e-FX may affect liquidity and volatility, BIS says

Market participants fear the rise of electronic trading may adversely affect liquidity and volatility in the forex markets, according to the Bank for International Settlements (BIS).

In a paper made public this month, the BIS puts forward the case that developments in electronic forex and the forex market generally could result in reduced volatility and liquidity.

While it concluded that electronic trading has yet to affect the markets in this way, the report said: “There are concerns that these changes will soon adversely affect liquidity and volatility in foreign exchange markets.”

Before electronic trading, the report said, forex dealers tended to execute small trades regularly throughout the trading session to be continually informed about market prices. This kind of activity occurred during a period when the forex market was “a conglomeration of two-way phone or e-mail conversations” involving a number of brokers, making the true market price difficult to pinpoint, with prices differing from dealer to dealer.

The rapid increase in price transparency as a by-product of electronic forex technology has, the report said, explained in part the drop in inter-dealer spot forex trading reported in the BIS’s triennial survey of the global forex markets.

While price transparency has hit volumes, it has also allowed new market participants to enter the forex arena. But this development makes it difficult to assess the impact of electronic forex on market-making activity, the report said.

But price transparency has caused net profits from forex trading to decline in recent years and the overall amount of capital assigned to market-making has fallen.

Ultimately, the report found that the adoption of electronic trading has not had a large negative effect on the forex markets. Daily and intra-day volatilities have remained within the same ranges seen in recent years, and the frequency of large intra-day movements has not risen significantly. But the report warned: “One could perhaps argue that the deepest changes in the structure of the forex markets are yet to come.”