FX debate: The changing face of overlay (Part two)
FX debate: Participants
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Executive summary
• The FX market is being transformed as new players seeking alpha enter it to compensate for low returns elsewhere
• Lower transaction costs as a result of IT innovation and the use of algorithmic trading mean that the quest for alpha in FX is more practicable
• Both active leveraged trading strategies and increased involvement from central banks as active asset managers in FX have boosted the markets
• Emerging market currencies are playing a bigger role since the arrival of the euro shrank volumes, but liquidity risk is often overlooked
• Electronic trading is playing a growing role in run-of-the-mill transactions and this has opened opportunities for specialist services and advice to be offered over the telephone
• The changing character of the market has placed new demands for focus and relevance on FX research |
Euromoney: There have been transformational changes in the foreign exchange world. Users of FX are taking the view that FX is not just a sideline to their main activity, but something that can, at a minimum, be done more efficiently and, at a maximum, generate alpha. FX may add incremental returns in what many believe will be a period of low returns from the stock and bond markets.
HB, JPMorgan: There has been a huge increase in the number of new pools of assets handing out mandates in the currency markets over the past 12 months. People who had never thought about currency as an area where value could be added are now buying into it. The UK public sector is one example.
AE, Millennium: People know that if they diversify their assets they’ve got inherent currency exposure. The majority have now come to the conclusion there is value in actively managing that. Therefore there’s been a proliferation of new mandates from a variety of sources. The UK is certainly one source, but the US has increased – Canada, Asia and southeast Asia too.
RG, UBS: In addition, consultants have played an important role. Their support has led pension funds and local authorities in particular to manage their international exposures more actively.
JS, Deutsche Bank: The growth of the market is fuelled by spread compression. With much lower transaction costs the hurdle to create alpha from FX has been lowered. Algorithmic clients are prime examples of this phenomenon; they now have many new strategies that offer promising returns with lower transaction costs.
GK, Bank of America: The leveraged accounts have been a key growth area in the FX space. Our prime brokerage team are on track to book 500,000 tickets this year and more than $3 trillion in volume, and that’s just the prime brokerage group. That’s a lot of FX turnover.
Euromoney: One key group of FX market users you haven’t mentioned is central banks. Do you see any change in their behaviour compared with a few years ago?
JS, Deutsche Bank: Like the rest of the market, central banks are changing dramatically. There used to be a handful of countries that treated FX as an asset class rather than a political tool. Because central banks reserves have grown dramatically their constituencies are pressuring them to invest these reserves effectively. The result is that more central banks are incorporating practices from the professional asset management industry such as treating FX as an asset class.
AE, Millennium: Central banks have become much more clever and intervene less. In this they’ve been helped by a market which itself has become more efficient and where monetary policy is more predictable. There will be extremes when you will hear of central banks becoming involved but to steady the ship rather than to materially affect the exchange rate.
MS, Pareto: Yes, and this is because the focus of central banks has changed a lot in, say, the last five years. Their remit now is to manage inflation rather than to manage the currency.
HS, RBC: Exactly, currency management is just a by-product not an end in itself. We treat central banks as another form of institutional investor. They’re large money managers, focused on increasing returns. Because of the meagre returns that they’ve been earning in government securities, playing with FX as an asset class isn’t as important to them because they’ve got a lot of work to do in terms of the diversification of the cash assets that they’re managing.
HDH, Overlay: Some years ago hedge fund and currency managers thought central banks were very good partners with which to lose money, and that’s not true any more. They are definitely changing their philosophy on currency and they behave much more like investors rather than regulators.
RG, UBS: Central banks have become far more transparent. They’ve had to intervene less because there has been lower volatility in their respective country’s economic fundamentals. For instance, GDP and inflation have been far more predictable and therefore the reason to intervene has changed. That doesn’t mean they have been less active. On the contrary, many have been seeing currency management as an alpha source.
AE, Millennium: But Rob’s right – they haven’t needed to intervene. Even the central banks of emerging market countries have in general reformed considerably. They’ve become less populist and more reformist. Central banks are more market aware and know well what they’re doing and the impact they make. It would be naive to think they wouldn’t come back in extreme circumstances, and they can exert a pretty powerful influence, as the Bank of Japan did only two or three years ago.
RG, UBS: Yes, and were we to return to a global inflationary environment, central banks would become even more active than they are today in currency management.
The rise of emerging market currencies
Euromoney: Another key change over the past few years is that we’ve seen roughly a dozen fairly important currencies disappear to be replaced by the euro, and another 10 or so are moving in that direction. How has that affected the marketplace?