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Crouching Tiger, Hidden Dragon?

The Asian financial crisis did more than knock investors’ confidence in the region – it also saw a dramatic decline in Asian FX markets as banks responded to lower customer volumes by reducing staff numbers. Another factor was that with almost no exceptions, electronic trading was rolled out in Europe and North America, while Asia continued with the telephone and conversational dealing tools.

Infrastructure issues as well as the enormous geographical and cultural differences around the region, meant that progress was slow – and until recently limited to the major centres in the region.

But if one believes that electronic trading, with all its benefits, is the catalyst for market growth, then a key element has been missing until the last few years. That is changing, however, as banks re-position their resources to take advantage of the growth in Asian markets. Indeed some very senior personnel – both e-commerce and markets people – have relocated to Asia at banks like Barclays Capital and JP Morgan and other institutions are expending serious resources on building and broadening Asian operations.

A recent report from the Bank for International Settlements (BIS) looks at the development of Asian FX markets, and finds that turnover of Asian currencies rose sharply between the 2004 and 2007 BIS Triennial Surveys of FX Turnover. Financial institutions became more important customers, and the participation of non-residents increased.

The report does note, however, that the continuing existence of exchange controls undermines progress and Herstatt risk remains widespread due to the low number of Asian currencies covered by Continuous Linked Settlement (CLS). This means that Asian currency deals against the US dollar in particular involve settlement at different times of the day rather than in a CLS “window”.

The report, which is authored by Yosuke Tsuyuguchi of the Bank of Japan and Philip Wooldridge of the BIS, notes that the depth and breadth of Asian foreign exchange markets have improved “markedly” in recent years. Volumes have grown rapidly and the diversity of market participants has increased, they note, but add that activity in Asian currencies remains concentrated in onshore markets to a much greater degree than that in major currencies.

“This indicates that foreign exchange controls are having the intended effect of stalling the internationalisation of Asian currencies,” the authors state. “At the same time, foreign exchange controls appear to be restraining the development of Asian foreign exchange markets by depressing derivatives trading and fragmenting activity between on- and offshore markets.”

The report also finds close links between the development of foreign exchange markets and the participation of foreign investors in local bond markets. “The absence of a liquid derivatives market in which to hedge currency risk might deter foreign investment in local currency bonds and, therefore, limit the diversity of bond market participants,” it states. “Managers of multi-currency bond portfolios typically prefer to hedge the associated currency risk because the volatility of currency returns is greater than the volatility of most bond returns; open currency positions are usually found to add volatility to bond portfolios without adding much return.”

This contrasts with equity portfolios, it adds, where the case for hedging is less convincing because the volatility of equity returns is much higher. The link between foreign participation in equity markets and the development of foreign exchange markets is correspondingly weaker.


Using data from the BIS Triennial Survey, the authors say that turnover of the 10 Asian currencies they study for the report rose from a combined $100 billion per day in April 2004 to $249 billion per day in April 2007. This means that growth in these currencies moved at more than twice the pace of that in the global foreign exchange market.

Although the turnover of each of the 10 Asian currencies increased between April 2004 and April 2007, the authors point out that there were marked differences in growth rates. Trading volumes for CNY increased more than sevenfold, from $2 billion in 2004 to $15 billion in 2007, they state, adding that at the other extreme, trading volumes for KRW increased by only 41% (after controlling for exchange rate movements), from $22 billion to $39 billion. HKD remained the most actively traded currency, accounting for 40% of total Asian turnover and exceeding the combined turnover of the second and third most actively traded currencies, SGD and KRW. IDR, MYR and PHP were the least traded, at around $4 billion each. Nevertheless, for the latter two currencies this represented a nearly fourfold increase over turnover in April 2004, they add.

The report observes that several factors that contributed to global growth in foreign exchange markets – investor diversification, carry trade strategies and the growth in high frequency trading – also contributed to growth in Asian markets, but they were much less of an influence than in the major currencies. Whilst algorithmic trading has had a minor influence, the authors acknowledge that investment flows both to and from Asia have increased sharply since 2002.

The IMF estimates that in 2007 inflows to the region totalled about $650 billion and outflows $500 billion, for a combined total of $1150 billion, and in 2004 inflows and outflows summed to less than $500 billion. In addition to foreign direct investment, portfolio investment increased, including purchases of local currency debt securities. Leveraged trades concentrated in IDR, INR and PHP, which were popular target currencies over this period for carry traders.

Equity inflows and the large amount of “commodity currencies” in the region also contributed to foreign exchange volume growth, as did the growth in international trade related to the region. The increase in volatility also contributed as currency managers and arbitrageurs were also attracted to the region.

While the authors note that the turnover of Asian currencies is a “small fraction” in the global picture, they also reveal that turnover of Asian currencies is low relative to underlying economic activity. For the world as a whole, turnover in foreign exchange markets is about 30 times greater than trade in goods and services, the authors say. Among Asian currencies, only HKD exceeds the global average; all other Asian currencies are well below the average. The ratio of foreign exchange turnover to trade flows is lowest for CNY, at around 2.

“These low ratios confirm that activity in Asian currency markets is driven predominantly by trade in goods and services,” the report states. “Among internationalised currencies, the ratio of foreign exchange turnover to trade flows greatly exceeds the global average: for example, it tops 250 for NZD. This indicates that a high proportion of turnover in internationalised currencies is generated by trade in financial assets.”

Segments and Settlements

Notwithstanding the fundamental nature of Asian FX trading, the authors also find that turnover between banks and non-financial customers such as importers and exporters grew at a slower rate compared to other client segments. Financial customers’ share of total turnover rose by about 10% between 1998 and 2007, to 27%, the report reveals, while non-financial customers’ share declined to 16%.

Inter-dealer activity remained high and stable at 57% of Asian currencies’ turnover, they add. That said, the balance of turnover in Asian currencies is shifting towards asset-related transactions at a much more gradual pace than that of the major currencies. In 1998, transactions with financial customers accounted for a similar share of turnover in Asian currencies as in major currencies: around 17%. In 2007, that share had increased to 41% for major currencies but only 27% for Asian currencies.

Intra-regional nuances in terms of regulations and market structure mean that capital mobility is restrained in some cases, thus inter-dealer transactions dominate the market. Equally they mean that some banks rely upon the FX markets for funding. While consolidation in the banking industry has seen a decline in the influence of inter-dealer transactions in the major markets, the authors note that this is not the case in Asian markets, perhaps because there are so many institutions with regional or local strengths.

Another factor was the haphazard take up of electronic trading across Asia, which has meant that price transparency has only helped to boost trading in certain currencies, thus inter-dealer volumes have remained high. As the e-channel permeates the market further, it is likely that this will change and that more customer-orientated volumes will move to dominate turnover in Asia as it does in the major currencies.

The report finds that the proportion of inter-dealer transactions conducted through either an electronic broker or a multi-dealer platform ranges from 58% to 4% in Asia. Customer trades are less likely to be conducted through an electronic platform, but again there is substantial dispersion, they state.

The US dollar continues to be the dominant currency in the region. As noted this raises the level of Herstatt risk – where one party to a trade submits payment hours before the counterparty does likewise. The authors note that CLS is starting to cover more Asian currencies, which eradicates this risk, but they also offer another possible solution – a reduction in the use of the dollar.

“Europe is an example of what could occur in Asia,” the authors says. “Starting in the 1980s, the Deutsche mark (DEM) gradually displaced the dollar in transactions between members of the European Union. In 1995, about 30% of turnover in euro legacy currencies (excluding DEM) involved DEM on one side. While the dollar retained its dominant place in global markets, within European markets DEM acquired an important role as a vehicle currency.

“In Asia, there are some signs of a movement in this direction,” they add. “For example, ATM systems in Indonesia, Malaysia, Singapore and Thailand were linked bilaterally in 2005-06 as part of the e-ASEAN project. Foreign exchange transactions between the systems are now settled in local currency directly, with no role for the dollar.

“While the volume of such transactions is small, an Asian currency could yet displace the USD in intra-regional transactions if economic and financial integration within Asia continues to progress,” they further state. “Another development which could reduce transaction costs and thereby encourage direct trading of Asian currencies is the expansion of electronic trading.”

Unsurprisingly, given the varied level of regulation around the region, the authors found that onshore trading is a much bigger factor in turnover than it is in the major markets. That said there is a shift towards greater offshore participation in Asian currency markets with non-residents accounting for 51% of turnover in 2007 from 47% in 2004.

Foreign exchange controls are mainly responsible for the proportion of onshore trading. They are also seen as being responsible for the domination of cash products over derivatives. The authors found that while derivatives turnover in Asian currencies is about one-and-a-half times that of the cash markets, in the major markets this ratio is typically between two and three times.

Exchange controls clearly represent a threat to continued growth in Asian currency trading given that they are put in place to suppress speculative trading, which is a key element in any market’s growth. That said, as banks and money managers seek opportunities and diversification, geography must, and will, play a part in that process, meaning Asian markets are likely to see further growth.

The dislocation in the global economy, where the US in particular is teetering on the brink of recession while Asian countries, especially those that are commodity rich, continue to perform decently, also means that more money may be attracted to the region.

Asia, it can be said with firm conviction, has thrown off the shackles put in place after the crisis around the turn of the century – and may be ready to become the engine room of further foreign exchange market growth.

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