Low volatility in the foreign exchange market shows few signs of abating. That is good news for companies trading across borders, but a headache for banks and investors seeking to profit from currency movements.



So far in 2014, volatility across the four major currency pairs – euro/dollar, yen/dollar, sterling/dollar and Swiss franc/dollar – has remained stubbornly within a 60 basis points range, according to financial news website Investing.com, an insignificant figure compared with the 1000 and 2000 basis point moves of the past.

In recent weeks, there have been signs that this might be about to change amid diverging interest rate expectations in the US and Europe. But global volatility levels of 7.5%, according to JPMorgan, remain well below the 10.4% average of the past decade.

“The FX [foreign exchange] markets have had low volatility but they’ve also been disconnected from what’s going on in the world,” says Patrik Safvenblad, partner at London-based hedge fund Harmonic Capital. “There is no shortage of news, both good and bad, but the FX markets are not responding to that news flow.”


Volumes down

The impact of low volatility is reflected in reduced FX volumes, which central bank data shows are down in all the world’s main trading centres. The US market has been hardest hit, with average daily turnover plunging by one-fifth to $811bn in April this year, compared with $1000bn in April 2013, while the UK saw the biggest decline in absolute terms, with $200bn wiped from the daily average of $2600bn in April 2013.

Japanese turnover, meanwhile, slipped to $363bn from $373bn, a drop of 2.6%, while in Australia it fell 8% to $168bn in the year to April.

The key culprit for low FX volatility is undoubtedly global monetary policy, investors and bankers say, with uniformly low central bank rates in the world’s largest economies over the past six years reducing relative returns in those markets. This has also dampened demand for carry trades, in which market participants borrow in low-yielding currencies to invest in more fruitful environments.

Regulation may also be to blame, as banks have shrunk their balance sheets to conserve capital and comply with new rules on trading and leverage. Meanwhile, controversies over benchmarks, such as the daily London ‘fix’, could not have come at a worse time for the industry.


Spreads fall

From a market maker’s point of view, less business has led to an inevitable contraction in spreads. “When the market is less volatile, it’s less interesting for people who are trying to trade FX just as an asset to make money, particularly when interest rates are low and the hunt for the carry trade is harder and harder,’’ says John Juer, FX head of financial engineering at Commerzbank.

“People who want to sell volatility do tend to keep selling it, and we saw this in 2006 and 2007. That has been said to dampen the market still further because everyone is long-gamma [long as prices increase and short as they fall].”

Amid competition for a declining income pool, there has been an inevitable impact on the bottom line. “You can see from banks’ recent profits that volumes are down and that’s obviously a concern going forward,’’ says Michael Hewson, chief strategist at UK-based financial derivatives dealer CMC Markets. “The lack of big moves has been causing people to pull out of the market because they can’t make any money.’’

With low volatility in FX markets appearing to have morphed into a semi-permanent trend, banks have recently moved to make changes to business models to reflect the new status quo. HSBC and Commerzbank both told The Banker that they have worked to turn low volatility to their advantage, using the opportunity to make their operations and services more efficient.

“Yields go down because you’ve got spread compression and profits can go down because you’ve got less volume, but it doesn’t necessarily follow that low volatility is really bad for business, it just depends on what you do and what your business model is,’’ says Commerzbank’s Mr Juer.

“In a paradoxical way, it can be a time when people take the time to upgrade their systems and improve operations because they have to focus on costs and be incredibly efficient. That’s what we’ve been doing.’’


Out of the doldrums?

It makes sense now to position for an eventual emergence from the doldrums, says Mr Juer. “A low-volatility environment can be a bit of a lull before quite a high-volatility environment, so what we’re seeing now could be the beginning of quite a volatile period. “There’s more and more competition for trading what volume is left so you get spread compression coming in. The other side of it we’ve seen is that it’s easier to trade when the market has low volatility so you can get more people coming into the market and showing very tight prices.’’

He adds that if the market takes off again, banks positioned to adapt best are those with the most established e-commerce platforms.

HSBC says it has focused on satisfying clients’ heightened interest in the detailed characteristics of trades, improving clarity of documentation and seeking out intelligent solutions.

“In terms of opportunities, clients want to own volatility but it’s relatively expensive given current interest rates,’’ says the bank’s head of FX indices, Hariton Korizis. “So we’ve tried to provide interesting opportunities to access this space and to look at products that cheapen long-volatility strategies, while not having to put too much capital at risk.

“Accessing volatility through volatility swaps is also proving attractive, as they isolate a specific risk metric, and liquidity has improved in these type of products.’’

Mr Korizis says one of the popular investable themes is once again the carry trade, though more in the emerging markets space. That strategy is typically accessed through structured products such as basket options or indices. “Accessing this through options helps clients manage risks in terms of risk-return profile, because they know what would be their maximum loss,” he says.

Low volatility has also spurred interest from clients ranging from banks and hedge funds to real money in finding efficient macro hedging strategies. HSBC has responded by ramping up research teams and investing in analytics.

“During the volatility spike caused by the recent depreciation of the renminbi, our position as one of the pioneers of renminbi internationalisation enabled us to help investors steer through this challenging time, as the Chinese delivered on their promise to encourage more volatility to the exchange rate,’’ says Mr Korizis.


Job cuts

Despite banks’ efforts, some elements of the business have been shedding jobs. Dutch group Rabobank exited FX prime brokerage in mid-2014, citing incompatibility with its overall strategy. New York-based brokerage INTL FCStone’s revenue dropped 8.5% in the April to June quarter after volumes at its FX prime brokerage plunged by $13bn to $65bn as subdued market activity and low volatility took their toll.

Denmark’s Danske Bank is slashing jobs in currencies and fixed-income trading, blaming falling demand and a shift by customers to digital trading. The cuts are in addition to a 2000 reduction in headcount announced in 2011 that is scheduled to be completed by the end of 2014.

Danske’s net trading income halved to DKr1.2bn ($208m) in the second quarter of 2014, after market-making revenues fell almost 80% from the same period in 2013.

Having exited commodities trading in the summer, Credit Suisse is busy cutting costs in its FX and rates business, by increasing the volume of trades handled by its electronic platform, chief financial officer David Mathers announced recently. The bank suffered its worst quarterly result since the financial crisis in the second quarter, posting a SFr700m ($748m) loss, down from SFr1.45bn in the same period last year. (The result was due, in part, to a US tax fine that the bank says slashed net profit by SFr1.6bn.)

Credit Suisse’s move to greater use of automation follows similar decisions by UBS, Barclays, JPMorgan and Deutsche Bank.

As banks across the globe respond to new capital requirements, proprietary trading restrictions and leverage caps, FX businesses have not been immune, despite some carve outs on trading, reporting and clearing rules for products including FX swaps.

A challenge for all has been regulator probes into allegations that banks colluded to rig the WM/Reuters ‘fix’, the FX benchmark used as the reference for trillions of dollars of trades. US banks have reportedly already begun receiving enforcement letters from US authorities, while the Financial Conduct Authority is said to be in settlement talks with UK, US and Swiss-based banks.


At the sharp end

As banks struggle with the impact of low volatility, the investment community has found itself at the sharp end of low returns.

“It’s not that difficult to make money but you have to be patient, and if you’re a volume trader it’s a lot more difficult to do that when you get periods of low volatility followed by sharp moves in one direction or another, such as the sharp move lower we’ve seen in the euro,’’ says CMC’s Mr Hewson. He also points to unconventional central bank actions, such as the Swiss National Bank’s intervention to peg the Swiss currency against the euro, as sources of frustration for investors.

“There’s an awful lot of central bank manipulation going on, which is rather ironic when you’ve got regulators fining investment banks for allegedly doing exactly what central banks have been doing for the past five or six years,” he says.

The Parker FX Index, which tracks the performance of global currency managers at 32 firms in the US, Canada, the UK, Germany, Switzerland, Sweden, France, Ireland, Singapore and Australia, was down almost 3% in the year to July 31, 2014.

For Harmonic Capital, it has been a decent year so far. “We’re up a bit, compensating partly for low volatility by taking more risk in exposure terms, but there’s a limit to how much you can do that,’’ says Mr Safvenblad.

“Clearly what we’ve seen is quite small moves, so even if you’re fully geared in terms of exposure, you’ve had quite little risk in the book in value-at-risk terms.

“It’s been very quiet, but the trading strategies we’ve been employing – growth-oriented or classic FX type models looking at pressures in terms of divergences in growth or monetary policy – have been working fine both in developed and emerging markets.’’

Not surprisingly, some investors have turned away from FX, amid disappointing returns. According to research house Hedge Fund Research, the assets managed by FX-focused hedge funds decreased more than 6% to $18bn in the first half of this year, after shrinking by one-fifth in 2013, following the demise of a number of firms, including US-based currency hedge fund FX Concepts, which at its height managed $14bn.

In January, Connecticut-based hedge fund QFS Asset Management shut its currency fund and returned almost $1bn to clients, blaming a lack of opportunities.

Still, with volatility picking up slightly in the recent period, conditions have been improving, with the Parker Index gaining 0.9% in August after returning to the black in July, when the number of currency managers reporting losses for the month dropped to 13.


Blame game

Hedge Fund Research’s Macro Currency Index, a wider measure of currency funds, tells a similar story, gaining 0.1% in July after losing 0.3% in the seven months since the start of the year.

One FX banker, who asked not to be named, says a shake-out among New York’s electronic hedge funds is responsible for a large part of the fall in US turnover. “A lot of people got into the business when volatility was high, but there has been a shake-out in which a handful of bigger players have become dominant,’’ says the source.

As the FX industry faces up to its challenges, one compensation may be in the belief that it is always darkest before the dawn, and in recent weeks there are signs that the long period of low volatility in the FX markets may be starting to come to an end. One suggestion of this is signs of divergence in central bank policy. Japan and the eurozone are continuing to ease, with the European Central Bank edging closer to full-blown quantitative easing, just as stronger growth in the US and the UK are bringing forward market expectations of rate hikes.

With the US Federal Reserve’s bond buying programme expected to end this month, the US is edging away from consensus monetary policy. The dollar in recent trade was at its highest level in six years against the Japanese yen, while the euro fell against the dollar to an 18-month low.

Elsewhere, speculation over Scottish independence drove demand for one-month sterling puts against the dollar in recent trades to their highest level in two years.

Harmonic Capital’s Mr Safvenblad remains optimistic and says subdued FX activity is all part of the market’s cyclicality. “There is a long-term natural volatility in markets driven by how much economies diverge and I’m sure FX markets will find their way back there,’’ he says.

For investors and market makers, it will be a case of better late than never.

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