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.”

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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.”

916.photo.jpg

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.

917.photo.jpg

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.”

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