Richard Olsen: Hello, Martin. It's a great pleasure for me to be able to interview you on the question of liquidity and the FX markets. Will you briefly explain to me what you think are the major driving forces behind today's liquidity in the FX market?

Martin Wiedmann: The experience now is what I would describe as 'discontinued' liquidity. We no longer have a 24-hour liquid foreign exchange market where you can basically transact any type of price. Today, it's mostly discontinued in that you have liquidity now and it completely disappears a minute later, and it may come back 20 minutes later, then disappear again. So, it goes in waves. I explain this for the following reasons. With the introduction of the electronic trading systems, there is no obligation anymore from the market-making participants, the market-making banks, to provide any liquidity. To the contrary, the market-making banks have basically just to show their interest, to show their bid or their ask in any given deal but they no longer provide a two-way market to the professional inter-bank market. So, in the old days, a Deutsche Bank could call up UBS, making a two-way quote, 25 million Euros against U.S. dollars, and we would be morally obligated to show a narrow and constant market spread to our professional counterpart at Deutsche Bank. Today, they wouldn't call us anymore and we don't call them anymore; that market, basically, has disappeared.

So, discontinued liquidity is one thing. The other thing is the large consolidation going on in our industry in terms of a lot fewer banks - with all the mergers going on around the world - providing liquidity. Another factor is that the few remaining banks, they globalize, they centralize their risk activities typically in one global risk book. What used to be dozens of different risk books around the world is now consolidated into one book, and the aggregated risk in that one book is much smaller than it was in the dozens of books before the globalization took place.

So, these factors, I think, have changed the foreign exchange market quite dramatically, and in particular the introduction of the Euro and e-commerce on everyone's agenda.

R: Doesn't the issue of moral obligation play an important role for the ECNs and equity markets? As ECNs spread, the fact that there is no moral obligation to offer two-way price will disappear in these markets as well and lead to lower liquidity in those markets.

MW: Absolutely, that's the case. It will have a constant and dramatic impact on the liquidity and on the spreads you see in that particular market because that moral obligation is gone. That will have an impact on the bid/ask spreads. I expect them to widen as a consequence because it's no longer economical to show a two-tic spread when the execution you achieve in the market is 20 tics away from that two-tic spread. The spread will widen which is a disadvantage to the market-taker.

R: Why have the banking mergers come about? Have they come about due to losses that people incur through market-making, or are there completely other forces?

MW: No, just an over-capacity of banks globally and a need to create synergies and get a more global reach and more critical mass. And only if you are one of the top global players do you have a chance to survive unless you are a good solid niche player. So I don't think it has anything to do with trading as such.

R: You think that's played a small role. For me, at least, the smaller trading rooms had a distinct advantage five, ten years ago, but today a small trading room I think has a very difficult position if it wants to be a market maker.

MW: Yes, very difficult, because they really have no chance to see major flows and to be on top of what's happening in that market. If they are a small niche player and don't have the critical mass and critical market share, they cannot leverage and piggyback on the large transactions they have to execute.

R: Can you explain a little more about this? Most people know so little about what market making actually involves.

MW: Well, only if you see constant flows and good quality flows in the market do you have a chance to position yourself accordingly. Only if you capture what client flows or real underlying flows are, which direction they're going, do you have a chance to take the correct or the right position on behalf of your organization. If you lack that, it's always a 50-50 game, and at the end of the year most likely you have not succeeded in performing.

R: So, basically, what's happening is you see the underlying flow, and based on the underlying flow you take up a strategic position?

MW: Exactly. You only can do that if you have the critical mass: If you have enough investors and capital flow to systematically track the market in order to get a better feel for it. Only then do you have a higher chance to perform.

R: What has the response been of the major banks to all the changes that are occurring?

MW: Global risk books, as I mentioned; smaller risk limits as a whole; electronic portals, electronic platforms, e-commerce offerings including content in order to become a low-cost provider; global platforms, meaning global deal-capturing systems that bring down the cost side of the business and having leaner operations and lower ticket costs.

R: Do you have any estimate what the size of the global risk book is of one of the major players?

MW: That really varies from institution to institution. There's no official data as such.

R: But you would not venture giving a rough estimate?

MW: Well, it depends how you measure and define it. The value
at risk taken in the country markets is essentially smaller than in any other business or trading business the bank does. So the fixed income risk, the equity risk, and the volatility risk any one bank takes is normally much higher than on the foreign exchange side. Take a loan book - your write-offs in a loan book - they are "X" times higher than they ever were in terms of risk in foreign exchange.

R: So the dramatic thing is, in a sense, even though the global need for FX transactions has grown dramatically, the amount of risk capital for market-making purposes has reduced.

MW: That's how I would describe it, yes. The underlying FX business is growing with increased capital flows and increased rate flows around the world. You have smaller risk limits on an aggregated global basis, as a result of the consolidations and the mergers and the disappearance of banks globally, that is exactly the case that you just said.

R: Can you just briefly explain to me what the initiative of FXall.com implies?

MW: FXall.com is an initiative of seven major global foreign exchange houses where we basically write prices to our institutional clients on a 24-hour basis. The institutional clients will always get the closest bid and ask spread provided from the bank they have a relationship with. So, if a client has relationships with all seven banks, he will get the competitive buy from those seven banks and can deal and execute on that narrow competitive price. The client will also receive research, and the FXall.com initiative extends to all foreign exchange products, all cash products bought and sold plus derivatives. It is expected to go live by the end of this year.

R: So I presume the technology is already in place.

MW: It's already in development but it's not rolled out yet as such.

R: Will one of the banks be the leader in terms of technology providers?

MW: No, it's a separate company so that out of seven shareholding banks, no company has majority, other market-makers will be invited to participate going forward.

R: So that might really revolutionize the retail market of the FX business.

MW: Well, first it will revolutionize the institutional market, but it may later have on an impact on the retail market. That will have to be seen. But, initially, it's something for the institutional clients.

R: Institutional retail, yes?

MW: Yes.

R: Can you briefly explain to me how the volume in the FX market is split between large and smaller tickets?

MW: Yes. I believe that 90 percent of the total global foreign exchange volumes are made up of so-called 'induced' foreign exchange tickets, meaning that foreign exchange is a pure byproduct of the securities transaction or foreign payment. And, typically, those deals are small in nature -- $100,000, $250,000 or maybe half a million dollars. But if you add it all up, it's substantial, and I think it makes about 90 percent of the overall global volume. The remaining 10 percent are institutional-type foreign exchange transactions. So it's important to know that all these little deals have a significant impact on the market and on the liquidity of any one market.

R: Do you have any clue of what the average price is at which the small deals are transacted?

MW: That varies largely from institution to institution and from client to client, from country to country. There is no benchmark as such.

R: And it's there where you see the biggest objective of banks to streamline their processing. Is that correct?

MW: Yes. That's where you need to basically be very efficient to process hundreds of thousands of tickets every single day, and where you can basically gain efficiency and also have an internal process in place to basically try to capture the bid and ask spread involved in the small retail type transactions.

R: And then there's the transactions from half a million to three million dollars?

MW: I would say induced goes up to - but that's really a question of definition - but it goes up to three million dollars.

R: And, then, beyond that, basically, it's the big transactions.

MW: Yes.

R: And it's those big transactions which are currently being affected by the disappearing liquidity, as you explained.

MW: Absolutely.

R: So, from your point of view, what is the stance of the regulators to this development?

MW: BIS formed a committee on e-commerce. Their basic goal is to monitor all the implications of e-commerce on the underlying markets, on the liquidity etc, and they try to keep a close eye on the changing marketplace.

R: We have so far not discussed the relationship of derivatives and the underlying stock markets. What do you see? Is there a feedback process?

MW: Yes. Any derivative market can only be as liquid as the underlying market is. If the liquidity in the underlying is discontinued, the liquidity in the derivative market will also become discontinued. As a consequence, overall, short-term volatility will go up and long-term volatility will stay at a slightly higher level than in the old days.

R: But, so, basically, your statement is that this is a danger for the short term but not as much for the long term?

MW: Yes. Implications in the short term are much higher than for the long term.

R: These kinds of breakdowns like the Asian crisis, do you think that's just part of the normal course of business?

MW: Yes, it happens every once in a while that markets become totally illiquid. In the case of the Asian crisis or the Japanese yen crisis in particular, maybe we're not on the same side, but using the Japanese yen as funding currency, if everyone is on the same side, the market becomes heavy.

R: Turning to the current developments, are there any lessons to be drawn for what is going to happen in the near-term future?

MW: I expect bid and ask spreads to widen. I expect that more deals will be done fully-automated electronically. I expect certain consolidation in the industry, meaning much fewer banks capture a greater market share; and that the volatility will move up, that we will see wider moves in future.

R: Can we return to the actual markets, to the Euro? What are your views there?

MW: Meaning which direction it goes?

R: Yes.

MW: Not really. That has nothing to do with whether the Euro goes up or down. It's a question of how will it go up or down. Will it be all the way, will it be volatile, will it be liquid.

R: But your feeling is that it will more likely be disorderly as opposed to orderly. Is that correct?

MW: Yes. But the question is how do you describe disorderly markets.

R: Do you see in the equity markets the local retail investors actually trading those markets? Could you imagine that this same thing happens in foreign exchange, or will it remain the domain of a few specialists?

MW: Oh, we've already seen more day traders using the foreign exchange market, and I think increased volatility, increased gapping, has also changed to benefit from that short-term volatility. You can see a lot of players coming back to the market who were abstaining the last few years and now they're back in business.

R: So that in time will....

MW: Low volatility is a bear market. We need high volatility. That's good for the currency market.

R: So, we're there. You're very bullish on the future.

MW: Right.

R: Thank you. It was great to get your insight.

MW: I hope you can benefit from it.