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FX debate: Executive summary
• What innovations are there in foreign exchange? Banks need to work with the buy side to find useful additional services for the investment process
• The use of exotic options is growing among investors, although few are trading volatility yet
• Prime brokerage is also making a difference by helping market players get access to more markets
• Standardized reporting is a point of debate and electronic trading also presents banks and investors with additional concerns |
FX Debate: Making the most of a benign environment (PART 1 OF 2)
FX debate participants
AE, Millennium We accept that foreign exchange returns will be helped by innovation. For example, if you can take credit risk as well as the currency risk in emerging markets, you can increase your returns dramatically. What are the innovations you are seeing at the moment?
KMc, Westpac Banks need to continue to come up with something useful to the investment process but, more importantly, something that can be taken by a client and integrated into the investment process without relying on the bank. Some of our modelling work is proprietary information. You can’t incorporate that into your investment process, whereas something like the Westpac dollar surprise index you can. We’re willing to disclose the investment process to top-end clients.
JA, State Street What excites us in research is the idea that markets go through regimes; different things work in different environments. Although it’s not a new idea, it’s presented in a new way. Markets work in synchronicity. Such things as the carry trade have analogues in the equity and fixed-income markets, and these become synchronous. That’s more of an investor behaviour issue, more of a risk appetite issue, than a fundamental issue. We’re not trying to come up with a better way of valuing something. We’re asking what investors are paying attention to, and what’s different about the regime now. If it’s a random walk, if we flip regimes randomly, that doesn’t help with forecasting. So the key part of our regime model is assessing the probability that we stay in the same regime or, if we change regime, anticipating where we are most likely to go.
MT, RBS In terms of innovative execution products, we have created new technologies that facilitate benchmark execution. We see a lot of clients tied to benchmarks, and with the uncertainties around the application of Mifid and FX we are seeing that client base grow. They love the way it facilitates both pre-trade and post-trade analysis and it is a concept that fits neatly into a broader portfolio of assets. Not only have we created our own benchmark, but also we have done research on beating benchmarks and trying to understand what our clients are seeking to achieve, and then we reverse-engineer solutions that may improve returns. Feedback suggests that many clients are not interested in taking any risk in trying to beat a benchmark. It’s just a line in the sand. That surprises me. Why wouldn’t you try to beat a benchmark if we could possibly help you do it?
AE, Millennium But most benchmarks in foreign exchange are just marked against WM rates?
CKG, SGCIB The old spot FX market, pre the IT/e-commerce revolution, was fantastic for banks, because the equity you needed to run a spot business was relatively low versus the returns you could make. That’s why the market was so much more broadly spread across a variety of liquidity providers because everyone wanted a piece of the good returns available. The IT revolution has changed this dramatically in two broad ways and this has affected the way that banks have expressed innovation. First, the flow part of the business has used IT in new ways to handle risk aggregation of large volumes of flows on much narrower bid-offer spreads. Secondly, the marketplace has used IT to model more complex products, giving rise to structuring and exotics opportunities. The key thing is that IT is the differentiator and it is not surprising that those banks that have led the IT revolution have created substantial first-mover advantages and have helped shape the innovation we have seen.
AE, Millennium What innovations are there in the exotic options market?
XP, FX Concepts The market has evolved over recent years. Five years ago the banks were the market makers and managers such as ourselves were the takers, but this relationship has been to some extent reversed. There has been a rush into strategies that sell options. As hedge funds have piled into that strategy, some of the mispricing opportunities have been arbitraged away, and this is a piece of the larger picture that explains why vols are low. As the spread between implied versus realized has diminished it is only natural that managers look for opportunities in other areas of the volatility triangle such as correlation trading (realized versus realized).
At FX Concepts, we have looked at options to improve risk efficiency, particularly in capturing carry. The basic premise of options is that mispricing exists because people are willing to pay a premium to give away risk. This strategy has become crowded of late. We have moved on to model the way volatilities move, both up and down.
AE, Millennium Are those on the buy side becoming more efficient in the way they put on their risk through options, or is it still basic?
RL, Barcap Some are using products with a lot of moving parts, particularly when you look at knock-outs and knock-ins in different currency pairs, and it’s certainly true that more people are now using second- and third-generation exotics. In the main, however, the business is still substantially vanilla and the volume of that business that goes through platforms is flabbergasting. These are clearly directional trades, executed on a streaming price basis rather than volatility trades executed with delta. That suggests that the end users are finding the use of options efficient.