BIS Report Sees FX Shift to Relationship Trading

The latest Bank for International Settlements Quarterly
Report carries a paper, Downsized FX
Markets: Causes and Implications
, which suggests that amongst the many
structural shifts taking place in FX markets, a move towards relationship
trading is underway.

The authors suggest that this shift, along with the changes
in the composition of market participants and their trading patterns may have “significant
implications for market functioning and FX market liquidity resilience going

The paper notes that trading with non-financial
counterparties has fallen 20%, a reflection of reduced global trade flows. It
argues, however, that conventional macroeconomic drivers alone cannot explain
the evolution of FX volumes or their composition across counterparties or

This is because fundamental trading needs only account for a
fraction of transactions, the authors observe, adding that instead, the bulk of
turnover reflects inventory risk management by reporting dealers, their
clients’ trading strategies and the technology used to execute trades and
manage risks.

Although it could be ascribed to the uncertain macro-economic
environment as well as geo-political shifts, the paper signals a change that
has seen the composition of participants changed in favour of more risk-averse

“The greater propensity to transact FX for hedging rather
than risk-taking purposes by these investors has led to a decoupling of
turnover in most FX derivatives from that in spot and options trading,” the
paper states. “Patterns of liquidity provision and risk-sharing in FX markets
have also evolved. The number of dealer banks willing to warehouse risks has
declined, while non-bank market-makers have gained a stronger footing as
liquidity providers, even trading directly with end users.

“These shifts have been accompanied by complementary changes
in trade execution methods,” it adds, before suggesting that the market
structure may be slowly shifting towards a more relationship-based form of
trading, albeit in a variety of electronic forms.

Although the authors say that the fall in global trade and
capital flows accounts for some of the decline in spot turnover, they also
highlight what they term the “decline” in prime brokerage, which has been
associated with a fall in trading by hedge funds and principal trading firms. The
paper says that overall PB volumes declined 22% and in spot they fell by 30%.
“Prime brokers have focused on retaining large-volume clients, such as large
principal trading firms (PTFs) engaged in market- making, while shedding retail
aggregators, smaller hedge funds and some high-frequency trading (HFT) firms,”
it says.

The paper also notes, in what could be termed a “chicken and
egg” scenario, that hedge fund returns have been under pressure post-crisis,
with assets under management falling further after the Swiss franc shock. It
also notes that the fall in PTF activity largely reflects the saturation of HFT
strategies focused on aggressive fast trade execution and short-term arbitrage.
The introduction of “speed bumps” in the form of latency floors by major
inter-dealer platforms made such strategies less attractive, it notes.

The paper does identify a shift towards Asian financial
centres on the part of hedge funds and PTFs, albeit from a very small base. “Specifically,
FX trading by hedge funds and PTFs in London and New York dropped by 50% and 10%,
respectively, but rose by 88% in Hong Kong SAR, more than doubled in Singapore
and tripled in Tokyo,” it states. “Combined, Asian financial centres now
account for 4% of trading by hedge funds and PTFs, compared with 1% in 2013. In
part, this shift reflects the increased liquidity of Asian currencies, inducing
PTFs to co-locate closer to the corresponding trading venues.”

The authors also note that in wholesale FX trading, a more
pronounced bifurcation of liquidity provision can be observed among dealers. “While
some banks have successfully built a business model around client flow
internalisation and warehousing risk, others merely act as a conduit by
operating an agency model,” they observe. “In this environment, the electronic
relationship-driven OTC model has thrived, whereas volumes on primary wholesale
electronic trading venues have declined.

“In addition, bank dealers have been facing increased
competition from electronic market-makers,” they add. “Some of these
technologically driven players have also emerged as flow internalisers, but the
majority of non-bank market-makers often do not bring much risk absorption
capacity to the market.”

The paper argues that these changes in the composition of
market participants and their trading patterns may have implications for market
functioning. “While relationship-driven, direct dealer-customer trading on
heterogeneous electronic trading venues delivers lower spreads in stable market
conditions, its resilience to stress may be tested going forward,” it suggests.
“For example, non-bank market-makers may have higher exposure to correlation
risk across asset classes. There are also indications of rising instances of
volatility outburst and flash events.

“Tentative evidence suggests that market participants rush
to traditional anonymous multilateral trading venues when market conditions
deteriorate,” it continues. “Hence, the risk-sharing efficacy of the evolving
FX market configuration is still uncertain. Any major changes to liquidity
conditions might have consequences for market risk and the effectiveness of the
hedging strategies of corporates, asset managers and other foreign exchange end


Twitter @Profit_and_Loss

Colin Lambert

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