Much has been made of the struggles of speculators to make money in FX in recent years. Colin Lambert takes a look at data that suggests speculators are on the decline, and hedgers on the rise – and he sees some good news for the banks in this, if they can stay one particular course.
Spot FX is “over-broked” to use the market vernacular – there are so many market makers, many of whom are recycling liquidity, that differentiating oneself in this market is extremely difficult unless you are either at the very quick end of the spectrum or are handling plenty of large tickets that require care around the execution.
Thanks to the market structure and in particular the need for credit facilities, the same cannot be said for the forwards and FX swaps market where risk warehousing is still a valuable service. In these markets recycling is extremely difficult due to the costs involved and, more pertinently perhaps, the major dealers know the real value of their liquidity and, in contrast to their spot brethren, are very careful about where they offer it to the broader market.
The challenge for the dealers is, inevitably, regulation and in particular the Basel capital requirements which are increasing the costs for the forwards and swaps desks. It is a challenge they would do well to overcome somehow, however, for turnover in these most valuable of products (in P&L terms) is on the increase. More importantly, a lot of the increase is being driven by customers.
Looking at the data from those global FX committees that break volume down across client segments, the last five years – from when the major centre committees better aligned their reports – have seen significant increases in swap and forwards turnover from customers, to the detriment of the spot market, which has had a less structured growth path.
From April 2013 to April 2018, daily FX volume with Other Financial Institutions (OFI), typically hedge funds and asset managers, has grown 16.4% to $1.36 trillion across the UK, US and Japanese centres (the other centres to report do not break out OFI data). This compares to growth in the broader FX market in these three centres of 14.6% across the same period.
The headline data does hide some big swings across product lines. However, because OFI spot volume is down 12.5% over the same period, although it should be pointed out that broader spot volume is down 21.4%, therefore this customer segment is punching above its weight. Over the same period, outright volume is up a huge 58.4% and FX swaps activity up an even more impressive 60.4% with OFI, both of which are significantly more than the broader trend of a 41.8% increase in all outright forward trading and a 25.5% increase in FX swaps trading.
This suggests that hedge funds and asset managers are hedging more interest rate risk than they were in 2013, something that is obviously the result of growing interest rate divergences between the US and many other countries and the uneven pace and uncertain path of economic recovery around the globe. That said, another product often pushed by banks as good for hedging risk – FX options – has also seen a sharp decline in activity across that five-year period, OFI activity is down 16.3% in options, again this is “better” than the broader 22.2% decline in ADV.
The story is similar in the Non-Financial Institution (NFI) space. Typically made up of corporates, spot volume from this sector has dropped 5.2% from April 2013 to April 2018, while outright forwards activity is up 16.4% and swaps volumes up 33.2%. Again FX option activity is down, NFI executing 9.5% less volume than they were five years ago.
Several of the major dealers have started to refocus on the regional bank segment again after one or two years away from the limelight and this sector too is following the pattern. Given how so much of this volume emanates from local corporates and asset managers this is unsurprising, of course, but over the fiveyear span, spot activity dropped 12.4%, FX options by a massive 35%, while forwards activity was up 49.4% and swaps by 16.5%.
Whichever way one looks at it, the products that are in demand from the client base at the moment are those that allow them to hedge term risk. Anecdotally a lot of the FX swaps volume is still executed in the short dates, but sources say that more clients are looking to hedge over one week than before.
The tensions evident in the geopolitical and macro economic climate over the past year as fears of a trade war have grown to almost become reality, are reflected in the April 2018 surveys achieving some new highs for activity – indeed even spot FX volumes are about or above trend.
Looking at April 2018, OFI spot activity was less than 1% lower than the average for the previous 12 surveys, however NFI volume was 10.9% above trend, while Other Dealers was 1.4% over. April 2018 was, however, nowhere near the busiest month for spot, for the OFI and NFI segments it was only the fifth busiest of the last 12 surveys and for Other Dealers, the third.
It is an entirely different picture when one turns to outrights and swaps however, for OFI and Other Dealer activity in the former is at a new high for the survey, 40% above trend for OFI and 52.6% above average for Other Dealers. Only NFI does not register a new high in the product, although it was 3% above average.
In FX swaps, all three customer segments registered a new high for activity in April 2018, with OFI up 46% above average; NFI 16.8% higher and Other Dealers 23.3% higher.
Again FX options reflected the apparent reluctance of customers to pay premium (even at low vol) for hedging, activity was around average over the 12-survey period, with OFI a fraction above trend, NFI 11.4% below and Other Dealers 2.6% above average.
The data should represent good news for the banks as the revenue stream from client business in outrights and swaps is generally higher on a per trade basis than spot where competition has squeezed spreads. Especially with the interest rate differentials coming into play there is still a spread, especially after credit etc is taken into account and, because the market typically does not move as fast, the dealer has plenty of time to earn that spread. More customers are, anecdotally looking to deal at mid (pre-credit costs), but this still leaves potential revenue on the table for the dealer.
The challenge may be for the FX options desks because without more volatility in spot rates they are likely to see their volume levels contract further, something that may be troubling for those who staff those desks.
Overall though, for an industry that likes to chant the mantra “client-centric”, the data makes for heartening reading. Not only are customers executing more with the dealers, but they are dealing in some valuable products. The picture is of an industry returning to its roots by delivering hedging solutions to real economy customers.
The Rise of Disclosed Trading
Spot activity may be trending lower in the FX committee turnover surveys, however there is an interesting trend emerging in that market – again one that suggests hedgers are on the rise while speculative players are on the decline.
The spot e-trading statistics from the UK and US surveys (the only centres to report such data), seem to be indicating a definitive shift in trading away from anonymous venues towards disclosed channels. The former are, of course, a favourite of the speculative trader, while the hedgers have little or no problem having their counterparty know who they are.
The various spot e-ratios for disclosed and anonymous in the April 2016 surveys and the latest survey results taken in April 2018 make for interesting reading. There is a relevance in using April 2016 because in the UK there was only $4 billion difference in spot FX turnover between the two surveys (in the US it was slightly wider but still close enough for comparative analysis).
In April 2016 in the UK, electronic broking systems, typically the anonymous matching systems, represented 36.1% of electronic spot volume and 20.9% of all volume, while multidealer systems were responsible for 40.7% of spot ‘e’ volume and 23.6% of overall.
In the latest survey, the broking systems had a 29.5% share of ‘e’ and 18.2% of overall spot volume, whereas the multidealers had 45.9% and 28.4%, respectively. Reinforcing that is a less significant, but still noticeable, uptick on spot volumes on the single-dealer platforms, which saw their share of spot volume rise over the two similar surveys to 24.7% of ‘e’ (from 23.1%) and 15.2% of all volume (11.2%).
In hard numbers, the disclosed channels across two similar months in spot FX handled more than $44 billion per day more, largely at the expense of the anonymous ECNs.
In the US meanwhile, in April 2016 the indirect channels, typically ECNs and other anonymous venues, handled 26.6% of ‘e’ and 18.3% of total FX volume, while the direct, or disclosed venues, handled 73.4% of spot ‘e’ business and 50.6% of total spot business.
By April 2018 however, the shift apparent in the UK was also occurring in the US where anonymous venues’ share of e-spot trading had fallen to 24.7% (17.3% of all FX spot turnover), while that of the disclosed channels had risen to 75.3% and 53%, respectively.
Again in hard numbers, single-dealer platforms saw a $10 billion per day increase, while ‘other’ direct channels, normally seen as aggregation, saw an increase of $25.5 billion per day. Thomson Reuters Matching and EBS saw absolute volume drop by $10 billion, while “Other ECNs” saw activity rise by $7 billion and ‘Other Indirect Channels’, broadly seen as those venues such as retail and small institutional platforms, saw activity drop by $6 billion. It should be noted that actual spot volume in the 2016 survey was some $33 billion less, however, and that will skew the numbers slightly.
Looking across both centres there has been a significant shift towards disclosed over the two year period, 67.6% of all ‘e’ volume in the UK and US in April 2016 was via disclosed channels, in 2018 this had risen to 72.5%. In terms of overall volume, the percentage has risen from 41.7% to 47.1%. Anonymous volume also fell as a percentage of total spot FX volume, from 20% in 2016 to 17.9% in 2018.