Trading currencies in the fast lane

NEW YORK (Reuters) - Richard Olsen employs just 15 people at his Olsen Invest hedge fund and admits the atmosphere in its Zurich office is more medical laboratory than raucous trading floor.

"It's extremely quiet -- a fully-automated factory, really," said Olsen, 57, a 28-year financial market veteran.

There's plenty of activity, though. Armed with high-speed technology and advanced mathematical models, computers are busy trading on the $4-trillion-a-day world currency market, able to transmit hundreds of orders in the blink of an eye.

Olsen, who also founded retail currency trading platform OANDA, was an early proponent of high-speed electronic trading. He developed a quantitative trading program in 1985, back when the most common way to buy or sell a currency still involved picking up a phone and calling a broker to get a price.

In recent years, others have been catching up.

The Bank for International Settlements said in December that increased activity by so-called "high-frequency" traders, rather than traditional banks, helped drive a 20 percent jump in daily currency market turnover between 2007 and 2010.

High-frequency traders -- those who use computer models to identify historical patterns or arbitrage opportunities and then execute many small trades at lightning-quick speeds -- now account for 30 percent of FX trading volume, according to the Aite Group, a Boston-based market research firm.

CURRENCY'S INCREASED APPEAL

Aite's Sang Lee said that the proportion of high-frequency trading could rise to 41 percent by 2012, partly thanks to the changing perception of currencies.

"We've seen a transition over the last four or five years to where people view FX more as an asset class in and of itself," Lee said, as opposed to just an exercise in hedging foreign exchange exposure or financing corporate mergers.

That may have something to do with the turmoil the 2007-2009 financial crisis unleashed in the stock market and among other assets such as commodities, he said.

The larger interest in currencies has sparked competition to offer faster trading systems. Online brokers such as OANDA and HotspotFX now compete with larger electronic platforms like Thomson Reuters Matching and ICAP's EBS, all of which rapidly churn out currency prices from multiple sources. Individual banks have got in on the game, too, with trading platforms of their own.

Trading volume at Knight Capital Group's HotSpotFX topped $1 trillion for a fourth straight month in April and was up 54 percent from April 2010.

"We've seen incredible growth in the last couple of years as FX has become much more visible," said HotSpotFX managing director William Goodbody. "There are a lot of hedge funds out there now that are currency-focused."

THE NEED FOR SPEED

Since model-driven traders can execute at lightning speeds, with differences in computer connection speed measured in milliseconds, getting an extra leg up is essential.

Telecom firm Spread Networks recently started offering the fastest round-trip communication -- 13.33 milliseconds -- between the financial capitals of New York and Chicago.

While the firm won't disclose what it charges traders for the service, CEO David Barksdale told Reuters Insider TV that demand has been great, "which proves there's a need for this."

Some funds even pay to set up the computer that handles their algorithmic trading in the same data centers used by the multi-bank platforms or exchanges on which they trade.

"It really has become a technological arms race," said Andrew Lo, a finance professor at MIT.

All that rapid-fire buying and selling makes the market more liquid and makes it cheaper than ever to trade. It's also loosened the grip big Wall Street banks once had on the market, since funds now have access to multiple prices and far more counterparties willing to trade with them.

Speed also brings risks, though, and the more automated trade becomes, the greater the chances a technical glitch can lead to violent, one-way trades that have nothing to do with sentiment or market fundamentals.

The world got a glimpse of that with the 2010 flash crash in the U.S. stock market, in which the Dow Jones Industrial Average plunged about 9 percent in minutes.

Lo said regulators have not been able to keep pace with the technological advances.

"We should think about it as we do highway safety. I may have a Ferrari that can go from zero to 60 in 4.2 seconds, but we should still have speed limits," Lo said.

Some currency traders had flashbacks this year when the dollar plunged nearly four yen in minutes after hitting a record low, though many said that was typical of trading in the highly illiquid hours between the time New York trading desks close and Tokyo ones have yet to open.

WEIGHING THE BENEFITS

There's also concern that smaller, slower traders are getting squeezed out of the market because they can't compete with the faster model-driven traders.

"It's an unfair advantage based on capital," said Robert Jarrow, a professor of finance at Cornell University. "The only way you can do this is if you have sufficient capital to invest in the technology and software."

Even Wall Street pros who don't use algorithmic models are feeling the heat.

"Unlike humans, machines never tire and are as robust at 4 in the afternoon as they are at 8:30 in the morning," said John McCarthy, director of currency trading at ING Capital Markets.

Proponents of high-speed trading say the enhanced liquidity and lower costs ultimately benefit everyone.

"Everything is much more open now," said Olsen. "It's spectacular that you can have such tight spreads for the everyday man and the everyday hedge fund."

And while Olsen and others conceded that speed is of the essence in some strategies, such as exploiting split-second, tiny currency price discrepancies across platforms, that is not always the case.

"Tech is only half of the game," Sebastian Yoon of CFN Services, a technology and infrastructure provider, told Reuters Insider. "The other half is coming up with the right trading strategy."

"The maximum speed is the speed of light, so until someone figures out a way to breach the speed of light, you're limited on how much faster you can get," he said.

(Reporting by Steven C. Johnson; Additional reporting by Fred Katayama; Editing by Chizu Nomiyama)