Global FX Markets Thriving in 2007

The global foreign exchange (FX) market is the world’s largest marketplace. In 1977, the average daily trading volume was US$5bn, but in the past three years this has seen growth of over 38% and daily volumes reached US$2.9 trillion this year. This is around 50 times more than the daily trading volume on the New York Stock Exchange. There are a number of reasons for the strong growth – the FX market trades 24 hours a day, is globally diverse and technological advances that automate the trading process create efficiencies.

The FX market is also being boosted structurally, as Rick Schumacher, at Wall Street Systems, describes in his article Foreign Exchange: Keeping Pace in an Explosive Market. Just as Russia did in July 2006, when countries make their currencies convertible on the capital account, the trading volume of that currency increases. “Worldwide structural changes are allowing significant increases in assets allocated to international markets,” notes Schumacher. This highlights the strategic shift to increasing international allocations that is currently happening in the FX market, which is driving the market’s continued growth.

Where to Get Your FX Fix

Traditionally, the major high street banks are where corporates go to buy or sell foreign exchange. However, competition has emerged in the FX market that has squeezed the dominance of banks. Taking the UK FX market as his example, James Arnold, at Investec, highlights one challenge to the banks in his article Non-banks in the UK’s FX Market. When FX was dominated purely by banks, it could be argued that areas such as pricing and service were not as competitive as they could have been. This encouraged non-banks to enter the market. Aided by the fact that the FX market in the UK did not require Financial Services Authority (FSA) regulation or banking status, non-banks offered corporates a simple premise – they allowed corporates to book their FX rate and make a payment at the same time, offering attentive customer service and competitive rates. As Arnold notes, “This one-stop shop philosophy attracted many clients. All of a sudden, UK companies could book an FX rate and send their payments with just one phone call.” But banks have not been usurped. The diversity of investment instruments available in FX markets extends beyond the reach of non-banks. For example, FX options, which offer corporates a degree of flexibility and security with their investment, can only be traded by FSA-regulated institutions. The entrance of the non-banks to the market has had the effect of forcing banks to improve their competitiveness, not just in the markets where they compete head to head, but across the board.

In addition to non-banks, the rise of algorithmic trading has shaken the tight grasp that banks had on the FX market. Banks are no longer able to control FX prices and spreads as they used to, because algorithmic trading has levelled the playing field between the buy and sell side. “Trading orders can now be automatically executed; market timing and price can be better controlled; and large volume trades can be automatically divided up into several smaller trades to reduce their market impact,” explains Wall Street Systems’ Schumacher.

Who’s Investing?

The broad spectrum of investment instruments, such as forwards, structured derivatives, swaps and options, in the currency derivative market attract a wide range of investors. For example, the flexibility of structured derivatives allows investors to benefit from currency development at the pace they require to hit their goals and can accommodate a variety of risk profiles.

Hedgers are drawn to the FX market due to the flexible, tailored solutions that are available to them here, according to Anders Vik and Valérie Schneitter, of Credit Suisse, in their article Foreign Exchange: An Overlooked Asset Class?. They explain, “In addition to portfolio or cash flow protection against FX risks, the hedger may have the opportunity to benefit from potentially favourable spot movements and enhanced hedging compared to forward transactions, or to reduce the upfront hedge cost compared with a hedge with options.”

In addition, investors and yield enhancers are drawn to FX due to products that offer capital protection even in unfavourable conditions. Some investments can generate returns in rising, falling, or stagnant market conditions. New investment opportunities are being seen in emerging markets, with particularly good growth in Asia and Latin America. “Moreover, structured derivatives offer investors access to currencies that are not freely convertible, such as the Chinese renminbi,” explain Credit Suisse’s Vik and Schneitter. For example, currency baskets that offer simultaneous exposure to a large number of different currencies are increasingly favoured.

Technology Increases Sophistication

As with all areas of finance, technology has an important role to play in FX, making processes more sophisticated and generating extra returns as a result. Electronic FX trading (e-FX) currently accounts for more than 40% of total FX volume, and this is expected to grow to 44% by the end of the year. Electronic trading has made it easier for more investors to enter the market, trade-processing costs have dramatically fallen, and smaller banks are better able to compete with their larger competitors. Schumacher, at Wall Street Systems, explains, “FX straight-through processing reduces capital and hardware costs and, in addition, trading fees for buy-side clients have been reduced substantially and on some platforms have even been eliminated.”

And yet the growth of the FX market, partly boosted by technological innovation, could be putting a strain on the very technology that helped it expand. This is the view of Adam Hawley, at Caplin Systems, in his article Defining a Web 2.0 Strategy for Online FX Trading Portals. Hawley argues: “The technology deployed in response to the first wave of online trading is not advanced enough to cope with the demand of today’s market-savvy participants.” As expectations and demands on the FX market evolve and grow, so must the technology that underpins so much of the market activity. This is being seen in the development of Web 2.0 and Rich Internet Applications (RIAs), which are a way of using the Internet as a platform for FX. When it comes to developing a strategy for implementing the new generation technology into their FX operations, there are four areas that Hawley identifies for special attention: drive down latency on core platforms; deliver core functionality to clients over the web; combine FX trading services with other assets; use RIA technologies to deliver the functionality of a desktop trading application through an Internet browser.

RIA technologies allow external web facing services to be integrated into the platform, such as research and news feeds. This allows traders to make instant decisions as news is happening. In fact, technology is advancing to take this trading decision out of the hands of the human trader, and putting it into the hands of software trading programs instead. News providers such as Dow Jones and Reuters have introduced more structured news feed capabilities to help this happen – by adding XML tags, news feeds can become ‘computer readable’ by algorithms. “By turning streaming text into ‘textual data’, such news is much more amenable to automated interpretation by a trading strategy. With the right tags, a strategy can analyse and react to news much more quickly than a human trader could,” explains Chris Martins, at Progress Software, in his article Algorithmic Trading in the FX World.

Technology in algorithmic trading is also moving on, from the original ‘black box’ algorithms, which suffered from being commoditised and didn’t allow alpha returns to be realised. The next evolutionary stage in this type of trading has been dubbed ‘white box’, and these algorithms provide trade strategists with a greater level of control and the ability to act upon unique trading ideas and incorporate these into the code of an algorithm to hopefully generate alpha returns. As Progress Software’s Martins notes, “The ability to customise algorithms according to a firm’s unique requirements and quickly develop algorithms for first mover advantage brings increased opportunity for competitive gain.”

Investor Strategy

One way for investors to get a return from the FX markets is to exploit the inefficiency linked to global interest rate differences. While a 12-month money market investment in Switzerland earns interest of 3%, a similar investment in Brazil could earn 10.75%. So-called ‘carry strategies’ try to profit from these differences, by investing in high yield currencies, and borrowing from low yield ones. This simple premise actually requires a fair deal of skill in predicting market volatility and the ability to take on the risk that this entails. “Timing and risk management are key to the success of such strategies. Even if the risks linked to simple carry trades cannot be eradicated, they can be greatly minimised,” say Credit Suisse’s Vik and Schneitter.

In their article , Kristian Siggard-Jensen and Johan Ditz Lemche, at Saxo Bank, sound a note of caution for carry traders, suggesting that they have become too focussed on differentials and are ignoring global macroeconomic signals. Without the highly volatile market that existed two or three years ago, carry traders are now willing to take more risk as the chance of losing a lot of money is comparatively low. However, Siggard-Jensen and Lemche predict that the interest rate hikes seen in Europe and the US are coming to an end – and it was these rate rises that helped boost returns in the carry trade. They predict a macroeconomic realignment occurring in the near future, which will start either in the US, Japan or New Zealand. “If we were carry traders, we’d look for another month at the most, then take the profits and find something else to put our money into,” say Siggard-Jensen and Lemche. This example shows that the global FX market is much more complicated than purely buying one currency, selling another and making a profit. The skill is in managing your risk exposure according to what you can afford and what you hope to get in return, taking into account a number of global market nuances.

As with other financial markets, the more risk you can afford to take on in FX, the greater the potential returns are. Another form of risk is seen in algorithmic trading – the risk associated with delegating your FX trading to an automated system. However, the same technology that creates this risk can also be used to mitigate it. Technology exists that can monitor portfolios and constantly check value-at-risk to make sure that any breaches of risk thresholds are immediately identified. “Corrective actions can be instantly taken, such as trading to take a position back to a more risk-neutral status,” explains Progress Software’s Martins.

Conclusion

Today’s FX market offers investors a wide variety of investment opportunities to suit all tastes and requirements. The rapid growth of this asset class in terms of instruments, currency markets and technology mean that corporates should investigate how adding or enhancing an FX thread to their investment portfolio could boost their returns. As with all asset classes, there are risks in investing in FX, but with a clearly thought out strategy and the right risk management protocols in place, these should cause corporates no undue concern. And with a large variety of banks, non-banks and traders competing to offer corporate FX services, the efficiencies available make the FX market just as viable as any other.

13 views

Related reading