Rob Mandeno, global head of FX spot and e-commerce at Deutsche Bank in London
As the credit crisis took hold, foreign exchange trading, regarded as a reliable source of profit, surged in popularity among investors. Now, as trading volumes begin to return to pre-crisis levels, the inference is that confidence is slowly returning to the global economy. Writer Charlie Corbett
As the world's financial markets lurched from one crisis to the next in the final quarter of 2008, global foreign exchange (FX) volumes soared. Panicking investors saw FX as an oasis of liquidity at a time when the rest of the world's financial markets had ceased to function. A market that had seen volumes fall off by 30% year on year in 2006 and 2007 saw volumes grow by 15% in 2008.
According to financial research company Greenwich Associates, FX trading volumes increased 17% among large corporates and by 13% among other types of financial institutions. Trading volumes from pension funds and fund managers grew by 21%, bank volumes increased 16% and the amount of trading generated by so-called retail aggregators rose 43%.
At a time when many international banks were staring into the abyss, FX represented one of the few sources of steady profits. Not only did volumes soar, but also trading spreads widened. A combination of high-currency volatility, the reduction in the number of trading desks operating and major concerns over counterparty risk led prices to soar and made FX dealing an expensive business for banks' customers. "People were running with so much fear in the last quarter of last year and the first quarter of this year that spreads were wider than what should have been implied by the liquidity," says Rob Mandeno, global head of FX spot and e-commerce at Deutsche Bank in London.
As the toxic dust begins to clear, however, the FX markets are rapidly returning to normal. In terms of the wider market, volumes are down 30%, according to Mr Mandeno, and spreads are once more contracting. "There has been a normalisation back to pre-crisis trends. What we saw in the crisis was a 'super-normal' situation," he says. "We are going back to trend. Volumes will stabilise and then gradually increase again."
Signs of life
The fall off in FX volumes reflects a wider feeling among global investors that perhaps the worst of the financial crisis is over. Stock markets are rising again and the world's seized-up debt markets are showing signs of life. Mansoor Mohi-Uddin, chief currency strategist at UBS investment bank, has noticed a change in risk appetite among his clients. "Since the second quarter, investors have become more risk seeking," he says. "They're trading out of safe-haven currencies such as the dollar, yen and Swiss franc, in favour of more high-yielding currencies, in particular emerging markets and commodity currencies."
But how sustainable is this recovery? According to Mr Mohi-Uddin, a lot of good news has been priced into the equity markets. "Positive news coming out of China and the fiscal stimulus packages that have been implemented in the G-7 economies - these factors have buoyed confidence over the past few months," he says. "Unfortunately, however, the underlying economic picture still remains very bleak. Markets have got ahead of themselves and I expect that there will be a correction in the second half of this year." He believes that high-yielding emerging market currencies, commodities currencies, sterling and the euro will all be pushed back down again against the dollar, yen and Swiss franc. "There is a very long deleveraging process to come from companies, households and governments. All of that suggests to me that the rallies we have seen in riskier currencies will be temporary rallies and we will probably suffer setbacks in the second half of the year," he says.
Changing attitudes
It is clear that volatility will continue to stalk the global currency markets in 2009, causing headaches for companies as well as the banks that service them. The relationship between banks and their clients became critically important in the crisis, as companies attempted to mitigate their currency exposure risk and sought liquid markets in which to invest. Counterparty risk shot to the top of the agenda after the collapse of Lehman Brothers in late 2008, as clients no longer knew who they could trust.
"In the past, there was an assumption that there was no credit risk when you were facing banks, now there's a realisation that everyone has risk. Risk was found in places where no one ever expected it before," says Mr Mandeno. As such, there has been a big demand for collateral agreements between banks and clients. These agreements, which require both parties to provide collateral to guarantee performance, reduce substantially mark-to-market risks on trades. "[Clients] don't have to worry about credit risk on banks and banks don't have to worry about credit risk on them," says Mr Mandeno.
Keeping it simple
The ability of banks to provide credit during the crisis has undoubtedly shaped attitudes among corporates about who they do their FX business with. Not only that, but clients are also looking for a full service offering from their relationship banks, above and beyond pure FX dealing.
Research from Greenwich Associates in April this year showed that in 2008 corporates allocated 37% of their FX trading volume to dealers on the basis of existing lending relationships, up from one-third of the business allocated primarily to those that lent to them in 2007. The research showed that the list of the world's top 10 FX dealers by market share comprises nine commercial banks and just one (former) investment bank, Goldman Sachs.
One of the more lasting effects of the financial crisis, in terms of client demands, has been a shift away from the more complex derivative products. According to Mr Mandeno, clients are looking towards more simplified offerings. "Corporates have really appreciated banks that helped them solve their issues by providing liquidity and cash through the crisis, when clients really needed to unwind positions or hedge their balance sheets," he says.
Scott Wacker, managing director for Europe, the Middle East and Africa FX sales at JPMorgan, agrees that customers are moving away from more sophisticated FX products. "The market is rapidly moving towards much more of a focus on market share, volume and flow," he says. Instead of dealing in complex, high-priced derivative instruments, banks are attempting to regain a foothold with clients through other means. "It has become a technological arms race. A number of the banks coming through the crisis realise that foreign exchange is a fairly low credit-intensive business, fairly transparent and therefore the money you make in foreign exchange is fairly unencumbered with long-term credit exposures," he says.
"It is time to go out in this market in a big way and the best way to do that is through technology."
Electronic dreams
One way that banks are going about taking on the competition is through e-commerce. The proportion of global FX trading volume executed through electronic systems surged to 53% in 2008, according to Greenwich Associates, up from 44% in 2007. Banks are beefing up their algorithmic trading capabilities and building ever-more sturdy electronic platforms that will allow more volumes to trade, at cheaper prices. "Everybody is trying to gain market share, in particular through e-commerce, and that is what is going to drive our market for the next six to nine months," says Mr Wacker.
Looking ahead, one of the biggest potential stumbling blocks for those banks involved in FX trading could be government-inspired regulation. As most governments blame the meltdown in financial markets on opaque over-the-counter (OTC) trading in complex derivatives, there have been calls for the establishment of a central clearing counterparty for the trade in OTC FX derivatives.
CCP under consideration
It is a proposal that has been met with some hostility in the market. Many believe that clearing all contracts centrally could tie up valuable capital and constrain the liquidity of companies that use contracts to hedge their businesses. Proponents of a central clearing house for OTC derivatives argue that it would remove systemic risk from the market, should the failure of a large dealer spark a chain reaction in the market. Ghosts of Lehman Brothers hang heavy in regulators' imaginations. Deutsche Bank's Mr Mandeno believes that a central clearing house makes sense, provided that it is set up in the right way. "Mitigation of credit risk is good thing from a systemic point of view in the FX market, but you need to make sure that not too much power is placed in individual venues," he says.
The landscape for FX dealing has changed as a result of the crisis in financial markets. As the dust settles and panic subsides, banks are realising that business models will have to change, especially in the light of potential regulation. JPMorgan's Mr Wacker says there are too many unknowns. "Governments are actively looking at bank regulation and we're still waiting for the results," he says. "In the meantime, banks and their clients have reduced the sophistication of the business that is being done partly because they know that governments are going to regulate it, which probably means more capital charges associated with it."
