and a range of forex management and reporting tools.

 

For businesses, online forex trading platforms can be a boon. Instead of having to meet forex needs by negotiating with forex dealers at major banks, businesses can now manage their own positions and obtain their own liquidity. They can see prices in real time, set rate alerts to advise them of favorable or adverse exchange rate movements, and place limit and stop-loss orders. Online trading platforms now have a wide range of currencies and forex products, including forex forward contracts, swaps and options, to help businesses manage their forex cash flow and risk management needs.

 

Online retail forex trading has grown rapidly. Figures from the Bank for International Settlements (BIS) show that by 2013, retail trading was making up 3.5 percent of total turnover in global forex markets and 3.8 percent of spot turnover. In Japan, where retail investors were very active, the percentage was far higher, at 10 percent and 19 percent, respectively.9

 

The

Takeaway:

Technological changes since the 1980s have transformed the forex market. Telephone dealing and paper confirmations are largely things of the past, replaced by sophisticated online forex trading platforms where everyone from giant banks to small businesses can trade forex actively. Now, businesses no longer have to obtain forex from banks; they can obtain real-time price quotes and execute trades via the online forex trading platforms. This can help businesses to better manage their forex liquidity needs and risk management strategies.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Foreign exchange market structure, players and evolution,” Norges Bank; https://www.unich.it/~vitale/Rime-2.pdf
2. Ibid.
3. Ibid.
4. Ibid.
5. Ibid.
6. Ibid.
7. “Limit order,” Investopedia; https://www.investopedia.com/terms/l/limitorder.asp
8. “Foreign exchange market structure, players and evolution,” Norges Bank; https://www.unich.it/~vitale/Rime-2.pdf
9. “Retail trading in the FX market,” Bank for International Settlements; https://www.bis.org/publ/qtrpdf/r_qt1312z.htm

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