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ECB: Structural Changes in the FX Market

In its latest review of the FX market, the ECB sees evidence of structural change taking place within the FX market, and suggests that the “engines for change” are moving in the direction of an intraday money market or even towards an exchange model.

Colin Lambert reviews the findings.

The European Central Bank (ECB) has released its 2003 Review of the Foreign Exchange Market Structure, the first such report since a much-abridged version of the 1999 survey was released within the ECB’s monthly bulletin of January 2000. The study, which was conducted by a working group of the European System of Central Banks (ESCB), reinforces the work of the triennial survey of FX turnover conducted by the Bank for International Settlements (BIS) in April 2001 (see Profit & Loss, November/December 2001).

Although much of the ECB’s report merely repeats sentiments found within BIS papers, it does acknowledge that structural changes have taken place in the FX market since its 1999 review. It sets out to study these changes, by taking an in-depth look at the activities of various market participants by segment, and also investigates potential engines for change which may result in what it terms “a gradual move towards an exchange model”.

The study draws on two main sources. The first is the BIS 2001 FX turnover survey, while the second is subjective information collected through interviews with a wide range of market participants on both sides of the value chain.

In terms of the changing structure of the market, the report breaks down the activities and strategies of each market segment with an emphasis upon the euro-zone. As far as the banking industry is concerned, the report acknowledges that many institutions have found it increasingly difficult to make money off the back of “everyday flow business” due to pressure on spreads.

It also acknowledges that the banking industry is suffering due to the consolidation of its customers’ operations, specifically in the corporate sector which, the report says, is a result of most corporates being less inclined to take risk, as well as the consolidation of subsidiary operations within a single central treasury.

However, one benefit to the banking industry is that the corporate world appears to be more willing to push business through one channel rather than spread it around the market. Banking sources tell Profit & Loss, however, that they believe this ‘new’ focus on relationships is because banking consolidation means large business cannot be effectively transacted through more than one name without substantial slippage, nor can it be pushed through the multibank portals.

This is an argument acknowledged by the report, which states that many banks are trying to persuade their customers to work on an order-only basis rather than a competitive basis, something which could result in a better price for the customer.

Notwithstanding this, the ECB report suggests that these moves will result in further consolidation in the banking industry – something it is not wholly supportive of – because larger trading houses, or ‘one-stop shops’ will become more important. “This means,” states the report, “that banks are not only competing on a quantitative basis, but also to a large extent, on a qualitative basis.”

This has resulted in a more integrated approach to FX trading by the banks, it continues, as they try to reduce costs and win market share through the development of closer relationships with their customers.

The report contradicts itself somewhat by noting that, “Flow-driven position taking is still a major source of revenue for banks.” However, it adds that this is only the case for those banks in the top tier that are now dominating the market. On top of this source of revenue, the report also notes that fee-based business, such as prime brokerage, currency overlay management, global custody services and access to liquidity over electronic systems is assuming greater importance.

Interviewees, it continues, suggest that in spite of the greater importance of the sales force in banking operations, there has been equal stress placed upon the proprietary trading function by market leaders looking to leverage off the increased customer flow they are seeing. This is an interesting statement for a central bank report, for in spite of the difficulties in proving such cases, there have been suggestions amongst regulators that such ‘piggy-backing’ activities could amount to insider trading.

Market sources also suggest to Profit & Loss that the increased emphasis on this style of trading means that the instances of ‘gapping’ in the market, due to liquidity shortages (something that is referred to elsewhere in the ECB report), are being exacerbated. This argument is centred upon the oft-expressed concern that as the market consolidates further and the power is placed increasingly in the hands of a few players, it will become commensurately more difficult for the market leaders to liquidate positions. This is seen leading to an FX market that is similar in many ways to the equity markets – moves will be less frequent, but deeper because liquidity is ‘one-way’.

Interestingly, the ECB sees further banking consolidation because it “still lags behind the corporate sector, and economies of scale are still possible”. It also sees further pressure on small and medium banks, resulting in them leaving the interbank market. However, it notes that these institutions may be able to use the resources freed up by such a move to exploit niches in other markets, such as the emerging markets.

Underpinning this move, it continues, is the fact that such institutions may be willing to follow the example in the US where larger banks have taken over the administration of FX activities of smaller institutions. Should this come to pass, it can be argued that the outlook for the FX market is somewhat less than rosy, because of all three major trading zones North America is widely seen as the weakest in terms of liquidity. If practices there are extended worldwide, once again it can be argued that the FX market will behave in a similar fashion to the equity markets.

Buy Side Activities

The report identifies what it terms general trends in the strategies of corporate operations that have resulted in the reduced turnover witnessed by the BIS survey. It cites “a number of corporate treasurers” who say that their firms’ senior management is becoming increasingly risk-averse.

The significant FX losses suffered by some large industrial groups are seen as one factor for this changing attitude, as is the less aggressive stance taken by corporates to the FX market. The report says interviewees are seeing less willingness to “spoof” the market on the part of corporate treasuries, although there is still “occasional aggressive corporate trading in some niche markets (especially in the Scandinavian currencies)”.

Thirdly, the report notes that corporate treasuries have had to come to terms with the new reporting standards introduced over the past few years, such as IAS39 and FAS133, which require regular marking to market of all positions including hedges. Interestingly, it does acknowledge that many corporate firms have given up hedging their currency exposures due to the cost of implementing adequate systems or documentation. This, the report states, “could, ironically, result in increased volatility in the firms’ P/L accounts”.

Although the report accepts that trading with “Other Financial Institutions” in the BIS survey (which generally means asset managers) rose in 2001, it says that the breakdown of activity amongst fund managers has changed. The most significant players in the 1990s were seen as the “global macro” hedge funds that became synonymous with the taking of very large, often contrarian positions over a medium term horizon. The activities of these funds has diminished however, the report says, while at the same time a greater number of smaller companies have emerged, many of which are CTAs.

The ‘new’ funds use a different trading style, the report continues, in that they tend to be very much model-driven. The time horizon of the model-driven funds is much shorter, around one or two weeks and sometimes intraday, and as such the sizes of positions are likely to be small compared to the macro funds.

The explosion in model-based trading is also seen as a potential threat to market liquidity, according to the report, a sentiment that market sources suggest to Profit & Loss is credible because although the models are varied, they tend to have similar basic behavioural patterns. These sources suggest that the biggest problem is that so many models produce signals at the same time of day (4:00 pm UK time is apparently the most popular), resulting in a sudden increase in demand for liquidity by funds that are regularly on the same side of the market.

The report also argues that many models produce similar key price levels and generate trading signals simultaneously; it also expresses fears about the use of models in less liquid markets.

Although this segment of the market has seen reduced volumes, the report says that the reduction has been covered several times over by the increased volumes seen from institutional or “real money” funds, that have accepted the need to neutralise the impact of currency movements upon their portfolios or maintain a hedge sufficiently close to their benchmarks. Although the sidebar to this feature notes that the ECB believes the impact of e-trading in the FX market has been a little disappointing, the report does note that real money managers are keen proponents of e-trading, primarily because of the calculation tools that provide net FX transactions resulting from a number of equity or bond transactions.

Reinforcing the impact of real money managers has been the growth of the currency overlay industry, as studied in the March 2003 issue of Profit & Loss. The report notes that the number of firms offering such a service has increased rapidly, although it also reveals that interviewees believe that business is increasingly being attracted to the top tier of firms.

Outside Influence

The report studies the impact of various trends in the market such as the increase of benchmark fixings, the transacting of large business on an order-basis and the gyration of business towards the European time zone on liquidity levels. It concludes that although there are concerns, as expressed elsewhere in this feature, liquidity is not an issue with the majority of market participants.

The report does not speculate upon developments in liquidity resulting from the increased concentration of the banking industry that it foresees, but it does note that the availability of sufficient liquidity is discontinued on a more regular basis than previous studies have shown.

The impact of Continuous Linked Settlement (CLS) is also studied following that service’s launch late last year, and the report makes the rather radical suggestion that a result of the need for greater intraday liquidity management due to CLS (which settles FX transactions net at certain fixed times in the day) will see the creation of an intraday money market.

Although it foresees problems in the calculation of intraday interest costs, specifically that they will not support the transaction costs, this is not the first time this suggestion has been made. The BIS has noted previously that a demand for liquidity at certain times of the day could lead to a new market evolving, and as reported in these pages, companies such as e-Mid are looking to take advantage of such developments.

Although some interviewees suggested that transactions not subject to CLS settlement could attract a ‘premium’ in the transaction rate, the working group suggests that price competition will preclude this eventuality. More likely, it argues, is that banks will widen the net of CLS through the provision of third party services.

Although the report provides little in the way of revelations and radical opinion, it does suggest that the FX market is on the brink of another period of change. Consolidation is likely to be the driver; however, it can be argued that the most worrying aspect of the report is the numerous potential threats to liquidity. Ultimately, market sources suggest, the leading banks will have to increase their commitment to the interbank market – specifically they will have to be more willing to provide liquidity to each other – or the market will have to take what could be the critical step towards an exchange model.

Are Multibank Portals Working?

The ECB review of the FX market structure is ambivalent on the question of the impact of the multibank portals. It notes that portals were established to counter customer resistance to single-bank platforms, but adds that “their commercial development has been slower than their promoters had hoped”.

The report suggests that the multibank portals have faced resistance on a number of grounds (corporate treasuries aside who have viewed them more favourably). Firstly, customers appear keen to maintain the quality of the advisory services they receive from their banking relationships, and are thus ensuring they sustain a close relationship with the FX sales team.

The report also notes that banks are increasingly competing on a qualitative basis, on the strength of their research and advice. All of this does not bode too well for the portals which proclaim that all banks publish their research to the site. The banks do indeed publish their research to the portals, but it seems clear that the best advice – that which will lead to a customer making or saving money – goes proprietarily over the telephone.

The second area of resistance to the multibank platforms, according to the report, is surprisingly in some of the marketing features that the portals place so much importance on. “STP is not always regarded as providing a decisive competitive edge,” states the report, because many buy side companies have very efficient back office systems and/or do not have a large amount of tickets to input. As business is aggregated within corporate treasuries for example, ticket size increases (possibly to the level that the treasurer wishes to transact it offline to avoid leaving a ‘footprint’) and ticket volume is reduced.

The third area of resistance is a familiar one (particularly in the wake of the failure of Atriax), the inability of a platform to achieve a critical mass. The report says that “customers are [still] waiting for consolidation among the various competitors before committing to a platform”.

If this is not enough, the report also points out that competition regulators are calling into question what the ECB says is the spontaneous trend towards consolidation and notes the investigation by the US Department of Justice into the portals.

The report also notes that many leveraged funds are reluctant to trade on the portals because they do not believe they provide sufficient liquidity, are too transparent when it comes to executing large business (resulting in regular price slippage) and, can reduce the level of interaction with the bank sales desks seen by so many as necessary for smooth and discrete execution.

Profit & Loss

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