For decades, corporate treasurers transacting in theforeign exchange (FX) markets have been feeling their way throughthe dark.

We're all familiar with the hazards inherent in making our wayacross an unlit room. When the lights are off, the furniture, floorlamps, and area rugs all seem intent on tripping us, no matter howhard we try to avoid them. Navigating with zero visibility isuncomfortable.

For corporate treasurers who need to make cross-border payments,purchase foreign securities, and/or settle international trade,using an opaque FX platform presents the same risk of gettingtripped up that a dark room might present. The global FXmarketplace is both immense and highly fragmented. Trades occur 24hours a day, five days a week, across every time zone. Yet, despitea daily average volume of more than US$5 trillion in the aggregate,FX markets are among the least “lit” of the capital markets.

Unlike the equity markets, the FX markets have no central portalfor price discovery and no consolidated tape to inform the broadermarket of the value of the securities or instruments being tradedat any point in time. In the equity markets, the consolidated tapereports every purchase and sale of every security, providingtransparency. Because the FX markets are so enormous, global, andopen 24 hours a day, an FX consolidated tape is not practical orrealistic, but its absence contributes to the opaque nature of thatmarketplace.

By their nature, FX trades are mostly one-off, bilateraltransactions in which operational users of FX—corporations, assetowners, and asset managers—tap their banking partners for thecredit they need to conduct their desired foreign-currencytransactions as well as for the execution of the transactions. Asrecently as 15 years ago, the vast majority of these transactionsoccurred via the phone or fax. Without a technological means forchecking market prices, institutions and corporations needing totransact FX gave their orders to one or more banks or brokers, thenreceived order fills that may or may not have represented the best,or most reasonable, prices available.

Nowhere was accurate aggregated data available on the overalltransaction pricing or volume in the market. Operational users ofFX had no recourse but to accept the prices delivered by theirbanks or representative brokers. In essence, the lights wereoff.

Enlightenment Coming Slowly to FX Market

Then, about a decade ago, a new generation of technology wasborn. Instead of using the phone to place an order, operational FXusers could turn to an order management system (OMS) or anexecution management system (EMS), which could not only managetrades but also—equally relevant—allocate a trade across multipleinternal accounts and provide for entry into forward positions, ifdesired.

Theseimprovements propelled FX forward. For the operational user of FX,they streamlined management of banking and custodian relationships.They also vastly improved operational users' middle- andback-office functions, providing automated recordkeeping andtrade-related services. At the same time, though, they encouragedthe emergence of speculators and high-frequency traders (HFTs) whocould take advantage of a more efficient and consolidatedmarketplace where speed and knowledge of order flow created anenormous advantage.

Ultimately, the new technologies did not make the FX marketplacemore transparent. In fact, the spread of these technologies mighthave created an even more opaque marketplace. In the simpler DarkAges, the bilateral market practice was heads up. The price makerand price taker had a conversation and came to a pricing agreement.The price maker made an undisclosed amount of profit, in return fortaking the risk inherent in establishing the position. But thoseexpected profits could potentially turn into losses; although thebanks might have been playing with the house advantage, during theFX Dark Ages, both sides of a transaction were more or less in thedark.

As the technology of the FX Renaissance emerged, that dynamicshifted. While some parties—primarily operational users ofFX—remained in the dark, others came into the light. A new host ofHFTs arose to arbitrage the inefficiencies that were now present ina market that was growing dramatically in size, and operationalusers remained the richest profit target for the price makers.

Despite this marginal result of the Renaissance, the inevitableeventually began to happen in this large, mostly unregulatedcapital market. Whistleblowers stepped forward to implicate theexecution practices of certain custodian banks. And as damage wasbeing measured and settlements negotiated, the next shoe dropped:a price manipulation scandal involving the FX marketplace'sprimary benchmark, the WMR Fix. All at once, every spotlight seemedto be trained on the still-dark recesses of the FXmarketplace.

TheFX pricing and manipulation scandals were big. Every major nation'scentral bank took notice. Committees were formed globally, and asenforcement extracted monetary payments from the perpetrators,regulatory bodies put their hands on all the light switches. Injust the last two years, bodies of work like the “Fairand Effective Markets Review,” published by the FCA and Bank ofEngland; the “FXGlobal Code of Conduct,” an evolving set of market standardsbeing developed by central banks and market participants; andMiFID II have been rolled out to address the market'slong-standing issues.

As a result, the FX market has begun to change—as markets do.The dark elements of the marketplace have begun to give way to morelight, to more transparency, and ultimately to more fairness andequal treatment. The winners in this cycle of change will be theoperational users of FX. But this benefit is not just going to landin their laps. They will need to embrace the changes andimprovements now available, and abandon their bad habits around FXtrade execution. And as with all change, adapting in the short runwill incur a cost, in exchange for expectations of benefits to beachieved in the future.

What's the Problem with Opaque Markets?

Certain market participants will argue that dark pools—whichprotect participant identity and deny broad participantaccess—create benefits to FX users who have access to them. Myinterest is not in arguing about a small market subset. A dark poolby itself does not present a broad market solution for the vastnumber of operational FX users.

The real problem with opaque markets is the economic cost thatFX users suffer because the lack of transparency negates theopportunity for market participants to achieve the best possibleexecution outcomes. When approaching a trade in the opaque market,the operational FX user is unable to complete the market analysisthat it would otherwise use to inform its trading decisions.

There are a few obvious examples of the cost impact of tradingFX without access to market intelligence. At the most basic level,operational users of FX must understand that when they select abank to act as their counterparty in an FX trade, that bank is notnaturally acting as their agent, and it has no obligation to offerthe best execution available at the time of the trade. In just thelast year, almost every large FX-dealing bank has had to disclosethis reality in the context of their market-making activity. In thesimplest of terms, when an operational user of FX discloses itsintent to trade to a counterparty, it may pay a price fordisclosing that intention. Since that operational user has noaccess to relevant and accurate market information, its has nobasis to negotiate a better rate with its counterparty. Knowingthat, one can see that the counterparty may fade its pricing tomaximize its trading profit.

Moreover, after a trade is executed on an opaque market,operational users of FX have no context in which to assess theperformance of that trade, since they have no basis for analyzingthe market conditions and dynamics that existed at the time thetrade occurred. This lack of information access has an economiccost, and the transaction cost analyses that my company hasperformed for numerous buy-side institutions has proven thepoint.

Our findings in these analyses have been quite consistent: Whenlarge asset managers trade FX without access to marketintelligence, they pay a higher price compared with our benchmark.This is especially true, and a consistent finding, for trade sizesgreater than $25 million and in non-G-10 currencies. That said, wehave also found significant cost impacts in very large trades ofG-10 currencies that are “worked” by financial institutions onbehalf of their clients. The lack of market intelligence prohibitsthe operational user of FX from assessing the market's conditionand health in advance of these trades.

EveryFX user should have a right to price discovery, as well as pre- andpost-trade market intelligence.

Even when operational users of FX approach the market using arequest for quote (RFQ), there is a danger that the result of thisprocess will not yield the best possible price outcome. Many FXusers believe an RFQ is a small auction that “lights up” themarket, allowing them to obtain the best possible price execution.But there are problems with this trading practice as well. First,the existence of an RFQ does little to address the opaque marketcondition. Second, when an operational user of FX declares itstrading intention, in terms of both its identity and the size andside of trade, that disclosure can actually negatively impact thetrade's execution from the perspective of the RFQ issuer.

The institutions that are invited to quote are all marketmakers, and they would be within their commercial rights to useinformation from a customer's RFQ for their own benefit. Aspreviously noted, recent bank settlements and disclosures have madethat practice better understood; still, the RFQ approach toexecution remains prevalent.

To achieve a benefit for the operational user of FX, the rolesin the execution scenario need to be reversed. The customer shouldbe completely anonymous; market liquidity data should be streamingand always available, as opposed to available on demand; and theprice makers' market view (their bids and offers by execution size)should be transparent and executable, not subject to “last look.”In an opaque market lacking these characteristics, the odds ofachieving a best-possible execution outcome is in the realm of slimto none.

Light at the End of the Tunnel

The good news is that interest in transparent FX markets isbuilding, as a result of both customer demand and the previouslymentioned regulatory actions and edicts. Customers needtransparency for intensifying compliance reasons. The litigationthreat stemming from whistleblower payouts is also motivating assetmanagers to take a much closer look at how they fulfill theirfiduciary requirements when transacting in the FX marketplace.

As the saying goes, necessity is the mother of invention, and somore choice is entering the FX market to allow customers differentexecution alternatives. Banks themselves have built algorithmicagency execution platforms that enable their customers to executeFX trades at third-party venues using the bank's credit and ordermanagement processes. The purpose of these agency algorithmicplatforms is to give the operational user of FX more choiceregarding their execution style and preference. Essentially, theoperational user of FX chooses a bank provider to act as an agenton its behalf. That user is then entitled to choose among a varietyof different algorithmic executions that range from completelypassive to intelligent.

Importantly, when the operational user chooses to execute its FXusing these platforms, its identity is protected from the ultimatecounterparty to its trades. This anonymity is a step forward in theprocess of achieving a best execution outcome. In addition, thesealgorithms naturally slice and dice the original trade size. Thisfragmenting of an order creates less market impact, particularlyfor large executions. Avoiding market impact maximizes favorableprice achievement.

FX electronic communications networks (ECNs) are also buildingliquidity pools that offer no-last-look, executable liquidity. AnECN is a virtual marketplace, like the New York Stock Exchange orNASDAQ. ECNs are electronic venues where market makers offertwo-way pricing (bids and offers) and where clients arepermissioned through the credit that they have with their bank(s)to access the pricing being offered by those market makers.

Theadvantage of ECNs is that they bring multiple market makers to oneplace, promoting pricing competition. These pools are often fullytransparent, but they may or may not protect customer identity. Anoperational user of FX who does not use an ECN limits itself interms of trading choice, forgoing the advances that can contributeto better trading outcomes.

ECNs that offer no “last look” are particularly attractive tothe operational user of FX. “Last look” is a term that describes acounterparty's right to reject a matched trade within a definedperiod of time (usually less than 250 milliseconds) if itdetermines, in its sole discretion, that the trade is notprofitable. The cost of “last look” can be significant tooperational users of FX, particularly when a market is movingagainst them.

One thing is for sure: The regulatory prescription fortransparent best execution, along with FX operational users' needfor compliance and fairness, is slowly moving the FX market towardthe light and away from its opaque history. This transition isinevitable, but the question remains: When will the market finallychange? Operational users of FX should take the preliminary stepsto explore the benefits of more sophisticated FX tradingalternatives like bank agency algorithmic platforms and ECNs.Depending on your needs and the size of FX trading activity, bothof these options may be effective alternatives for delivering lowerall-in execution costs. A good way to measure the potential benefitis to analyze a selection of historical FX trades against areliable benchmark to determine the cost of your current FX tradingpractice.

There is no doubt that the operational users of FX are beginningto avail themselves of solutions that better enable them tonavigate their walk across the dark room that represents the opaqueFX marketplace. The good news for treasurers and risk managers isthat there are readily available alternatives to the opaque andcostly FX executions that have been the norm for many years. Theearly movers will achieve best execution outcomes and cost savingssooner than those who wait on inevitability. A good place to startthis cost-saving exercise is by launching a conversation with yourindividual banks, with a provider of transaction cost analysis, orwith an ECN provider. The FX market is adapting rapidly; keepingyour knowledge base current will be illuminating.

Lighting up the FX market is a good thing, and the time hascome.

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James L. Singleton is the chairman and CEOof Cürex Group, a New York City-basedinstitutional foreign exchange execution services and dataanalytics company whose mission is to provide best executionoutcomes to its buy-side customers.