Last week saw the announcement of the closure to the public of macro hedge fund giant Moore Capital – an act that would have bought a wry smile to generations of FX traders who have, over the decades, found the firm’s business (ahem) a little tricky to monetise. Obviously there are multiple circumstances that led the decision to return money to investors – not least the persistently low interest environment in today’s world, however I also think that some big macro hedge funds have trouble operating in today’s markets – and the lesson from this and other episodes would make instructive reading for some large asset managers.
Moore Capital is not the first to make this move, of course, several other major hedge funds such as Brevan Howard, have done the same and part of the problem is that they became so big that modern markets were a difficult place in which to operate. The problem is actually getting what have become very large deals done – the liquidity is available of course in FX markets, but increasingly it comes at a price as LPs get better at identifying trickier flow (although in many instances the analysis is really a question of how many times you let the steamroller run over you before you decide discretion is the better part of valour).
The availability of better data and the technology to analyse it quicker has undoubtedly made it harder for some larger hedge fund players to execute without slippage – and in a market with volatility as low as this, that slippage becomes an over-sized factor in performance. When markets are kicking off 100 points a day the odd two-three points here and there don’t matter – when the day’s range is often n the single digits of points it does.
So market impact has become a big factor for the larger players and their inherent lack of patience when executing has also played against them. Typically a lot of the major global macro players found best execution to be sweeping the market – some would call it machine gunning – but in the era of last look and better analytics they find their rejection rates soaring (and we won’t go into the “only you” factor!) It hasn’t been that much of an issue until recent years when volatility died, but talking to a friend at one of these firms I understand that the cost of rejects has risen significantly over that time and has started to have a noticeable impact on the bottom line.
These funds are, effectively, the latest “victims” of the shift in attitude in FX markets whereby liquidity providers are taking much more care with where, and to whom, they stream. For years any FX trader could tell you that quoting some of the big global macro hedge funds was a futile task that cost money but their voice was never heard amidst the congratulatory hubbub from the sales desk celebrating more volume credits, or from the management offices where status in an industry poll was being chased.
For some firms, notably prime brokers, this flow retained a modicum of value, but for the majority it was just hard work – now, thanks to better analytics, the fallacy that the revenue lost is made elsewhere in the firm has been laid bare and this has been reinforced by firms demanding more from their trading desks as the latter too struggle with low volatility and pressured returns. In those circumstances it is inevitable that LPs seek to turn off, or widen, trickier flow.
Paradoxically, my recent column about last look being used to price these firms has relevance here because it could be argued that they would be less impacted by wider spreads than they are by rejections. Either way, the impact is being felt.
There is one other factor that plays a role here as well – the changing nature of the relationship with the LPs – and the FX Global Code has played a role in this. It will sound bizarre to most readers outside of a certain generation, but even a decade ago I was treated to stories of hedge funds salespeople – normally the ones in the dealing room with the biggest watches – still telling their clients they could do a better job than the machine when it comes to getting deals done. The quid pro quo for the flow was always in the form of decent entertainment, which is fair enough, and what one person euphemistically told me one day was “tailored market colour”.
It was nothing of the kind of course, it was information on the type of market activity, the sharing of which nowadays would be in breach of the FX Global Code (not that many of these macro hedge funds have actually signed up for it of course). In the dark days, some hedge fund managers were often at the centre of the “I want to know all what your customers are doing but I don’t want them knowing anything about my activity” relationship model.
So while this latest closure is very much about a range of macro themes, the challenge in executing in modern markets is a serious factor. For decades there has been a debate in the FX industry over how, or if, to quote certain very aggressive flow. That debate was largely between trading and sales and currently it seems as though the former has the upper hand.
Ultimately this again comes back to the value of true liquidity – LPs are getting much better at assessing where this precious commodity is best deployed and often the answer is not where it has historically been. Some hedge funds have adjusted their execution style and are benefitting accordingly, others, maybe because they are simply too large, have not – and this is where I think there is a lesson for some asset managers out there, especially those looking to either disenfranchise the banks or put them into greater competition. It is unlikely that a shift to such an execution style will result in revenue for the LPs and therefore, inevitably, questions will be raised as to how these firms are quoted.
Several asset managers have come out loudly against last look and I have great sympathy for their view, but if they were to shift their execution style to a more aggressive fashion then they are inevitably asking for either higher reject rates or wider pricing. Such a shift, should it come, will also happen much quicker than it did with the macro hedge funds.
There is an optimal balance between LP and customer in FX markets but finding it is tricky. There is little doubt that in some cases the balance has shifted too far towards the customer (helped tremendously by the banks’ thirst for market share at any cost). Around the turn of the century the balance was too far towards the banks. We often hear about the value of data and the analytics that crunch it – the next area to benefit should be achieving that optimal balance. Along the way some traditional big names may find themselves marginalised and that will be a shock to some, but it is really just the market modernising.
The benefits of trading foreign exchange will still exist – probably grow again – but it will be on an entirely different set of rules.