In this column on February 10 I bemoaned the lack of risk takers in markets, noting that the surge in passive investing in equities markets meant that inevitably the market swings, especially during corrections, will be wild. The last week has kind of highlighted what I meant, it is to be hoped that CTAs and hedge funds managed to fulfil their remit and managed to save at least some investors’ skins – especially those late to the rally.
Obviously those risk takers that do exist would probably have been selling this last week, but towards the end, or maybe this week, some will inevitably start building again. They are unlikely to be led by automated traders, however, because as I noted in the aforementioned column, the data is all pointing one way, mean reversions have been blown apart and until they are told otherwise, the only way is down.
I raise this not to give everyone a “told you so”, but to highlight the risks to the FX industry if the market structure continues with its shift to an equities style, with the associated shift of risk absorbers to brokers. Of course, it very much depends upon where you sit in the industry, speculators should be loving this volatility, but if you accept the premise that the end user, the asset manager or corporation, sits at the heart of the FX market’s raison d’etre (and, incidentally, the heart of most revenue generation), then the last thing you want to see is a market heavily balanced to the broker/passive model.
A strength of the foreign exchange market has always been how it managed to incorporate so many different views, but that also takes different types of player, not least serious risk takers (and I am talking more than a few seconds or even minutes) in banks and hedge funds. As bank trading operations are hamstrung by regulation and management’s collective antipathy to risk, and hedge funds suffer criticism for not managing to keep up with the S&P 500 (I suspect they will in February!) there is a real risk that the FX market ends up looking like equities, in that we often get the biggest move of the day at the “close” (which, ridiculously and highlighting their indifference to FX, many asset managers still believe exists at 4pm London most days) and that the way we treat customer flow becomes even more homogenised. If that happens then the FX market suffers swings like equities, it will all be one way traffic – and who really will enjoy hedging cash flow in such an environment? All of a sudden, an administrative function at a customer will become potentially expensive and it’s not meant to be like that: there are meant to be banks offering them a reasonable risk warehouse price and not just another algo that risks triggering a big swing due to the nature of liquidity in FX markets today.
It is also important to note that customers need to think about how their relationship works if we do get an extended period of volatility. The peer-to-peer model being promoted by a few noisy buy side interests in particular would be tested in such an environment, I also think that banks would be perfectly in their right to place a lower priority on customer requests from firms that have decided to move to this model. Risk transfer will still be available of course, but could come at a much steeper price, and I don’t blame banks or other LPs for deciding they do not want to fulfil the liquidity provider of last resort role for these customers. The peer-to-peer model can still work, of course, but I am fascinated to know how it copes in volatile environments when waiting for a match costs real money, especially if the backstop of a bank stream is unavailable.
I have to stress that FX markets dealt quite well with last week’s volatility, although we don’t know exactly how things went for the customers who could have paid a higher price to hedge, but we should not be complacent. The shift in market structure is still fairly nascent and there are risk absorbers around, but if the trend continues…my nightmare scenario becomes a distinct possibility.
*In my column of February 10, I mourned the passing of Steve Jennions and received many messages from those who knew him but hadn’t heard the sad news. I understand that the funeral takes place on March 13 in Norwich.