Facebook for Forex cuts the costs of FX bargains: An Integral part of business

Jan 20, 2011
by Dominic Hobson

Integral has a simple idea: to cut the cost of foreign exchange trading by using technology to widen the number of counterparties market participants can do business with. The company then uses further technology to aggregate executable prices from banks, brokers, ECNs and foreign exchange trading platforms, and sort and rank them to give its users the best bid or offer price for a trade of the size indicated. The CEO says the model is working exactly as intended.

“When we first entered the foreign exchange market, executing trades at what we would consider normal standards of fairness was considered completely revolutionary,” says Harpal Sandhu, CEO of the Integral Development Corporation, a private equity-backed technology company based in California. “Yet all we were doing was executing where the market really was, and reporting that to the customer on a real-time basis.”

It is indeed a remarkable commentary on the power of habit and legacy that foreign exchange has remained such an opaque and lucrative market for the banks and brokers that intermediate the overwhelming majority of cross-currency transactions. In fact, the incumbents, as the prime beneficiaries of the opacity of the foreign exchange markets, have fought a remarkably successful rearguard action against the power of Internet technology to disrupt their model of business. Integral was founded by Sandhu and a colleague from a capital markets software business he sold to SunGard way back in 1993, and began to focus on the foreign exchange market in the late 1990s. But it was not until the closing months of 2008 that the company finally corralled enough liquidity to ensure that the benefits of joining the network (in terms of tighter and more stable pricing and sufficient depth and immediacy of liquidity) outweighed the costs.

“Two years ago we had reached the point at which the network effects of the number of participants was such that the mathematics was showing the customer that nothing is better than this,” says Sandhu. “It was at that point that we knew we had reached critical mass. We changed our sales methodology to stop talking about our vision, about what we thought was possible, and trying to evangelise to people, and started to say, `Just look at the prices.’”

The prices the customers are looking at are executable prices from multiple liquidity providers they choose to interact with (and which agree to do business with them). Integral technology aggregates them, then sorts and ranks them to give the customer the best bid and offer price for their particular trade size. Trades are executed with (credit-approved) counterparties in real-time, and reported back to the customer immediately. In principle, competing prices from multiple banks ensure that the Integral model will always provide value, because users can actually see the competing bids and offers jostling for their attention in real time. Anyone can join the network, the only constraint being the willingness of counterparties to transact with each other. At present, most hedge funds are trading with counterparties on the Integral platform through their prime broker, either using the prime broker as an agent or giving up trades for clearing and settlement by the prime broker.

The technology is proving particularly popular with quantitative traders, says Sandhu, because they like the instantaneous nature of the digital linkages of the network. “We provide our APIs directly into their algorithms, so they execute the trades in real-time with market-making institutions, and can see the prices of all the assets they are buying and selling in the currency of their choice, in real-time, all within a single network,” he explains. “It reduces risk significantly, particularly on the execution side.” Sandhu says this does not put Integral in competition with foreign exchange prime brokers, despite the fact that their role is to enable hedge funds and CTAs to source liquidity from a variety of executing dealers while maintaining a credit relationship, secured on collateral placed with them, and in which the prime broker also clears and settles the trades on behalf of the fund. That is because prime brokers that use the Integral platform merely extend the range of counterparties they can offer their clients: nothing else changes.

In effect, the prime brokers are white-labelling the Integral technology platform, and using it to expand their agency foreign exchange business under their own brand. The increased transparency and competition do diminish their ability to widen spreads, but the loss is offset by higher volumes. Sandhu admits Integral does not always enjoy such a constructive relationship with the incumbents in the foreign exchange market. “We meet with a great deal of support from institutions which like the message, and use it to acquire new customers,” he says. “And we meet with resistance from some of the incumbent institutions, who are the primary beneficiaries of what we consider to be a rather opaque model of transacting business on behalf of their clients.” This is why Integral was content to grow the business slowly, waiting until it had garnered enough counterparties for the platform to be impossible to ignore as a route to market. “We wanted to be sure that, once we took a strong position in the market, the banks would still support it, even if they opposed it, because we would represent an important base of customers they want to access,” says Sandhu.

As it happens, shrinking the profitability of foreign exchange for the banks was not the principal goal of what remains fundamentally a technology company, though it was an almost inevitable by-product of its ambition to automate what the founders of the company realised was an OTC marketplace with high levels of manual intervention that are hard to justify in the presence of modern technology. The real goal, as the name of the company suggests, was to integrate a fragmented marketplace. In other words, Integral is a network “utility,” in the same way that the electricity grid or the telephone system is a network utility. Sandhu likens elements of the Integral network to Facebook, in the sense that everybody with an identity on the network potentially has a cheap and convenient form of access to everybody else on the network.”We do not want to use the word `social’ but we have definitely built a `relationship’ network,” he says.

Creating a low latency digital network that links dozens of FX market-makers with hundreds (and potentially thousands) of institutional customers is not easy.

It entailed the creation of a series of data centres around the world, translation engines to facilitate communication between customers and sources of liquidity using different systems, and the establishment of a fast, secure and unbreakable telecommunications network to link all of these various counterparties together. Professional users can plug into this physical network (which Integral calls FX Grid) through an interface application called FX Inside, which not only gives them access to real-time prices, but equips them with tools to select the best bid and offer for their particular pair and trade size from all their credit-approved counterparties. FX Inside also enables users to match and execute trades in real-time, and receive immediate confirmation. Sandhu says that the performance of the system dazzled early adopters. “For us as engineers, it was just the combination of maths and a live network,” he explains. “But, for business practitioners, it was a form of magic. Humans cannot match the speed, efficiency and optimisation of the computer.” The first buyers of the service were second and third tier banks, which were in practice customers of the big banks. It was relatively uncontroversial, because those big banks saw Integral as a distribution channel to this type of client. Institutional brokers, including futures commission merchants (FCMs) such as Newedge, FC Stone and ODL Securities, were followed by retail brokers.

Sandhu claims a majority of the Japanese agency FX market for Integral, which has opened an office in Tokyo. He says the London office of the company is growing its business in the United Kingdom and Continental Europe, and that its offices in Hong Kong and Singapore are also adding volumes. “We continue to grow at over 100 per cent per year, in terms of volumes,” says Sandhu. “In a typical month, we grow nearly 10 per cent.” Since volume and revenue are directly correlated, even net of the discounts the firm offers for volume, that means Integral is doubling its revenue every year.

To keep growing at that pace, the company needs to keep uncovering pockets of inefficiency in the foreign exchange markets. Sandhu is too polite to criticise the business model of the custodian banks, which have long used foreign exchange earnings as a means of paying for the custody services they offer to institutional clients virtually for free, but it would be surprising if he did not see the opportunity. Many institutional clients were insisting on the use of third party firms to execute FX trades even before the crisis, which has highlighted the costs of using custodian banks to complete trades. Indeed, the attorney general of the state of California has launched a law suit against a major global custodian on behalf of the CalPERS and CalSTRS pension funds, alleging that the bank effectively over-charged the funds on FX. Though this has yet to be decided in the courts, there is a strongly held view in some quarters that there is an inherent conflict between the role of a custodian bank as fiduciary and its role as an FX execution provider. Sandhu has a clear view on this. He thinks that custodians should act not as principals in foreign exchange transactions but as agents in the marketplace on behalf of their institutional clients, and get paid not by spreads but negotiable commissions.

“Ideally, institutional investors should be using their custodian bank as a credit intermediary, and as a central clearing house and settlement mechanism, but not as a counterparty to the trades,” he argues. “The counterparty to the trade should be a number of liquidity sources, forced into competition with each other in real time. By using Integral technology, custodians can not only execute with 100 per cent compliance to their fiduciary responsibility to achieve best execution, but in an auditable and transparent way. By white-labelling the technology, they could also offer the service directly to their clients, so the clients could serve themselves, using the custodian only as their agent in the marketplace, and as their clearing and settlement agent.”

In other words, custodians could follow the approach of the prime brokers, and offer their clients white label versions of the system. Sandhu says five of the top six FCMs in the United States are already using white-labelled versions of Integral technology, and he sees no reason why custodians should not follow suit. He adds that a number of custodian banks have warmed to this idea already. (He will not say which, but it would be surprising if their number did not include those obliged to surrender FX earnings to colleagues in the investment banking arm of the same group.) Others, of course, see it as a threat to their business.

“They are asking, `why are you destroying my business?’” says Sandhu. “They need to realise that no truly sustainable business can thrive at the expense of its customers. That, when they take money away from their customers, it is a zero sum transaction. Generally speaking, they will be better off taking less money off an individual customer, while offering to their customers a transparent and fair solution. In the end, more customers will come into the market, and overall volumes will go up, because transparency has increased and the costs associated with execution will come down.”

It is worth asking how custodians have managed to defend fat spreads in institutional foreign exchange brokerage for so long. One reason is the sheer lack of information at the disposal of the average institutional client. Trying to check whether the prices of dozens of foreign exchange trades were fair or reasonable by comparing them with historical data weeks or months after the event is hard, but not impossible. In this endeavour, Integral can help. The platform actually generates a great deal of FX price data as more than 40 brokers and banks around the world stream to Integral in real-time the prices at which they are actually willing to execute. Integral collects all of this data, and the prices at which transactions are actually executed, and then makes it available free through its TrueFX.com web site.

“It shines a very bright light on the whole process of FX execution,” says Sandhu. “We are recording historical transaction and tick data of real executable prices, and publishing them on the Internet for free. People can go back in and validate the level of execution they were receiving from their agent. The data we make available is much richer and deeper than historical ticker files.” In return for a name and an e-mail address, the TrueFX site contains fully cleansed, downloadable, time-stamped, tick-by-tick data on 32 major currency pairs, and less detailed information on another 140 cross-rate pairs.

Sandhu claims the data is so clean that algorithmic traders use it to model trades in preference to data from Reuters and other sources. It can also be used retrospectively to analyse the reasonableness of prices. But Sandhu reckons there is an even better way to manage FX execution costs. A forthcoming feature on TrueFX.com, dubbed SpotCheck, will enable users to check the fairness of executed currency transactions within minutes, if not milliseconds, of the time their own transaction was executed. This is a tool which institutional investors would be foolish to disown. Indeed, it is potentially revolutionary, if they can persuade their custodians to share data with them in real-time, or something close to it. This prompts an important and topical question in an era when selling price data has become such an important revenue generator for stock exchanges: why does Integral give away, every day, gigabytes of valuable FX market data in this way?

Sandhu offers a very Californian answer. “Part of the view of Silicon Valley companies like ours is that markets are more interesting for platform providers if those markets are bigger,” he explains. “One way of expanding markets exponentially in size is by increasing the trust and the transparency into what is actually going on in a market, and simultaneously reducing the friction to invite more participants into the market. In doing so, the market becomes so much larger that, even though the margins of a platform utility provider like us are a tiny fraction of what they might have been if we were a market maker or a direct participant in the market, the nature of the business is much better. We have seen this in so many other industries that have been impacted by the transparency of the Internet. In this industry, as in so many others, people look initially at the model and say, `How can it possibly make sense for you to give away for free something that previous service providers were charging large amounts of money for?’ The answer is that there is actually a rationale to it that makes a lot of sense.”

This is the argument with which the custodian banks must now engage. Their entire revenue model has depended on lack of transparency – lack of transparency into how they get paid not for their primary task of safekeeping but by collecting a turn on cash, foreign exchange and securities lending transactions generated by the assets they hold on behalf of institutional investors. White-labelling Integral technology, and switching to an agency model, is one answer to the declining level of trust institutional investors have in the opaque FX model. It is one which the prime brokers have in effect adopted already. So has one major custodian, State Street, which paid $564 million to acquire the Currenex FX trading platform in January 2007. However, Currenex fits rather well into the traditional model of foreign exchange trading at custodian banks. It leaves ample scope for spreads to be widened, or adjusted at the last minute, particularly in volatile markets. Custodians have long treated some clients more equally than others. Only the wisest and best educated clients enjoy both the finest prices, and information to verify that they are getting them. This is the opportunity that Sandhu sees in the custodial banking sector. “Our view is that the agency business model in foreign exchange will take off as soon as the customers are educated enough to appreciate what they are paying now, and how much they might save,” he says. In his view, allowing custodian banks to white-label Integral technology offers the banks a way out of an existential dilemma. His challenge is that Integral is not the only enterprise to have understood the underlying direction of the FX business.

Investment banks and broker-dealers are building and acquiring platforms that compete with the Integral model. Goldman Sachs has added FX to its REDI multi-asset class trading platform. The Liquidus platform offered by foreign exchange broker VCap FX also aggregates liquidity from multiple banks, and ranks bid and offer prices by size and depth, and offers instantaneous transparency. Inter-dealer broker ICAP has turned EBS, the electronic foreign exchange trading platform it acquired in June 2006, into the market leader in spot FX. It currently offers round-the-clock access to 2,800 traders on in 50 countries. In January 2006 Knight Capital acquired the New Jersey-based foreign exchange ECN, HotSpot FX, for $77.5 million. It offers buy-side dealers direct and anonymous access to executable prices, supported by post-trade transaction cost analysis. Broker Baxter-FX runs another ECN, which offers streaming spot quotes in 55 currency pairs from four major banks. In January this year FXAll, the ten year old FX trading platform founded by the investment banks Bank of America, Credit Suisse, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS and now part-owned by private equity firm TCV, acquired from Citi the LavaFX ECN.

All of these businesses compete with Integral, but they are also a reminder that those who believe in electronic trading and the tighter prices and greater transparency it brings to the FX markets, are on the right side of history. “Philosophically, our approach was a very different way of looking at the marketplace,” says Sandhu.

“Most market participants did not understand what we were doing, and some might still not do so entirely, though almost everybody who tries it appreciates the benefits, even if they cannot explain why.” He thinks the reduced costs and risks of automation, and the greater transparency and higher volumes that result, mean that the FX market will get bigger yet. Certainly, Integral does not just talk about the philosophy of taking smaller slices of higher volumes. The firm actually gets paid by charging users a commission, measured in tenths of a basis point- that is to say, the fifth decimal place after the zero. “We get paid by straight commissions that are a tiny fraction - perhaps an eighth of the typical commission that a bank would charge their customers,” explains Sandhu. “We charge in dollars per million dollars traded through the network. It is a very small amount, fully transparent, published up-front, and billed monthly. And, as a neutral technology provider, there is never any conflict of interest with a bank or broker.” There are discounts for volume, and users can opt to add the Integral commission to the price of the foreign exchange bargain, in order to offer zero commission trading. Users also pay only when they actually transact business through the network. They can connect for free, and make use of the tools and data on the site, for free.

But ultimately even the FX market, despite regular political denunciations of its apparent ability to grow at many times the rate of world trade, must be finite in size.

“Eventually, we become a utility,” says Sandhu. “We do not mind that. We do not mind continuing to lower our costs.” Perhaps Integral will be taken public or sold to a bank or broker or an inter-dealer broker or even an exchange, like EBS and LavaFX and Currenex before it. Those are doubtless among the options its private equity shareholders are pondering. Yet it could also evolve into a privately owned utility service provider (like Fiserv) or a part-public-part private utility (like Omgeo). It could become a user-owned, user-governed utility (like CLS Bank). A central counterparty is less compatible with commercial viability, no matter how fashionable in other sectors. But there is of course an obvious next step for Integral to take in its present form: apply the same network philosophy and technology platform to similar problems in other asset classes that are traded OTC, such as precious metals, energy and other physical commodities. It is a route ICAP has taken EBS down already. Whatever asset classes Integral does identify, they will have to share the characteristics Sandhu pinpointed in the foreign exchange market in the 1990s. Foreign exchange was then the OTC market par excellence. It was large – perhaps even the largest market in the word – and it was liquid. It had never come under the control of a group of intermediaries organised as an exchange. Price discovery, negotiation, execution and even clearing and settlement were done on purely bi-lateral basis. The necessarily limited number of relationships made it hard for any market participant to judge whether the prices they were being offered were reasonable or not. This did not mean the rates were “unfair” - indeed, justice has no part to play in any market – but it did mean that the foreign exchange market was inefficient. Every trading relationship incurred the costs of discovery, establishment and credit assessment, and it was expensive for any one participant to enlarge the circle of his counterparts. The principal achievement of the Integral network, says Sandhu, is to have reduced those costs. He says Integral has cut virtually to zero the cost of finding and connecting to new counterparties, and that it is cutting costs further by standardising the cost of negotiating, executing and settling trades with every counterparty. “We looked at this highly fragmented world of OTC market participants and said, `Look, there must be a way of using technology to integrate this highly fragmented world,’” he recalls. “We knew we had to do it in such a way that the individual market participants would be able to retain control of the number of direct relationships that they have, but also in a way that dramatically reduced the friction associated with establishing and maintaining those relationships. The result, we always knew, would be a much wider network of relationships, and much more efficient execution.”

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