By Matthew Walter and Alexandra Fletcher
Banks are seeing a steep decline in profits from currency trading, as once-lucrative businesses are eroded by the rise of electronic trading and the proliferation of new platforms.
The pain is being felt across the industry. Banks reported sharp drops in currency-trading revenue last quarter, in many cases deepening a slump that began early this year. Even Deutsche Bank AG, the world's biggest foreign-exchange bank, reported revenue "significantly lower than the prior year" even as the volume of transactions it handled hit a record high in the third quarter.
Banks are struggling on two fronts. A calm in currency markets relative to the swings of the last few years has reduced overall trading activity. And the explosive growth of electronic trading has brought transparency to a roughly $4 trillion-a-day market, making buyers and sellers less reliant on big banks to pair them up.
As the easy profits from handling trades for clients vanish, banks are being forced into an arms race, analysts and traders say. That means offering better terms to customers and spending heavily to develop electronic-trading platforms of their own.
"The FX market has gone through a transition to being much more automated, and an obvious conclusion of automation is it becomes much more competitive," said Fabian Eliasson, head of currency sales at Mizuho Corp. Bank in New York. "It's the same thing that happened with stocks 20 years ago," when trading moved to electronic exchanges, eroding profits for traditional brokerages.
Starting in the late 1990s, stock trading became mostly electronic and largely automated, leading to a surge in trading volume but with smaller profits to be had on each trade. Banks reduced their number of traditional stock traders and sales executives, who courted clients with tickets to sporting events and expensive dinners,and revamped their businesses to center on services such as devising trading strategies for clients.
The transition in foreign exchange may take more time, because the market is less heavily regulated and more decentralized, but the change is inevitable, said Richard Repetto, a principal at Sandler O'Neill + Partners.
"With everything getting more transparent, it's going to be tough for foreign exchange to stay in the 1930s," he said.
The rise of electronic trading comes at a time when overall volumes are leveling off, as central banks intervene to limit currency movements and, by extension, traders' opportunities to profit. Policy makers also are keeping interest rates at rock-bottom levels, reducing the appeal of "carry" trades, where investors borrow a low-yielding currency and buy one that offers better returns.
BarclaysPLC partly blamed a slump in foreign-exchange trading for a 19.8% drop in revenue at its fixed-income, commodities and currencies division in the third quarter. Smaller players fared even worse. Commerzbank AG CBK.XE -1.90% reported a 45% drop in fixed income and currencies income in the first nine months of 2012, while Royal Bank of Scotland Group RBS.LN -1.36% PLC said its foreign-exchange income declined 44% in the same period.
The biggest hit to profits comes from the narrowing gap between bid and offer prices in the foreign-exchange marketplace. Banks quote two prices for currencies: the rate at which they are offering to buy, and another, typically higher, rate at which they will sell. But with increased competition and prices from multiple sources streaming across clients' computer screens, banks have been forced to reduce that bid-offer margin.
"It seems as if the industry is grabbing onto as much volumes as possible to the detriment of margin," said Jim Iorio, the New York-based global head of foreign-exchange distribution at Barclays BARC.LN -1.29% .
Major independent trading platforms, including ICAP IAP.LN -1.17% PLC's EBS and Thomson Reuters, have reported declining volumes in 2012. Central banks report that this year, global currency-trading volumes have fallen slightly from the peak of $3.8 trillion a day for 2011. The total is up from $2 trillion in 2006.
To be sure, most foreign-exchange desks are still making money, and international corporations continue to rely on their banks to exchange large amounts of currency. Hedge funds, which have pulled back from currency trading this year, may jump back in if markets become more volatile.
At the same time, though, even for banks that have been able to increase their overall trading volumes, the size and profitability of those operations is declining.
"The e-trading business is one of economies of scale. Initially it can be tough, but there is a tipping point of volume where you begin to make money," said Simon Jones,Citigroup Inc.'s C -1.51% London-based global head of electronic foreign-exchange. "We have to constantly innovate and spend money on technology."
Citigroup's "Velocity" online platform and the "Barx" online trading system at Barclays both feature foreign-exchange trading. In July, Deutsche Bank rolled out its next-generation currency-trading platform through its Autobahn system.
Investments such as those have allowed some banks to bolster their volumes, at the expense of banks with smaller trading operations. According to Euromoney, the top three—Deutsche Bank, Citigroup and Barclays—controlled 39.5% of volumes in 2011. It was the first time the three biggest players increased their collective share since 2007.
"Different banks are taking different approaches," said Firas Askari, head of foreign exchange at BMO Capital Markets in Toronto. "Some of the larger, more global banks are trying to get into a volume game. Some of the smaller banks like ourselves are really focused on building strategic partnerships with key customers, and becoming more of a trusted advisor over the longer term."
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