FX Markets: A Slippery Chimera?

Cheaper trading, payments and faster automated processing

SAMUEL GARNETT, HEAD OF FX TRADING, EIGER SECURITIES LLP

Last summer we posted an article revolving around the apparent birth of a new ‘ethical’ paradigm in foreign exchange trading markets. A volley of new foreign exchange trading venues being launched over the summer period, with the lion’s share being explicitly aimed at ‘even access’, seemed to be setting a precedent for a new dawn in the world’s largest and, arguably, most complex market. So where are we one year on? What are the main issues being talked about in the currency markets as we move into the autumn of 2013?

One thing is certain, which is that, on the vendor side, the market has been considerably quieter in terms of new product launches this year, with a definite focus instead seeming to have shifted to consolidation of businesses and tackling the raft of new high-level regulatory changes impacting FX clearing. In addition, whilst the array of new product and FX venue launches last summer were all apparently working away in the background, none have seemingly rocked the boat in terms of practically offering anything ‘game-changing’ for currency markets.

Underlying market-wise, the September triennial survey by the Bank for International Settlements showed that, as of this year, average daily turnover in the global foreign exchange market has reached $5.3 trillion, up from $4 trillion in 2010. The same survey also confirmed a jump in UK market share, with $2.73 trillion of the $5.3 trillion being trading via London, a figure up by 47% since 2010. One of the most notable findings of the survey, however, was that trading between financial institutions has risen by 48% over the same period, accounting for $2.8 trillion of daily turnover. Conversely, business with non-financial institutions fell by nearly 5%, and now makes up 9% of global daily turnover.

The above findings tie in very succinctly with a high-level view of financial market developments over the last three years. With huge expansion of central bank balance sheets, most notably the US Federal Reserve, foreign exchange trading has risen dramatically, as banks either shift assets around the world through various vehicles, or use available excess capital to trade the FX markets outright. At the same time, it is of little surprise that, in parallel, non-institutional participation in FX markets has fallen, as global small to medium-sized businesses have seen a contraction in markets and trading.

All the above links precisely to what we see as one of the biggest issues facing FX market participants this year, and in particular the non-institutional participants. This issue is, in conditions of increased volatility of currency prices, how do market participants appropriately manage risk versus reward? One thing at the outset is certain, which is that the increased number of ‘venues’ offering access to trade Spot FX markets on margin are of little real-life use to many entities that simply want to manage underlying ‘deliverable’ risk. A company treasurer, or fund administrator, when faced with a future-dated cashflow currency exposure, has traditionally had only two means of management – the first being to accept the associated currency price risk, and leave the exposure until it materialises, the second being to fix a forward rate to match the anticipated cashflow date. However, whilst the former can pose significant risk to underlying costings, the latter has become increasingly frustrating for many entities, in being tied into a contracted price for a future date, in fast-moving markets. This is especially true where global competition is higher than ever and an edge on an FX rate can make a large underlying difference to revenue.

Interestingly, the subject of much comment in the news this month has been Aviva’s reported use of currency options to hedge both balance sheet and cashflow risk, in volatile FX markets. These instruments, consisting of straightforward rights to buy or sell currency at future dates, without obligation, have been popular tools at the institutional level of the market for many years.

It has only been the last year, however, that has seen a growth in these products being offered to the wider market. Non-institutional dealers, and investors, can now access online platforms where they are able to access and trade these markets on a liquid basis. To date, however, most non-institutional entities (companies, a large proportion of funds and individuals) that are not looking to trade on ‘margin’ but looking to manage underlying costings and risk, have been left out. These products have only been the preserve of larger companies and funds that are most attractive to banks in terms of the volume and frequency of trading they require.

One of our views, however, for moving into the last quarter of 2013, alongside anticipated increased volatility of FX markets, and a ‘topping out’ in terms of liquidity, is a levelling of the playing field for non-institutional entities, looking to stay ahead of currency markets in terms of their ability to manage aforementioned risk. Despite last year in particular seeing many banks, vendorsand brokers in the FX market calling for greater ‘transparency’ and level access to the market, we believe there is potential for a breakdown in the underlying basis of these calls. Particularly in light of greater FX market regulation, it is likely that the make-up of the market is going to re-evolve over coming months, with all entities weighing up the real costs of ‘pure price-driven’ dealings focusing on the price of headline instruments, alongside the actual ability of many entities offering such a proposition to continue in light of politically-driven changes.

We believe that currency markets will become increasingly difficult to navigate, in a highly competitive economic environment, and as we move toward 2014, companies and traders will look towards more comprehensive products backed by informed ideas and thinking, rather than towards autonomous ‘electronification’ (much hyped, particularly last year). In an FX market that looks to be re-diversifying in some respects, counterparty risk will need to be at the top of the agenda for traders and treasurers alike. Corporates and fund administrators, for example, looking for more competitive pricing on their FX, will have to stay savvy when trying to strike the balance between cheaper pricing available from web applications being sold by many small FX brokers on the one hand, and the value-added-backed pricing now starting to become increasingly available from sources such as the custodian or some brokers.

FX traders, and the variety of entities looking to hedge FX risk, need be aware of the pitfalls that underlie dealing with many of the vast number of FX margin-trading companies out there. Extremely small bid-offer spreads need to be looked at in the context of the indeterminate pricing for rolling FX positions over, often referred to as the ‘rollover rate’. Furthermore, value-add in terms of appropriate information on products, applicability and suitability need to increasingly come to the fore. In a similar fashion, we believe that for ‘FX payments’, both counterparty risk and compliance risk (with many such FX payment companies ceasing operations this year after a risk clampdown by the main banks) need to be at the forefront of thinking for treasurers and individuals. The much hyped ‘levelling’ of the playing field of last year for FX markets, we believe, is dying a death no sooner than the idea emerged. The explosion of web-based use for financial dealings, combined with a huge increase in institutional-level liquidity over the last years, is fundamentally what has fuelled the boom and hype over costs of trading having reduced in FX, with competitiveness rocketing. Fundamentally, the market as it exists is unsustainable. As we enter a new era of financial markets tapering in terms of regulation and liquidity, the FX market has to change.

Samuel Garnett is head of FX Trading at Eiger Securities LLP and of the FX payments operations at Eiger Foreign Exchange, a provider of inter-dealer broking services to global banks. Eiger launched its FX Options Desk at the beginning of October.