Over 70 German investment managers, foreign exchange overlay managers, banks and corporates convened to discuss the latest trends in the forex industry at the second Risk FX Briefing in Frankfurt
Regulatory, cost and market-structure changes are altering how participants make trading decisions, while they seek improved data and analytical tools and more efficient credit models.
Geopolitical risk continues to create uncertainty, with ongoing trade tensions, a weakening US investment outlook, European elections and Brexit top of mind.
The new market paradigm
- The shape of the new market structure is becoming clearer, opening the way to an increasing volume of exchange-traded business. New asset classes and solutions – such as forex futures – are seeing increasing take-up.
- Regulation and technology continue to be key drivers. The revised Markets in Financial Instruments Directive (Mifid II) has had a substantial influence. With a greater focus on best practice and best execution, buy-side customers are getting smarter and more demanding.
- Sell-side firms are under pressure to automate businesses and become more efficient, driving down costs to match the economics of the current market. Scale is a primary focus to safeguard business.
- To reach critical mass in terms of economics, banks are increasing volumes on multi-dealer platforms and hedging with clients – rather than other banks – to reduce costs.
The impact of the new market structure on liquidity and execution
- The liquidity picture is changing, with more competition on spot products than forwards.
- While top-of-book liquidity is stronger than ever, the depth of the book has shrunk. This has led to a change in execution style where splitting big orders is more prevalent.
- Depth of liquidity is also a key concern for the buy side. Risk transfer is still the dominant method of executing transactions, but there is an increasing trend towards algo trading from other asset classes – typically in less-liquid currency pairs.
- Non-bank liquidity is a key source for accessing markets, with new providers appearing in the list of market-makers.
- For buy-side participants seeking liquidity, the focus is on quantity and quality, with transaction cost analysis (TCA), broker assessments and workshops helping firms identify an appropriate selection of providers with the requisite credentials.
- Sell-side firms are also ramping up efforts on TCA and best execution, with some banks including spots and forwards within monitoring programmes, despite being outside the current scope of Mifid II.
- Investors are becoming more demanding in looking at best execution and historical TCA results – providers’ structures, processes and abilities to generate asset alpha are frequent paths of enquiry.
- It is valuable for investors to develop relationships with central counterparties across spot and forward desks, especially during times of market stress, when algo execution will likely be less solid. Rather than risk distorting the market through multi-quote pricing by phone, a more accepted practice now is to opt for a single counterparty and hold them responsible for execution on larger deals.
- Clarification over reporting swaps through approved publication arrangements is a welcome development and has helped bring transparency and the opportunity to review data and processes.
- In measuring performance, benchmarks such as the WM/Reuters benchmark fix are becoming less relevant. Market participants are more careful about simple one-month WM benchmarks and trying to take into account factors such as forex basis in different currency pairs at different periods.
[Liquidity providers are dividing into] global giants and boutiques, leaving a squeezed middle of those who have a cost base, which is too large but without the critical mass to join the top providers and achieve the necessary economies of scale
Enhanced data and analytics needs
- Participants are adding algo trading to their forex armoury and exploring the potential of blockchain, artificial intelligence (AI) and machine learning to enhance systems and processes and drive better insights from data.
- A key challenge for the sell side is to automate end-to-end process, including the downstream side and back-office settlements. There have been major advances in front-office automation, pricing and risk management, but there remain armies of people sending and chasing payments worldwide.
- Data analysis is becoming increasingly important. Mifid II best execution is a useful process forcing participants to analyse every trade to become better at predicting market moves and managing inventory. For the buy side, TCA analysis could potentially tell you which broker to use, at what time of day and the streaming price for different currency pairs.
- Banks are also using digital labs and other specialist units to partner with financial technology organisations and accelerate onboarding of key technologies, such as blockchain, AI, machine learning and natural language processing.
The evolution of forex hedging
- Developments in currency hedging have resulted in more nuanced programme designs and sophisticated implementation methodologies. Key considerations include cashflow management, competitiveness of currency trading, forward contract collateralisation and reporting detail.
- Forex futures are gaining prominence as German asset managers seek new sources of liquidity and a cheaper alternative to forex forwards.
- Clearing is a major challenge due to the cost of margining. The likelihood is that it will be mandated in the future, which will focus attention on margin management.
- Buy-side firms are supportive of bringing more business from over-the-counter into the listed space. The higher the transparency, the lower the cost of trading for the buy side. The expectation is that it will follow a similar path to equities becoming more commoditised 10–15 years ago.
- Rather than trading forex forwards, another emerging dynamic is for buy-side entities to trade spot themselves, agreeing a fair basis in competition with a sell-side firm and then switching this position into a forex future.
- Many investors now consider the strategic and tactical aspects of currency hedging – defining the long-term portfolio hedge ratio and the ranges within which this hedge ratio may vary.
- In the future, there will be a place for exchange-traded instruments, with demand from smaller clients willing to implement a standardised hedging product option, driven by quantitative signals and with simple, transparent execution.
“Investors are looking for something that’s very hard to deliver – outperformance, at low cost and with minimal risk”
- Clients’ due diligence processes typically focus on the past and present, but not the future. Instead of questions around regulatory requirements, compliance policies and producers, investors would be better served by asking how providers will cope with changing liquidity, the cost of resourcing, and research and technology needs in the front and back office.
Central bank view
- Two years on from the launch of the FX Global Code, momentum is building around its goal to build more fair and transparent markets.
- The current list of 700 signatories to the code includes the world’s 30 largest banks, European Union central banks and selected sovereign wealth funds and supranationals.
- Progress on the buy side has been slower, with one-third of the 30 largest asset managers, and around 10 corporates from sectors such as aerospace and oil.
- Key benefits for the buy side include opportunities to review internal processes, reassure stakeholders, reduce compliance risks, enable more rigorous appraisal of dealers and promote integrity in the market.
- Some buy-side firms have expressed reluctance to incur the costs of adherence when the sell side were responsible for wrongdoing. In the European Central Bank’s (ECB’s) view, both sides’ participation is required to improve standards, and firms should see it as an opportunity to review policies and influence best practice.
Geopolitical risks and their impact on forex markets
- At the 20-year anniversary of the euro, several factors are driving volatility in Europe. The region stands divided, with substantial changes to come, including Brexit, eight European country elections and a change of personnel in the European Parliament, the European Commission and the ECB.
- The US dollar remains the dominant currency in forex but the outlook has changed. Last year the dollar was buoyed by the US Federal Reserve’s tightening stance, optimism about the US economy and lower expectations for the eurozone. But Fed chairman Jerome Powell surprised everyone with a return to a more neutral policy, a lack of forward guidance and likely swifter shrinkage of the balance sheet. The likelihood is that the dollar may have peaked.
“[The US and Europe are] converging to a kind of no-man’s land on monetary policy”
- Sterling isn’t considered undervalued. In the event of a no-deal Brexit, a drop of 10% GDP could be expected in the UK and the prospect of sterling trading at less than one euro.
- Emerging market (EM) currencies came under immense pressure over tightening liquidity conditions last year, so the end of US monetary tightening is good for EM currencies as a whole.
- EM markets should no longer be considered all in the same basket – the outlook between countries can vary dramatically. The big sell-off at the end of last year means there are now value-driven opportunities to be had, but the outlook could vary for the rest of the year.
- There are high interest rates in Turkey and Argentina. In Asia, Association of Southeast Asian Nations countries behaved quite well during the EM change because they had a strong China behind them.
- The Russian ruble often moves ‘lock step’ with oil prices, but US sanctions have distorted the picture. Russia has some of the strongest macro-fundamentals of any EM currency – a current account surplus, a large-net international investment position and a strong fiscal policy – but foreign investors are less keen that each disagreement seems to lead to President Trump increasing sanctions.
“There continues to be a kind of political risk premium in the ruble and that makes it hard to forecast”
- Future geopolitical risks to watch out for include the level of private debt in Europe, growing US debt – especially government debt – and the possible extremes of President Trump’s international trade tactics and re-election campaign.