Are we undergoing a sea change in the FX trading landscape? I suspect we are but the direction in which change is heading will be familiar to those of a certain generation.
Over the past few months I have had many conversations with FX traders about market conditions and while there is a fair bit of doom and gloom it’s not all misery out there. Those that are unhappy have generally had either a rigid trading framework placed upon them in the form of rules around what they can and cannot do when holding customer orders, or they grew up in the high volume days of just a few years ago. The former exist largely in banks, the latter in market making firms or the e-business.
The happier ones, according to my totally unscientific and anecdotal survey, are those traders who can ride out the threat of a drawdown or two – absolutely be able to take losses at times – but generally hang in there with their positions. In other words, an old-fashioned, macro trader. Those in that community I have spoken to over the past few months are not exactly turning cartwheels, but they are making decent money and the volatility of their P&L is not excessive. Things could be better – isn’t that always the case? – but they could be a lot worse.
In this week’s In the FICC of It podcast, P&L’s editor Galen Stops recounts the story of a meeting he had with a market maker in which his luncheon companion bemoaned the state of the market, specifically the lack of volatility. The opportunity seen by this person was in the technology business – and in the ‘cast I express my doubts over whether that particular boat has sailed, but other firms are hanging in there on the trading side and preferring to look at their strategies. What they are then doing, it seems, is adjusting them back to what could be termed more traditional styles.
Even among non-bank market makers there is word that at least some of the quant skills available in the firm are being directed towards seeing if slightly longer term, predictive strategies can be developed. The answer to that is for much brighter people than me to deliver but I would have thought there might be something in it, as long as they can bridge the divide between having fantastic price action data and insight but still having to be reactive to news events and economic trends.
There is little doubt in my mind, as I have argued previously in these columns, that the market makers’ skill in pricing in events has largely taken away the opportunity for traders to jump on a news event – the news is out and 25 milliseconds later it is appropriately priced in. Of course there are occasions when that judgement is incorrectly priced, but the lack of real risk appetite in the market means few are willing to test it to the extent it would cost them serious money, and besides, the speed of their technology means the market maker has the opportunity to adjust without too much damage.
This means that anyone wanting to make money out of trading the FX market has have a longer, probably more macro, view. It has to be about the bigger picture than one release or statement, even, as I have said before in these pages, it might be that traders have to have a view, wait for something to go against it and then (assuming the new input is not sufficient to change their overall view) trade with the benefit of a better entry level?
That same skill of the market makers (along with a bit of last look) I mentioned earlier also tends to negate those still trying to squeeze a living out of arbitrage – the FX market is largely too efficient for this to work anymore – and even if it did, the volumes we are seeing would make returns pretty meagre compared to the technology spend required to operate the strategy in the first place.
If the sea change I am describing here is actually happening, then this requires those market makers to adjust their view of the world as well, and into the bargain I suspect it would force a few of the weaker firms out of the ecosystem. Such a change would mean lower volumes generally because the number of high volume accounts will drop dramatically. Equally, the lack of volatility in markets just encourages internalisation strategies even more, meaning less volume hits the public market – it will be interesting to see how spot FX volumes play out in the BIS Triennial Survey to be released in September compared to the pretty awful month the public platforms during the survey month of April.
For the market makers such a change means opportunity to make more money from less flow, ifthey are really able to hold some risk for a period of time. The flow they will be interacting with will be less “timed”, the technology of the liquidity consumer will be less speed-focused and the latter will not care if the market drifts away from their position initially – they are emphatically not about the instant gratification that has dominated thinking and traders’ strategies for much of the past decade or more.
There has always been the tendency in foreign exchange circles to focus solely on the busier, and often louder, participants and over the past decade this has been the active trading community. That community is shrinking and is likely to continue to shrink as opportunities fail to emerge. For once the banking industry may actually be ahead of the game with its broad decision to focus more on the value accounts over the past two years. The sharp, clever and awkward counterparties have been cast off to exist in a world of ECNs or that populated by liquidity recyclers, who have, in turn, run into problems with some banks over their own flow (which of course is coming from the same sharp, clever, awkward players the banks had already turned off!)
Whichever way things turn out the FX industry is in a period of introspection within which businesses are pondering how, maybe if, they should progress – and of course there is always the “darkest before the dawn” element which means, not for the first time, the industry will switch direction just in time for conditions to change! There is, however, a sense that something has to change, because selling vol is a limited strategy and at some stage the risk/reward will just not be there.
That said, it also needs to be reiterated that a lot of the unhappiness being expressed with conditions is coming from that segment of the industry that lives exclusively for volume. Corporate treasurers, central bankers, asset managers and even those governments not engaged in some form of currency manipulation have absolutely no problem with current conditions, and nor do an increasing number of hedge funds who are returning to the macro game. This would not be the first time conditions in the foreign exchange market prompted a widespread change of strategy amongst players – I very much doubt it will be the last. What I am certain of, however, is that there is nothing too concerning about changing conditions in markets – that is, and has been, a fact of life since they first started.