The decentralised and fragmented structure of the foreign
exchange (FX) market has always been both its greatest strength and biggest
weakness. Customisability, deep liquidity and resilience are its major plus
points, while lack of transparency is its biggest problem. The doubling in size
of overall trading volumes since 2004 has only exacerbated the trend. One only
needs to look at the ongoing problems suffered by Bank of New York Mellon, which
has been accused of overcharging clients on FX trades over a 10-year period, to
see that lack of visibility still remains a major problem despite the
technological advances of the past decade.
However, treasurers can
easily avoid transparency issues and improve liquidity and credit risk by
following best practice guidelines. The first step is in performing regular FX
transaction cost analyses, collecting achieved rates and comparing them against
market rates at the time of trade. This data is readily available and will allow
for direct cost calculations. Equally, treasurers should use competing FX trades
to achieve better pricing. For example specialist FX brokers tend to offer far
better rates than the commercial banks. Although this means having dealing
facilities with several providers, wallet sharing allows for better price
discovery, improves firm liquidity and spreads credit risk over several
counterparties instead of concentrating it on one single provider.
As well as market-specific problems, the current outlook of the world economy
presents other issues. FX has always been one method used to express a view on
the state of country, but with interest rates still at record lows, central bank
policy is the major driver of exchange rates in the current market. For example,
the Bank of Japan (BoJ) has sought to significantly devalue the yen (JPY) over
the past 12 months in order to boost growth. The JPY is currently trading just
below ¥100 per US dollar (USD), meaning treasurers who hedged yen sales before
the aggressive BoJ action in December are currently enjoying 25% higher dollar
receipts compared to the current spot price.
While the JPY has
recently consolidated the BoJ is still expected to maintain a loose and
aggressive policy, which leans towards a negative bias. Not all central banks
are created equal however, and the ‘elephant in the room’ remains the US Federal
Power of the Fed
Currency movements in reaction
to Fed policy, particularly to the news of a slowing down of asset purchases or
‘tapering’, are easily overwhelming normal trade flows and are completely
dictating the path of some currencies. The Indian rupee (INR) is the current
and most extreme example of this, depreciating almost 20% against sterling since
May this year. Other emerging markets, notably Turkey and Indonesia, have also
suffered large outflows since tapering was announced leading to unwanted
instability in almost all areas of each economy and prompting official
intervention by central banks and governments.
Even developed market
currencies are not immune to the power of the Fed. The Australian dollar (AUD)
has fallen by 18% against the USD since April as the Reserve Bank of Australia
(RBA) cut interest rates to counteract the country’s slowing economy. Declining
commodity prices (a direct result of Fed policy) and falling demand from China
for raw materials is forcing the Australian authorities to attempt to rebalance
the economy, and a lower exchange rate is the first step in the that process. As
such, multinational corporations (MNCs) with operations in Australia or exposure
to AUD should consider hedging to best mitigate FX exposure.
are many other products available than can help reduce currency fluctuations,
such as futures contracts, participating forwards and non-deliverable forwards
which allow for hedging to take place even in the absence of a deliverable
forward market in a currency. The recent development of non-deliverable forward
markets allowed for the hedging of many emerging market currencies. Crucially,
such hedges rely on an active spot market for currencies, which rapid
appreciation/depreciation of a currency and the governmental response to such
moves via capital controls can stop almost overnight.
With an end
now in sight for the unprecedented global monetary easing in place since the
2008 financial crisis, treasurers need to be increasingly aware of tighter
monetary policy on capital flows and the resulting knock-on effect on exchange
rates. Emerging markets with perceived weak governments will be most heavily
impacted as investors withdraw capital, with funds flowing back into developed
countries as interest rates gradually normalise.
Looking further ahead, upcoming regulatory changes have
the potential for further evolution of the FX market, particularly the general
trend away from over-the-counter (OTC) markets towards regulated ones. Although
it is unlikely that the current Markets in Financial Instruments Directive
(MiFID II) (the updated Europe-wide legislation for investment services) will
seek to regulate spot FX, the broader scope of instruments that will trade on
regulated exchanges once MIFID II is complete means that multilateral trading
facilities (MTFs) and organised trading facilities (OTFs) may decide to bring FX
under the same umbrella in order to attract greater flows. Greater flow would
need to be compared to the greater costs of on-exchange trading, but a rival
exchange-based FX market is becoming much more likely as technology continues to
drive down the costs of trading.
The US Dodd-Frank Act complicates
matters further still, with certain products exempt from regulation (spot,
swaps) while others such FX options and non-deliverable forwards (NDFs) are not.
The fragmentation of products between exempt and non-exempt creates the problem
(or opportunity from the banks’ perspective) of arbitrage between trading
centres covered by differing regulations. This will impact on execution venues
and overall market liquidity and treasurers should be aware which products and
which venues offer the best solutions for their individual needs.
Increased regulation is also very likely to spark another round of product
innovation and financial engineering, broadening the scope of FX products and
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