Mechanics of Trading Through Brokers:Voice Brokers and Electronic Brokering Systems

The traditional role of a broker is to act as a gobetween in foreign exchange deals, both within countries and across borders.Until the 1990s, all brokering in the OTC foreign exchange market was handled by what are now called live or voice brokers. Communications with voice brokers are almost entirely via dedicated telephone lines between brokers and client banks. The broker’s activity in a particular currency is usually broadcast over open speakers in the client banks, so that everyone can hear the rates being quoted and the prices being agreed to, although not specific amounts or the names of the parties involved. A live broker will maintain close contact with many banks, and keep well informed about the prices individual institutions will quote, as well asthe depth of the market, the latest rates where business was done, and other matters. When a customer calls, the broker will give the best price available (highest bid if the customer wants to sell and lowest offer if he wants to buy) among the quotes on both sides that he or she has been given by a broad selection of other client banks. In direct dealing, when a trader calls a market maker, the market maker quotes a twoway price and the trader accepts the bid or accepts the offer or passes. In the voice brokers market, the dealers have additional alternatives.Thus,with a broker, a market maker can make a quote for only one side of the market rather than for both sides.Also, a trader who is asking to see a quote may have the choice, not only to hit the bid or to take (or lift) the offer, but also to join either the bid or the offer in the brokers market, or to improve either the bid or the offer then being quoted in the brokers market. At the time a trade is made through a broker, the trader does not know the name of the counterparty. Subsequently, credit limits are checked, and it may turn out that one dealer bankmust refuse a counterparty name because of credit limitations. In that event, the broker will seek to arrange a name-switch—i.e., look for a mutually acceptable bank to act as intermediary between the two original counterparties. The broker should not act as principal.Beginning in 1992, electronic brokerage systems (or automated order-matching systems) have been introduced into the OTC spot market and have gained a large share of some parts of that market.In these systems, trading is carried out through a network of linked computer terminals among the participating users.To use the system,a trader will key an order into his terminal, indicating the amount of a currency,the price,and an instruction to buy or sell. If the order can be filled from other orders outstanding, and it is the best price available in the system from counterparties acceptable to that trader’s institution, the deal will be made. A large order may be matched with several small orders.If a new order cannot be matched with outstanding orders, the new order will be entered into the system, and participants in the system from other banks will have access to it. Another player may accept the order by pressing a “buy”or “sell” button and a transmit button. There areother buttons to press for withdrawing orders and other actions.Electronic brokering systems now handle a substantial share of trading activity. These systems are especially widely used for small transactions (less than $10 million) in the spot market for the most widely traded currency pairs—but they are used increasingly forlarger transactions and in markets other than spot. The introduction of these systems has resulted in greater price transparency and increased efficiency for an important segment of the market. Quotes on these smaller transactions are fed continuously through theelectronic brokering systems and are available to all participating institutions, large and small, which tends to keep broadcast spreads of major market makers very tight. At the same time electronic brokering can reduce incentives for dealers to provide two-way liquidity for other market participants. With traders using quotes from electronic brokers as the basis for prices to customers and other dealers, there may be less propensity to act as market maker. Large market makers report that they have reduced levels of first-line liquidity. If they need to execute a trade in a single sizeable amount, there may be fewer reciprocal counterparties to call on. Thus, market liquidity may be affected in various ways by electronic broking. Proponents of electronic broking also claim there are benefits from the certainty and clarity of trade execution.For one thing there are clear audit trails, providing back offices with information enabling them to act quickly to reconcile trades or settle differences. Secondly, the electronic systems will match orders only between counterparties that have available credit lines with each other.This avoids the problem sometimes faced by voice brokers when a dealer cannot accept a counterparty he has been matched with, in which case the voice broker will need to arrange a “credit switch,” and wash the credit risk by finding an acceptable institution to act as intermediary. Further, there is greater certainty about the posted price and greater certainty that it can be traded on. Disputes can arise between voice brokers and traders when, for example, several dealers call in simultaneously to hit a given quote. These uncertainties are removed in an electronic process. But electronic broking does not eliminate all conflicts between banks. For example, since dealers typically type into the machine the last two decimal points (pips) of a currency quote, unless they pay close attention to the full display of the quote, they may be caught unaware when the “big figure”of a currency price has changed. With the growth of electronic broking, voice brokers and other intermediaries have responded to the competitive pressures.Voice brokers have emphasized newer products and improved technology. London brokers have introduced a new automated confirmation system, designed to bring quick confirmations and sound audit trails. Others have emphasized newer products and improved technology.Therehave also been moves to focus on newer markets and market segments. The two basic channels, direct dealing and brokers—either voice brokers or electronic broking systems—are complementary techniques, and dealers use them in tandem. A trader will use the method that seems better in the circumstances, and will take advantage of any opportunities that an approach may present at any particular time. The decision on whether to pay a fee and engage a broker will depend on a variety of factors related to the size of the order, the currency being traded, the condition of the market, the time available for the trade, whether the trader wishes to be seen in the market (through direct dealing) or wants to operate more discreetly (through brokers), and other considerations.The 1998 Federal Reserve turnover survey indicated that brokers handled 41 percent of spot transactions, and a substantially smaller percentage of outright forwards and FX swaps. Altogether, 24 percent of total U.S. foreign exchange activity in the three traditional marketswas handled by brokers. In the brokers market, 57 percent of turnover is now conducted through automated order-matching systems, or electronic brokering, compared with 18 percent in 1995.