Since the introduction of the euro and the accompanying demise of the

tradable currencies it replaced, sterling has become increasingly

attractive. Andy Webb looks at the long-term trends.

Whatever view is taken of the merits (or otherwise) of the UK’s

membership of the eurozone, sterling’s continued existence has proved

something of a boon for many FX traders.

The arrival of the euro brought the demise of important tradables, such

as the deutschmark, franc and lira, creating a problem for traders who

were seeking diversification or simply something with which to make

their P&L targets.

Though many previously illiquid east European exotic currencies have

taken up a fair proportion of this slack, sterling has also proved an

increasingly important alternative tradable – and an attractive

tradable at that. FX markets seem unconvinced that the UK will be

joining the euro in the near future. Political ramifications aside,

current economic studies (such as Ernst & Young’s survey on

external investment into Europe) also appear to support this view.

However, UK Chancellor Gordon Brown’s recent statement regarding the

five economic tests for entry, plus uncertainties about the possibility

of a referendum, have resulted in a steady rise in sterling volatility

in recent months. Couple this with an increasing propensity for

trending and (with the exception of the breadth and volatility of its

bid-offer spreads) sterling holds out considerable promise as a trading

vehicle.

Long-term trends

Whether or not it is accepted that the importance of its survival

role alongside the euro is reflected in sterling’s behaviour, there can

be little denying that this behaviour has changed significantly since

the euro’s introduction on January 1, 1999. For example, in the two

years prior to the launch of the euro, GBP-USD largely traded to and

fro in the 1.5800 to 1.7000 range. However, in the two years following,

there were appreciably stronger trends both in terms of the major

downward trend during that period and in its reversals. The overall

trading range also expanded significantly: 1.4000 to 1.6750.

This increase in trending behaviour also persisted during the

subsequent two years (January 1, 2001 to January 1, 2003) with much of

the preceding downward trend being reversed in the process (see graph

1).

Graph 1: Sterling trend behaviour

913.photo.jpg

While increasing flows into sterling after the launch of the euro may

account for much of this change in nature, there have been a number of

other influential factors. First, during the past 15 months there has

been a fundamental decline in confidence in the US economy, which has

driven much of the dollar movement in the same period. As a result,

some argue that it has been more a case of the dollar weakening than

currencies such as sterling strengthening that has driven the strong

upward trend seen in cable (sterling-dollar pair) since March of last

year.

Another factor has been the change in many banks’ risk appetites. In

the past, if a trader at one bank decided to take a major view on a

currency, counterparts elsewhere might decide to block the way by

taking opposing positions. Tighter risk management controls and loss

limits have made such behaviour far less common, so there is now a

decreasing likelihood of this sort of substantive obstruction to trend

development.

In part, this increasingly conservative approach to risk can be

attributed to the losses that many banks sustained in connection with

declining equity markets. In addition, the geopolitical situation since

9/11 has been extremely unstable, prompting a further reduction in risk

appetite. A further issue specific to FX is that, since the

introduction of the euro, many FX desks have been radically trimmed,

leaving fewer personnel to manage the book and resulting in a

reluctance to take substantive risks when thinly staffed.

This change in risk attitude is apparent in more than just spot

trading. In the past, in less liquid currencies, such as sterling,

option traders not uncommonly tried to defend their positions in the

cash market. For example, traders who had sold knock-in barrier options

would try to protect that barrier level in the spot market to prevent

the option from being triggered, while other traders would try to force

the market through the barrier level.

With the greater risk aversion prevalent today, traders are more

reluctant to defend or attack barrier levels because the risk/reward

ratio of such a strategy is not regarded as attractive. The net result

has been the removal of yet another barrier to development.

Bank economists also have an influence – or lack of influence.

Divergence of opinion among economists (and the degree of respect

afforded those opinions) used to encourage equally divergent opinion

among traders, making the evolution of trending less likely. Today,

processes such as interest rate decision-making have become

increasingly transparent and predictable so this divergence of opinion

is now minimal, thus removing yet another obstacle to trending.

Jekyll and Hyde

Although sterling may now be exhibiting trending behaviour on a

longer-term basis, its intra-day demeanour is different. Lengthy

periods of sideways inactivity are punctuated by occasional violent

break-outs, which are in turn followed by further inactivity (see graph

2). To some extent, this type of market behaviour is self-fulfilling:

traders see little reason to take a view in a flat market, as they may

not be able to recoup their losses in the same session if that view is

proved wrong.

As a result, sterling has a tendency to reach a level and hover there

while awaiting the arrival of the next major flow or news item. When it

arrives, it is typically seen as perhaps the only P&L opportunity

of the day, so proprietary traders consequently rush to participate in

the move before it ends.

This goes hand-in-hand with the shift in traders’ time horizons. Five

years ago, many traders felt comfortable with taking a one-month or

longer view of a sterling position. Now, that sort of approach is the

exception rather than the norm. In the current environment, more time

spent in the market is regarded as synonymous with increased risk, so

the preference is to get in and get out as quickly as possible,

preferably intra-day.

Although this is also true of other currencies, the tendency is

particularly pronounced in the case of sterling because the bulk of the

day’s activity takes place in London. Therefore, unless an exceptional

event takes place, there is little perceived benefit to running on

positions opened in London into New York or Far Eastern trading hours.

Furthermore, if a position is held over into non-London hours and has

to be cut, liquidity will be thin and a poor fill will probably result.

Graph 2: Sterling intra-day behaviour

914.photo.jpg

Customer and technology influence

While risk aversion among proprietary traders has been a prominent

factor in sterling’s rather ‘stop go’ nature intra-day, a fundamental

shift in the behaviour of other participants has also reinforced this.

In the past, corporates or fund managers had a tendency to call up

multiple banks with the same (substantial) order. Cable or other

sterling pairs no longer have the liquidity to support this sort of

strategy, and even if it were attempted, the first tranche of the order

would alert other participants, who would mark the market away from it.

Particularly where there is a strong degree of trust between client and

bank, there has been a fundamental change in the way that sterling

orders are managed. In such circumstances, the client is prepared to

reveal the entire order to the preferred bank. As the bank then knows

that it does not have to scramble into the market to beat 10 other

banks with an identical order from the same client, it is able to work

the order gradually throughout the day, rather than suffering the

market impact of a single large trade. This has a considerable

influence on sideways periods of market behaviour because the bank has

the freedom to feed the order in gradually, letting the market fall

back (for a buy order) to the bottom of the trading range before

executing the next tranche.

The switch from voice to electronic trading has had a similar

influence. Because electronic trading is anonymous, traders are less

reticent about entering multiple small orders during the course of a

day, whereas in the past they would have been embarrassed to make

frequent approaches to voice brokers in small size (the response from

the voice brokers to such an approach would also have been less than

co-operative). And the anonymity of electronic trading has made traders

far less concerned about reversing or cutting positions with tight stop

losses, further fuelling the narrow range intra-day fluctuations that

are often seen in sterling.

Who benefits?

Sterling’s increasing volatility and trendiness benefits a variety

of market participants – commodity trading advisers (CTAs) being an

obvious case in point. Historically, CTAs have favoured currencies

because of their greater propensity for trending, particularly when

compared with markets such as agricultural commodities, because this

behaviour fits well with the trend-following strategies that many of

them use.

Arbitrageurs have also been major beneficiaries of sterling’s change of

behaviour, as increasing volatility has thrown up numerous trading

opportunities. This is in stark contrast to the period immediately

before the euro was launched when many currencies (particularly those

due to be subsumed into the euro) were flat to the point of tedium.

Increasing arbitrage activity among EUR-GBP, EUR-USD and GBP-USD as a

result of greater sterling volatility has provided a wider benefit to

the market as a whole. If arbitrageurs see a large order offered

perhaps as much as five points off the market, they may still be happy

to take the price if it will allow them to lock in an arbitrage that

still offers adequate margin. This, in turn, encourages other

participants to continue showing prices in the market, thus supporting

liquidity.

However, despite the broader advantages of increasing arbitrage

activity, the sterling market is still a far-from-perfect arbitrage

vehicle due to the breadth and volatility of bid-offer spreads. A

market where the spread can fluctuate from two to six points and back

again in a matter of seconds is hardly an ideal backdrop for

arbitrageurs.

An alternative source of sterling liquidity would do much to improve

this because the overlapping bid-offer spreads that should inevitably

result would provide a tighter net dealing spread. These tighter

spreads would boost arbitrage activity, which would further enhance

overall liquidity – thereby also negating the traditional argument that

a parallel market begets liquidity fragmentation rather than

improvement.

What next?

As mentioned earlier, the eastern European exotic currencies have

absorbed much of the liquidity that formerly belonged to the first wave

of euro entrants. As such, it is tempting to assume that when these

exotics join the euro, sterling will be there to benefit from the

ensuing liquidity slack. Will sterling’s volatility and trendiness

thereby become even more pronounced?

The short (and obvious) answer is that nobody knows. But there are

reasons to believe that history could repeat itself and that another

group of exotic currencies could pick up the liquidity benefits instead

of sterling. Rather than trying to squeeze more liquidity into

sterling, many proprietary traders may prefer to switch their

activities to currencies such as the South African rand, Asian exotics

or the Middle Eastern currencies. For some second-tier banks that have

little leverage in the major currencies, there is also the attraction

of being able to develop a niche specialism in some of these currencies

and thereby generate some buy-side revenue on the back of this as

liquidity in these exotics increases.

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