FX emerges as the big winner of the crisis
FX volumes have risen to new heights on the back of a huge increase in spot volumes and more activity from a broader range of players. But what the figures really tell us is that FX has matured as an asset class. Geraldine Lambe reports.
Already the biggest traded market in the world, currency trading has leaped to record levels this year. According to data published by the Bank for International Settlements (BIS) in early September, an average of $4000bn is being traded every day, up from $3200bn in 2007, when the BIS last carried out a survey of the global market.
The huge rise has been driven by an almost 50% jump in spot foreign exchange (FX) volumes to $1500bn per day, and reflects increasing trading activity by 'other financial institutions', a segment that includes hedge funds and other non-bank counterparties such as pension funds and mutual funds.
Current levels are underpinned by a variety of factors, not least a shift away from more risky business to less capital-intensive product lines in the wake of the financial crisis.
But while banks such as BNP Paribas - already strong in structured FX solutions - recently built full FX platforms to capture a larger share of the flow business, simultaneous data from the Bank of England reveals that there is an increasing concentration of FX trading among a handful of banks. According to the data, the 10 banks with the highest turnover have grown their market share to 77%, from 70% at the time of the 2007 report.
What the figures really tell us, however, is the growing maturity of FX as an asset class. While traditional asset classes have become more correlated - as was dramatically demonstrated during the recent financial crisis - FX markets have been able to provide an alternative. Because of their low correlation with other asset classes, more and more investors are tapping into currency markets with a range of strategies.
A recent survey reports that currency is at the top of the asset classes that fund managers are most likely to move into over the next 12 months, ahead of equities and commodities. "In terms of asset classes, FX has been the real winner out of the crisis," says James Davison, head of FX structuring for Europe, the Middle East and Africa at BNP Paribas. "Volume growth is underpinned by trade and hedging flows, but the real growth is in the emergence of FX as a viable, speculative alternative to equities."
A familiar pattern
The trajectory of the shift to FX could follow a similar pattern to the earlier take-up of commodities. Before the introduction of exchange-traded commodities (ETCs), it was difficult for investors to benefit from the potential returns and diversification offered by commodity markets. This all changed as soon as ETCs and exchange-traded funds became widely available.
Now, a similar pattern may be emerging in the FX markets, with the introduction of exchange-traded currency products in the US and Europe. Using these, investors have easy access to a range of currencies, including all the G-10 currencies as well as more exotic but increasingly popular emerging market currencies such as the renminbi and the rupee.
Moreover, currency markets offer a liquid mechanism for macro-based investment strategies. A strategic view, such as taking a long-term position in a basket of commodity currencies to reflect the belief that commodity prices will rise, enables investors to avoid the contango (in which distant delivery prices for futures exceed spot prices) that can affect commodity markets.
FX is also well suited to those taking a tactical view. According to data from Fund Strategy, a specialist magazine for the investment industry, playing out macroeconomic strategies using FX is reaping rewards. For example, an investor worried about sovereign risk in Europe at the beginning of this year who went long yen and short euro would have seen a 23% return.
The movement of funds into the safe haven of the Swiss franc is another demonstration that investors, worried that there may yet be another asset correction, are using the currency markets to mitigate such risk. And, while corporates may argue that volatility in the currency markets is climbing, it is still much lower than in the equity markets, making it a less risky asset. Data shows that annualised average daily volatility of the euro/dollar pair over the past decade is 140% lower than the volatility in the EuroStoxx 50 over the same period.
Economists believe that macro strategies will increasingly drive asset returns. Investors are grappling with a host of themes: the violent swings between risk aversion and risk appetite, the increasing muscle of the Chinese economy, the widening disparity in monetary policies, the persistence of sovereign risk, the emergence of new regulatory frameworks and the increasing scarcity of and competition for key commodities. Because all of these can be neatly addressed using a variety of currency strategies, the continued rise of FX as a mature asset class is assured.
Though that may please the investors, central bankers and policy makers may not be so happy.
