Markets battle with central banks

Foreign exchange (FX) used to be the quiet nuts-and-bolts end of the capital markets, a business driven by real economic needs that stayed well below the radar while credit derivatives flew into trouble. But over the past year, FX markets have provoked heated debate in Switzerland, Scandinavia, Australia and elsewhere, as investors fleeing euro-denominated assets look for other developed markets in which to park their cash.

This has led to heavy intervention to stem appreciation against the euro or dollar, most spectacularly in Switzerland. Good business for the FX desks of investment banks, whose central bank clients have growing and increasingly complex needs.

“Earlier this year, reserve accumulation had slowed significantly, so flows were commensurately quiet. But against the backdrop of the euro crisis, currency stabilisation has become an important issue. While I do not believe that this focus is coordinated, there is certainly heightened interest in avoiding currencies moving too far out of alignment with each other,” says Jim Iorio, head of FX distribution at Barclays in New York.

Uncertainty about the euro is also prompting the diversification of FX reserves that have grown significantly in recent years. Gerald Dannhaueser, global head of FX sales at Commerzbank, says central banks are increasingly adopting the same perspective as conventional large portfolio managers, making careful asset allocation decisions. “We are seeing higher demand for emerging market and commodity currencies from central banks. That is partly a function of the very low interest rates in core FX markets,” he says.

Market barriers

Efforts to control FX appreciation may be a boon for domestic companies that want their exports to remain competitive, but they can make life much more complicated for global companies. The superior growth rates in emerging markets naturally encourage companies to focus their business development in those regions, but that entails complex cross-currency hedging needs.

Rob Bogucki, head of emerging market FX for the Americas at Barclays, says currencies such as the Mexican peso are increasingly as much in demand as any developed market currencies. Consequently, banks need to respond with equally sophisticated product offerings, across all three market time zones (Americas, Europe and Asia). But this is not always straightforward.

“Corporates are unanimous that their exposure to emerging markets will continue increasing rapidly, quarter after quarter. The concern seems to be that the FX markets are not maturing as quickly as the rise in companies’ exposures,” says Mr Bogucki.

In a bid to stem inflows into local currencies, many countries have restrictions in place that limit foreign participation in onshore currency markets. Even in the massive Brazilian market, most trading takes place in non-deliverable forwards. But this is an imperfect hedge for a company that needs real currency delivered to support real payments.

When these difficulties are combined with the lower currency volatility engendered by greater central bank efforts to smooth fluctuations, the natural tendency is for corporates to review the need for a hedging programme. Mr Bogucki says a relatively boilerplate approach to hedging during the peak of currency volatility has given way to a much more dispersed approach, with many companies choosing not to hedge all their currency risks.

Electronic platforms

This need not dismay FX bankers. Instead, it entrenches the need for deeper client relationships and advisory activity, despite the rise of electronic execution on an increasing range of developed and emerging currencies, which now accounts for about 60% to 80% of all flows. Mr Dannhaueser believes the trend towards five or so top players consolidating the FX business has slowed. There is still a clear role remaining for regional players that have strong commercial banking relationships – in Commerzbank’s case, serving the needs of the German mittelstand, for instance, in eastern European currencies.

Preserving a consistent client relationship is important for banks below the top few players in FX markets, which are unable to compete on flows. They have to make tough decisions about whether the investments needed to keep up with the latest low-latency trading technology can be justified in terms of franchise size.

“Corporates need to hedge, money managers doing portfolio re-weightings need to trade. We focus on a client base where we can help them facilitate their daily, weekly or monthly trade flows, and on the e-commerce side that means not just in-house execution, but workflow solutions that could involve confirming many trades across many platforms,” says Nick Downes, head of eFX sales at Commerzbank in London.