FX stands up as an asset class because it is liquid and transparent, and it has trends, volatility and big user numbers. William Essex looks at the likelihood of this enduring.
Foreign exchange is increasingly being treated as an asset class in its
own right. This is partly because it is uncorrelated to any other asset
class, which is useful in current market conditions, and partly because
it is a zero-sum game. Currencies may weaken but there is a winner for
every loser; the overall market does not fall. And FX offers an
attractive combination of liquidity and transparency.
It is also accessible. Mark Warms, chief marketing officer of
electronic trading platform FXall, says: “It is relatively easy for
banks to establish margin-trading relationships with their customers in
the foreign exchange market. Margin trading accounts in FX provide
customers with the ability to trade high multiples of leverage because
of the unique level of liquidity and transparency in the institutional
FX marketplace. Banks are increasingly offering these margin-trading
services because new systems enable them to track customer positions in
near real-time.”
Mark Warms:
‘Margin trading accounts in FX provide customers with the ability to trade high multiples of leverage’
Volume momentum
Will the trend continue? The figures suggest that it has some
momentum. FXall had record average daily volumes of $10.6bn in June
(and went cash-flow-positive in July, two quarters ahead of the
business plan) and reported an average trailing monthly growth rate of
20% for the year to end-June 2003. Further up the scale, EBS reported
its busiest trading day in five years on September 30. EBS’s volumes in
interbank spot foreign exchange were $177bn on that day, which was
substantially ahead of the company’s average daily trading volumes for
2003 (to end-September) of $100bn. That figure already represents a 28%
increase on 2002.
In a survey of 2500 users of FX conducted in February, Greenwich
Associates found: “Of the largest users, roughly one in four trade FX
as an asset class. In that group, the largest FX traders have the
greatest propensity to trade FX as an asset class. 40% of banks, just
under 30% of fund managers and 50% of hedge funds trade FX as an asset
class.” The survey also found that “less than 10%” of corporates and
“around a quarter” of central banks and other government agencies did
so.
Greenwich Associates’ survey is an annual event but the question about
usage was asked for the first time this year, so the answer is
significant as an indicator of FX’s popularity rather than as a trend
indicator. But it supports the conclusion: FX is now in the big league
as an asset class.
A question of durability
This prompts a variety of questions. First, are current market
conditions so in FX’s favour that a change would be sufficient to
reverse the usage trend? Following on from that, are the intrinsic
attractions of FX sufficient to withstand increased competition from
other (recovering) asset classes? And does FX really work as an asset
class?
While conceding that it is justifiable to refer to “good” or “talented”
FX managers, Tim Lind, senior analyst at Tower Group, thinks there is
room for doubt on this last question. “There is a debate among
traditional asset management firms about whether the FX market
represents a random walk, and whether therefore there is any expected
return over time. We work with some very large institutional managers
who tell their clients that there is no point in active currency
management because it’s a full random walk,” he says.
As unpredictable as the weather
There are too many variables affecting currency movements for the
FX market to be forecasted, just as there are too many variables
governing the weather for the nightly report to be a reliable indicator
of what is going to happen tomorrow. Mr Lind says: “I am cynical about
people’s ability to predict the future direction of currency markets.
The variables, which range from interest-rate movements and the fiscal
policy of governments, lead to a lot of unforeseen things.”
There is a case, however, for believing that even a random walk, or
near-random walk, can offer an investment opportunity (and even the
weather, to over-stretch the analogy, can be traded on the futures
markets). “The growing trend is to challenge the traditionalists’
view,” says Mr Lind. “Currencies are an inefficient market, even though
liquidity is good and spreads are thin. The market is inefficient in
that people buy currencies not because they expect currencies to
increase in value over time, but because they need the funds for other
activities in, say, the capital markets or international trade. The
fact that people are forced to buy currencies provides an opportunity
to play against that market and thus to leverage that inefficiency for
short-term gain.”
There may not be an expected rate of return over time but at any point
there could be a likely pattern of economic, or just trade, activity
that would provide a basis for active management.
If this is true, there is scope for forecasting and thus scope for
modelling. Dr Sam Gover, portfolio manager for financial strategies at
systematic hedge-fund manager Ikos Partners, says: “Global capital
flows, as people move their cash from one economy to another, are a
major driving factor for FX. It could simply be that foreign investors
have started buying assets in Japan, for example, or that a lot of
Japanese investors like to hold Treasury bonds, thus buying dollar
assets and selling the yen.”
Dr Sam Gover, Ikos Partners:
‘If the banks lose a bit of control, that is going to be a good thing’
Model of behaviour
Whatever it is, it is substantially predictable. “What you’re
trying to model at the end of the day is how everybody else is going to
behave and whether they are likely to continue buying or selling,” says
Dr Gover. This is not dissimilar from what happens with other asset
classes, except that it occurs at a macro level with a wider range of
variables to take into account. “We believe that there are
relationships to look at between foreign exchange movements and equity
markets and bond markets, which can tell you how an economy as a whole
is going,” he says.
The case against random walk may have some validity, therefore, but the
case for treating FX as an asset class rests at least as much on how
market participants behave and on the inefficiencies they generate.
Winners and losers
This can be taken further. Ulrich Leuchtmann, FX manager at Invesco
Asset Management, expands Mr Lind’s point about “forced buyers” of
currencies. “There are natural losers in the FX market. Corporates just
want risk reduction rather than performance, so they are willing to
take small losses as an insurance premium,” he says. “Also there are
the central banks. The Bank of Japan, for example, is concerned to
smooth the dollar/yen exchange rate and not to make money. It’s a
natural loser. If you are in a zero-sum game and have natural losers,
there must be, by definition, natural winners.”
Dr Gover says: “Generally, the central banks’ objective is that their
currencies should not move in too wild a fashion. They generally like
to slow down movements.”
Central banks are predictable. There are some good historical
precedents for playing against the central banks. But if FX is
intrinsically an attractive asset class, because the market is
inefficient and because a would-be winner can seek out a natural loser,
can we expect volumes to remain high even if conditions change? Almost
certainly, yes. Any other answer would depend on the assumption that
the FX market is efficient, at least to the extent that all its
participants recognise its current attractiveness and would react
efficiently to any change. The secondary assumption behind “no” would
have to be that current conditions are uniquely conducive to
high-volume, FX-as-an-asset-class activity.
There is something in this, however. Mr Leuchtmann points out that the
dollar weakness of recent years has contributed substantially to the FX
market. “A typical global investor is an Asian or a European investor
who buys largely dollar-denominated assets. [Recent] overall dollar
weakness, at a time when equity returns and running yields on bonds
were low, has made FX management much more obvious as a problem.”
Mr Lind makes a similar point. “As capital markets have been challenged
over the past 24 months, differentiating yourself in performance is
just a matter of a few basis points. A lot of buy-side firms are being
much more careful, paying closer attention to treasury and cash
management. Not leaving currency or cash in unproductive accounts is a
growing trend.”
Trends and volatility
Current market conditions may be conducive to rising FX volumes,
but not uniquely conducive. What is needed to maintain the FX market is
not an endless recurrence of today. Jack Jeffery, CEO of bank-owned
interbank FX broker EBS, says: “Over the past 12 months, we have seen
good trends in the market. People like that. They also like the
volatility in the market. We have had a long-term trend with periods of
volatility and what our customers are seeing is that there are
opportunities within small time periods but also opportunities over the
long term.”
What matters is not “more of the same” but more instances in which
trends establish themselves and endure; more instances in which flashes
of short-term volatility provide short-term opportunities. And if the
FX market somehow manages to go forward without trends and/or without
volatility, there is always the secondary argument that technology is
bringing FX usage as an asset class towards critical mass.
Jack Jeffery, EBS:
‘We have seen good trends in the market. People like that. They also like the volatility in the market’
The technology factor
“Something else we hear from customers is that there is an increase in
the number of people accessing the FX market now,” says Mr Jeffery.
“For example, small hedge funds and commodity trading advisers are
accessing the market, who traditionally were not able to do so.” How
are they doing it? Technology.
Dr Gover makes the same point. “One major development in the way the
whole market is working at the moment is that it is moving from being a
very interbank-dominated market to new electronic platforms, such as
FXall and Currenex.”
For Dr Gover, looking at FX from a hedge-fund perspective, this is
significant. “For us, that is making FX much more attractive to trade
because we can now trade it electronically. If the banks lose a bit of
control that is going to be a good thing because, generally, as the
intermediaries move out of a market, there should be more opportunity
for other people.”
For FX to go on being treated as an asset class in its own right, it
needs trends, volatility, big user numbers and an ongoing combination
of easy access, transparency and liquidity. In short, it needs to stay
the way it has always been.
Mr Warms concludes with a eulogy to FX’s traditional virtues. “There
are not many markets that grew up so liquid and so transparent, in
which you can request a price from any number of banks on a large
transaction and they will instantly make you a price on the spot, with
a very tight bid-offer spread and no commission added. And there’s no
exchange involved. It’s just easy.”