ANALYSIS OF THE RETAIL FOREX TRADING INDUSRTY

Executive summary

This report is analysing forex retail trading industry. Defining the industry is based on
market participants’ segmentation and on BIS stats collected from 54 central banks
and monetary authorities. Industry-specific factors, threats and attractiveness are
assessed through five forces analysis (Porter). Broad environmental influences and
market development evaluation analysis for next five years is conducted through
PESTEL framework (OUP).

In conclusion the analysis shows that retail forex market is continuously attractive
market over next five years when:
a) Targeting high trading volumes and/or
b) Differentiating through additional knowledgeable trading services and/or
c) Providing profitable proprietary trading to customers.

Defining the forex industry

Forex is an acronym for foreign exchange, a market (called also FX or spot market)
where currencies can be exchanged in order to do business internationally (Martinez).

Forex market is the biggest financial market in the world – it is about 10 to 15 times
the size of daily trading volume on all world’s stock markets combined (Galant and
Dolan). According to the most recent available data of Bank of International
Settlements (BIS) the traditional foreign exchange markets (spot transactions, outright
forwards, foreign exchange swaps) daily turnover amounts to $3.2 trillion. This report
focuses on spot market, as the forwards and swaps are foreign exchange derivatives
and therefore differently regulated, different in characteristics of market players and
customers.
Table 1 presents the turnover of forex markets, whereas spot trading represents a
turnover of ca $1 trillion per day.

Table 1. Daily turnover of global forex markets (BIS).

According to BIS survey the retail trading market forms a 57% of FX trading spot
market – a daily turnover of $570 billion. Forex retail trading firms are market players
who provide currency traders with access to an open trading platform that allows
them to buy and sell foreign currencies (Olsen).

Beside high trading volume there are two main features that distinguish forex markets
from other financial and currency markets (Cabrera):
 Speculation accounts for most of the volume;
 Transparency is low.

Galant and Dolan estimate that upwards of 90% of FX trading volume is based solely
on speculation. The markets speculative nature comes from a zero-sum game logic:
there is a corresponding loser for every winner. ‘Forex market makers don’t care
about the absolute value of any currency – their primary concern is the relative value
that will result in a trade’ (Olsen).
As a globally open market with no central market place it is very hard to control and
regulate the market. Therefore the transparency of pricing, profitability, supply and
demand is low. Appell describes that the profit making in forex market is one of the
worst kept secrets. In retail trading the profits are mainly produced over the spread of
the trade, which in average is 0.03% from the volume of a trade (Salcedo). Based on
the latter and BIS stats the estimated profit of providing spot trading should amount to
$62.7 billion a year. Some proof to this calculus can be found from U.S. government
sources whereas ‘currency trading has been the richest source of trading revenue for
U. S. banks over the past 12 years, accounting for $2.1 billion of the $5.2 billion total
trading revenue in the second quarter of 2009’ (Appell).

Identifying and segmenting the participants

Forex market has no central marketplace and is best described as a decentralized

multiple-dealer market (NFA). There is no physical location where dealers meet with
traders nor there is a screen that consolidates all executable quotes in the market
(Cabrera). The current market participants are (Cabrera, Olsen):
 Governments and Central Banks – implementing monetary and economic
policies (non profit oriented)
 Banks and Investment Banks – providing services for their commercial
customers or trading own accounts (proprietary trading);
 Hedge Funds – leverage and diversify their investments;
 Businesses – international trade;
 Individuals and SME-s – trade currencies for purchases or speculation.

Their interrelation is described in Chart 1.

Chart 1. Forex market participants and their interrelation (Olsen)

Five Forces Analysis

Porters five forces analysis is conducted in order to assess the attractiveness and
threats of the industry (Porter).

Threat of new entrants is high, because the market is unregulated, growing and
commoditised. ‘In recent five years retail electronic trading in the FX spot markets
has been exploding with newcomers’ (Cabrera).

‘The great divide between the “big banks / investment banks” as whole sellers and the
“retail brokers / market makers” is diminishing’ (Olsen). The competition is fierce
and market is upward and backward integrating as large market players loosen their
trading conditions (minimum trading amount) in order to attract more retail customers
and small and vital players grow from retailers to interbank market participants. For
example Citigroup has agreed to sell its LavaFX foreign-exchange trading platform to
retail electronic platform FXall (American Banker). The process of concentration as
global trend can be noticed also from BIS report provided in Table 2.

Table 2. Global concentration of forex industry (BIS)

The consolidation is related to economies of scale where profitability from providing

trading platforms is related to large volumes.

The power of suppliers and buyers is very low as ‘forex market has no central
marketplace’ (NFA). Trading takes place in a number of well accessible
interconnected markets, volumes are high and trading facilities are automated. ‘Even
very large currency traders and institutions are rarely able to single-handedly drive the
direction of market or prices’ (Olsen). Spot trading has high growing interest for
newcomers because it is accessible to everyone, is related to liquidity and offers plain
cost (spreads) on trading (Olsen).

The threat of substitutes is high. As driven from speculation all other financial trading
systems are potential substitutes. Market participants have responded to this threat by
providing low entry and exit cost, high liquidity and value adding professional on-line
trading advice.
Competitive rivalry is very high among market participants. The similarity in
commoditized trading platforms has resulted in high cost competition. Differentiation
between competitors is provided through additional value adding services like market
analysis, trading assistance, trading hints etc in order to provide winning and
profitable trading strategies for customers. Many market players have started
proprietary trading – deciding and making trades on behalf of their customers.

Summarising the analysis of five forces one can notice that the industry is attractive
because of its growth and high liquidity. Open, unregulated and easily accessible
market has led to fierce cost competition. Differentiation comes from additional value
adding knowledgeable services with an aim to provide higher profitability for
customers’ trades or customers’ capital under proprietary trading.

Strategic analysis through PESTEL framework

In order to externally and strategically analyse the attractiveness of forex retail trading
market and its different macro environmental factors an analysis based on PESTEL
framework was conducted for understanding market movements, business potential
and further directions for operations.

At odds the forex market is equally positively affected through political,

environmental and economic factors over large and abrupt changes. Abruptness and
uncertainty create volatility thus rapid movements on currency markets which attracts
speculative capital. For example in contrary to expectations the ongoing crisis has
fuelled the market.

Political factors. In general FX markets are lightly political because developed nations
want to release restrictions on the flow of global capital (Galant and Dolan). For
example after China relaxed forex controls in 2005 (Country Commerce: 85), the
daily average trade of Renminbi 9-folded during 18 months (BIS). Because of its
global size local political factors usually have little long term impact to the market.
For example if UK would join euro zone then the global forex trade would decline
only 2% (BIS). I think in next five years the political intervention to the forex market
fundamentals will continually diminish.

Economic factors. Forex market is global, borderless and liquid financial market that
operates 24 hours a day (NFA). According to Keynes macroeconomic uncertainty
(crises) lead people to stay or invest in more liquid instruments (Skidelsky). Because
of its high liquidity, growth and profit potential, easy entry and exit I think forex retail
market is continuously attractive market in next five years. Fierce cost competition
will be opposed with value adding knowledgeable trading services with an aim to
attract customers over higher profit potential. As a zero-sum game, trading needs
discipline and comprehensive market context analysis and therefore the service of
proprietary trading will have significant role in growth potential.

Social factors. Retail forex trades are not guaranteed by a clearing organisation and
forex arena has not been the safest for participants (Salcedo). Over the last few years,
there has been a sharp rise in foreign currency scams (NFA). This ethical issue has
alerted governments to regulate the market. Although in U.S. NFA tries to regulate it,
the global openness has enabled them to regulate many but not all forex firms (NFA).
Despite additional regulation will most probably appear in next five years, the
‘increased legitimacy and transparency should fuel forex’s continued growth’
(Salcedo).

Technological factors. Trading in the FX spot market is typically commission-free

when done over electronic trading systems, and the spread has fallen dramatically
over the last five years as a result of improved technology (Olsen). ‘Trading systems
have been so far the collection of indicators and chart patterns that one examines to
determine when to enter or exit a particular market’ (Jurgilas).

The speculative nature of the market is interested in relative movements of currencies.

The latter depends on large amount of information and variables. Winners are those
who can interpret them quicker and more accurately. I believe that in the future
computerised analysing tools will play very significant role. The future of electronic
trading systems is related to how quickly and in which quantity and quality
information is interpreted in order to be winner in this zero-sum profit market. Better
handling of information is vital in order to maintain and attract customers.

Legal factors. Forex has so far been largely unregulated marketplace (Olsen). I think
low transparency and legitimacy will lead to additional regulation in order to protect
newcomers and relatively small participants in forex trading industry. Especially it
will take place in proprietary trading where traders collect customers’ money for
speculation on behalf of customers over their own account. This trend will result in
higher regulatory and capital need barriers to entry the market. For example in U.S.
you have to apply for membership in NFA and obey their regulation in the market,
e.g. net capital has to equal at least $20,000,000 (NFA).

In conclusion the PESTEL analysis shows that the market should stay attractive
during next five years. The continued growth potential and fierce cost competition
will lead to attaching value added services to trading systems. Proper information
synthesis of the currency markets impacts customer profitability which will become
the driver of scaling the volume of trading. Higher needs for comprehensive market
knowledge and professional approach increase customers demand for proprietary
service. The latter impacts more intense regulatory activity.

Sander Kaus
May 28th, 2010
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