FX in Asia: A Question of Risk and Reward

The potential for Asian FX markets has long been talked about but has rarely been delivered, that may be changing, however, as Colin Lambert finds out.

When, in the early morning of October 7, 2016, the FX market witnessed a flash crash in Cable, there was a collective metaphorical shrugging of the shoulders, as epitomised by one London-based trader who told Profit & Loss, “It’s Asia – that type of thing happens.”

The perception is that institutions pay less attention to Asia, allocate fewer resources to the region generally and, as one global head of FX puts it, “Rely upon Asia not to drop the ball.”

Fair or not, this seems to be the attitude at many firms, which, while making the right noises about the potential for Asia, remain reluctant to invest heavily there. “We feel, in an electronic world where large risk is rarely held for any length of time, that we can manage our Asian activity from London,” explains the global head of FX. “You can account for any latency in your pricing and your top talent is close at hand in case something goes wrong.”

While some data suggests that activity in Asian centres continues to rise strongly, there could be a caveat as previously noted. In the last Bank for International Settlements’ triennial FX turnover survey, the share and volumes through Asian centres continues to rise over the previous decade (except in Australasia where both Australia and New Zealand have declined), however, that survey does not allocate volume according to where the risk is managed. So while the trades undoubtedly emanate from Asia, in many cases it is a 24 hour e-trading business in London or New York that is managing the risk.

That said, the growth in activity has been impressive. In the 2007 BIS survey, Asian centres accounted for $936 billion per day of activity, a 21.8% share. In the 2016 survey the same centres handled $1.673 trillion per day, a 32.3% share, and that includes the Australasian centres that had declined – on mainland Asia the story was very positive.

Singapore remains the darling of Asian FX markets, in the nine years to April 2016 activity in the city-state rose by almost 75% to $523 billion per day, third only to the UK and US. That is only part of the story, however, for in spite of what is widely seen as its declining influence as a centre, Japan handled $415 billion per day in 2016, up 37% from nine years earlier. It should be noted that activity across the same period in the UK outstripped Japan, while the US was broadly similar, but either way, the perception of decline in Japanese FX markets may be short of the mark – thanks mainly to the booming retail FX industry there.

The China Story

The other big story over that nine-year period has since accelerated further – and that is China. From $9 billion per day in 2007 (0.2%) of all activity, in 2016 China saw average daily turnover of $73 billion for a 1.1% share of global activity – and sources say they confidently expect that to be much higher in next year’s BIS survey. “I will be staggered if it has not at least doubled in influence,” says one Asia-based FX trader.

Jeff Ward, head of NEX Markets, Asia, also believes that China will continue to play a growing role in the region’s FX market “Now that China has enhanced its technology infrastructure with the deal we signed a few years back, there is a greater ‘e’ focus there,” he says. “Historically, greater automation has led to increased volumes and I would expect the same to happen in China.”

Interestingly, Ward confirms information from other sources that in Asian hours, before Europe opens, NEX Market’s FX platforms handle more USD/CNH business than they do USD/JPY – a quite remarkable statistic given the yen’s position as one of the major currencies.

The China factor is also cited by Michael Prendiville, founder and managing director of investment manager Taf Capital. Based in Perth, Western Australia, Prendiville founded the firm in 2013 following a successful FX trading career in banking and he says, “China holds the key to the whole emerging markets space for me. There is obviously a lot of political noise around the US-China relationship at the moment and that often plays out in this timezone – we are in the front line in Asia as these events unfold.

“China’s influence has been felt for some years on the global macroeconomic and geopolitical stage, but it is now starting to feed through in FX markets,” he adds. “If China wants to respond to US actions, the currency will be at the forefront of how it does so.”

Prendiville acknowledges that often markets in Asia are quiet, but he says that is no reason to suppose they will remain so. “The chances are that if something happens with China then it will happen in Asian hours – and if it does it will impact liquidity in the region as a whole. This is no longer just a dollar story, if something happens in China now there are reverberations across all markets, including G10 – this is not just an EM story.”

Ward is keen to stress the benefits brought about by technology in developing Chinese markets. “The development in China has been impressive,” he says. “With CFETS’ upgrading of the onshore structure, this has meant the market now not only has a robust RFQ mechanism, it now has an equally robust CLOB.

“There are meaningful amounts going through the platforms, and it will be interesting to see how the API model evolves in China, that will probably be next,” Ward continues. “The only potential obstacle in Chinese markets is policy direction – will the authorities continue to open up the market? To me the question is only about the timing, it will happen – just look at the Silk Road initiative and the China 2025 programme – if these are to be achieved, then a more open currency market is one ingredient. You need people to be able to use your currency if you are to internationalise your economy.”

Regional Growth

While China inevitably dominates thinking in Asia, there are other initiatives underway across the region. “There is a real push to bring institutional values to the retail FX market in Japan,” says a senior e-trader in Asia. “The Japanese brokers are the big drivers of activity in the yen and they are being pushed by their liquidity providers to adhere to the FX Global Code and to be more open about how they trade. If that succeeds I believe it could open the doors to even more activity in this region because we could break down the barriers between retail and institutional and attract more flow from the bigger players.”

Japan aside, other centres are also looking at the structure of their market, with increasing automation being the common factor. “We are involved in the development of these local markets,” explains Ward. “Bank Indonesia is a good example of a local regulator that has publicly stated its desire to move its markets onto an electronic platform, and we will see more.

“The challenge is always if there is a mini currency crisis as we are seeing at the moment, then the work on the market infrastructure development can get delayed – I personally believe it is only a matter of time however before the work recommences at the same pace,” he adds. “Bank Indonesia is very focused on helping to build a deep, liquid currency market and it recognises that more electronic trading, with better data, can be a big driver of that.”

Change is also being debated in the Phillippines, where the local central bank, Bangko Sentral ng Pilipinas (BSP), is considering a more democratic market structure, less reliant upon the banks. BSP earlier this year circulated a proposal to the local market that would loosen the banks’ hold on the local FX market and instead shift responsibility to multilateral entities where the banks and other counterparties are held to account thanks to multilateral, rather than the current bilateral, agreements.

“There is a big story to play out in terms of the market structure in Asia,” says an Asia-based hedge fund manager. “The noises we are hearing suggest that more national authorities are open to greater automation and, possibly, to non-bank market makers. If that happens, we think market conditions improve – they’ll be more stable.”

Infrastructure Plays

Away from local markets, there are also changes underway in G10 markets in Asia, with Singapore in particular making a play to be the region’s trading infrastructure hub. An “industry transformation map” (ITM) published by the government there, says Singapore seeks to be “a leading international wealth management hub as well as the Asian hub for fund management and domiciliation”.

Included in this, Singapore’s government has also stated that it is seeking to become the “global forex price discovery and liquidity centre in the Asian time zone”. The city-state’s central bank the Monetary Authority of Singapore (MAS), also stated at the time the ITM was launched, “With Asia expected to attract a larger share of global investment flows, MAS will encourage key FX players to anchor their matching and pricing engines here, to enable market participants to benefit from better liquidity and greater efficiency in executing FX transactions.”

The plan has already seen rewards with both UBS and XTX Markets signalling their intention to site their FX infrastructure in Singapore, however NEX Markets’ Ward still believes there will be multiple trading centres in Asia. “At the moment, Singapore seems to be making the strongest push to build its FX market infrastructure,” he says. “However I don’t think there will be a single dominant centre in the fashion of London in Europe or New York in the Americas. Singapore has pulled ahead, though, thanks in part to it attracting more infrastructure development schemes, look at the firms that are siting their pricing infrastructure here.”

Ward points to NEX Markets’ distributed matching model as working well in regions like Asia, however he does acknowledge that there is a threshold at which the complexity of technology required to meet the demands of such a varied client base outstrips the user experience and cost. “If Singapore achieves critical mass through its initiatives then things develop a momentum of their own, he accepts, but is quick to add, “The other centres will still be important though.”

Obstacles

For all the optimism around Asia, especially as Chinese influence grows, there remain some not insignificant barriers to success, foremost local regulatory attitudes. “Look at Malaysia,” observes the Asia-based hedge fund manager. “The local authorities are really worried about the offshore market and have effectively banned any local trader for being involved in NDFs. That takes away a lot of liquidity and makes the onshore market makers more reluctant to price.

“Dealers also have long memories in this region,” the hedge fund manager continues. “We all remember how some countries reacted during the Asian crisis and effectively bankrupted offshore trading by imposing impossible rules on their markets.”

Ward is more confident, however. “I don’t think local regulations are going to put a ceiling on growth just yet, but it could happen at some stage,” he says. “We need to remember that these FX markets are pretty small in comparison to others, not least because they are massively controlled and are not electronic.

“I think that the local regulators in some centres realise that they can effectively monitor activity in an electronic market, and also that this brings greater liquidity, which is crucial to their economic development. I don’t think we will see regulation get any more restrictive in the region, but there are broader questions like will Asian centres get EU equivalency? That dialogue is ongoing, so I am hopeful that it will be settled in due course.”

The other main obstacle is as old as the hills in FX terms – liquidity and market conditions. “Liquidity is holding up and spreads are contracting,” says Taf Capital’s Prendiville. “But if China were to respond more aggressively and the trade war intensifies, then there would be real contagion in the region and liquidity would dry up.

“Although NDFs especially are following G10 in building liquidity levels, there is still a hell of a lot of difference – mainly gap risk,” he continues. “You get announcements in EM and see the market gap without a price, followed by a period of wider pricing. The random volatility still restrains some market makers from pricing as aggressively as they can.”

Prendiville sees emerging markets as an opportunity play thanks to these types of conditions. “The cost of trading is simply higher in these markets,” he observes. “Until the start of this year emerging markets were low beta, which meant you pay more to trade for not a lot of movement. Now there are opportunities and so you are willing to pay the wider spread, but that doesn’t mean that longer term these markets will be more stable – activity is linked to events, but spreads aren’t, they don’t compress during quiet times.”

Prendiville also points out that while investment managers are happy to hold risk over a period of time in G10 markets, it may not be the same in emerging markets, especially Asia. “You don’t really want to be exposed over a weekend in EM, for example,” he says. “Too much can happen while the markets are closed and liquidity will not be there early on Monday morning. We think there has to be something specific, a real opportunity, to be involved in these markets for a period of time.”

The Asia-based hedge fund manager agrees, “There is great potential in Asian markets, but no-one seems willing to take it because it involves risk. You have to be able to stand in markets when they get volatile and few in Asia are willing to do that. Either they are subservient to the head office in the western world somewhere, or they are underresourced, or insufficiently experienced.”

In one way Asia does reflect the global market in that there are concerns in some quarters over what is seen as a reduction in the number of market participants willing to provide liquidity on a consistent basis. “There is a real opportunity in Asia, but it means taking risk and investing resources,” observes the global head of FX. “Above all, you really do need experience. An experienced trader or risk manager would see the benefits of stepping in at certain times, especially when there has been a move. Too many Asian traders and institutions’ first instincts are to withdraw from the market – that’s why Asia is the great opportunity that is never taken.”

The regional head of e-trading believes it is a question of proportionality. “There is plenty of opportunity, it’s really just a question of scale. Don’t try to be too big. There aren’t that many large tickets traded in Asia, therefore your trading infrastructure and resources have to be allocated differently.

“You need to be able to take risk in regional currencies, because without that most customers don’t want to know you, the e-FX head continues. “A G10 franchise means nothing to these customers, they get that liquidity anywhere they like, EM is where it counts. They want a complete relationship and that means both markets – and there are opportunities in both.”

There is also the question of a different cultural approach – in Asia relationships are built over long periods of time, as observed by the global head of FX. “Yes there are more risks associated with being a service provider in Asia, but the growth in the region is likely to be greater than anywhere else, so the time to be in the market is now if you want to benefit from that growth. The relationship is vitally important there and those that are providing a good service now will have customer loyalty going forward. Asia is a tough place to break into – it takes time and resources. I would go as far as to say that if you’re not there already it will need a decade for you to build a significant presence.

The End Game

Ultimately, in spite of the potential obstacles, the sense is that Asian markets are going to be the next to benefit from the growth of automation. Led by G10 markets this growth may be, but emerging markets are likely to follow, and with the opportunity set in the region overlaying this infrastructure development, the future looks bright.

“The relationship with your liquidity providers in Asia is vital because of the gap risk and that means you take a considered approach,” Prendiville says. “We think, for instance, it is important to have a high hit ratio with your LPs, we endeavour for a 100% hit ratio because that gives the LPs confidence that we are approaching the market the right way.

“With the advances in infrastructure, it is no longer a disadvantage to be a trader in Asia,” he adds.

The e-trading head believes that while there may be challenges from the various regulatory regimes, in general, “Asia has a lighter touch than the US or EU – and that could be important for firms struggling to deal with the cost of compliance in these centres.

“This is why the MAS initiative is so important,: the e-trading head adds. “It costs money to run a trading infrastructure and Singapore is helping to fund that, you can’t underestimate the value being offered.”

For Ward it is about the diversity and opportunities on offer. “Asia has been the great growth story and I think it will continue,” he says. “It has great infrastructure in the developed centres like Singapore, Tokyo and Hong Kong and great potential in more emerging centres. Look at the BIS data, most of the growth has been in emerging markets and NDFs, in particular Asia, and I expect that to be reinforced in next year’s survey.”

Galen Stops

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