Foreign exchange debate: Banks and buyside face up to market pressures

Foreign exchange debate part two: The changing face of the foreign exchange market
Foreign exchange debate: Learn more about the panelists

JK, Amundi The most important thing in the economic background to the foreign exchange market is that the Federal Reserve has started quantitative easing. It’s a very important signal because there’s not much that the bond market can continue to do to help in easing monetary conditions in the domestic US economy. The euro has already dropped to a very low level. So for the US quantitative easing to really work, to take effect, it has to work through other countries in the world. That’s why quantitative easing is driving the dollar down, and it will continue to go down. This will be a very important theme for many months. Even if some strong data might come later, I don’t think that strength will drive the dollar up because the effects of quantitative easing will last for many months. Thus I see the dollar going down, pushing other currencies up, forcing other central banks to cut interest rates. It’s very clear that the US authorities want the dollar to go down but it doesn’t necessarily mean that they want the other currencies to go up. What they really want is the other countries to share the burden of quantitative easing, which means that they want to force the other currencies to have appreciation pressure so that all the central banks in the world will cut interest rates and share in the inflationary burden. That’s what I think, and that’s why we can see finally, after the quantitative easing, that the main arena is gold; the gold price keeps on going higher, higher, higher, because that’s the only thing that’s out of this circle. Sui Chung, Euromoney Richard, is that what you’re hearing from clients? Is that how the clients of UBS are looking at it, that QE II is what’s driving the sentiment? Or is there a broader variety of opinion?

RL, UBS As far as QE II is concerned, undoubtedly there is a view that it is what is weakening the dollar, and we have to say that something is driving it that way. I do share some of the views that James has expressed. Not least I’m minded of a meeting a while back in which our head of Japan economics in response to what clients thought about Japan said: "Why don’t we start by asking the clients what they think of the US because whatever they think of the US, if it’s good halve it for Japan, and if it’s bad double it.’ To some extent you could almost use that analogy for the entire world today. So to that extent the question of beggar thy neighbour is not particularly appropriate. It’s a question of the US doing what it needs to do for its own domestic concerns, given that the Fed does have that dual mandate of price stability and employment. If we’re all reliant on the US, we’re going to have to pay the price.

Sui Chung, Euromoney Martin, is this what you hear from the clients of Credit Suisse? Do you encounter similar sentiments?

MW, Credit Suisse It’s hard to construct a very bullish outlook for the dollar in this environment. There’s QE II and looking at the fundamentals it’s really difficult to see anything other than that. However, having said that, it’s all in the price. QE II was a long time ago now, and now it’s there and the dollar isn’t really going anywhere with its initial reaction. Probably we have to look differently. If you look at Europe, it’s back in the spotlight again. Europe needs to restructure; we believe there is almost no other choice than to restructure, and then if they do who’s next on the list after Greece and Ireland – Portugal, what about Spain? The euro has been fragile again and we will see it under immense pressure once more. But, as I said, it’s hard to construct a case for a much stronger dollar, but maybe collectively the market is wrong again.

Sui Chung, Euromoney Ian, from the trading side do you see some of those themes coming through? Martin mentioned that it’s all in the price now, so are people on the wrong side of it?

IOF, Deutsche Bank There seems to be an element of the market saying that governments have fallen behind the facts of the matter. Looking at the price action, that’s where it seems to have been led. The clear winner seems to be gold, as James said. There’s a clear trend there and that’s going to continue. If you look in Europe as well at the blow-out in some of the credit spreads, it’s done on very thin market conditions. There are continued concerns about Europe and it means that people are moving out their prices rather than things being blown out on any real strong volume, which is another difficulty.

MM, Sun Trading One of the interesting outcomes of what’s going on is that some of these smaller countries that are strong trading partners with the larger countries that are clearly going to encounter this depreciation are in a position where they’re going to be more active in their currency. So to that extent there’s going to be more activity and great opportunities to trade in those markets.

The eurozone situation

Sui Chung, Euromoney Professor Olsen, both Martin and Ian have brought up the issues in the eurozone with what has happened in Ireland and so on. What options does the eurozone have in this situation?

RO, Oanda The eurozone is, just as are all the other countries, in a torment, in that the number of options of how to move have been strongly restricted. So the politicians don’t have a free agenda, they cannot set the agenda, and events will dictate the subsequent events, and obviously this is very dangerous. It reminds me of a trader who is close to his margin call, he’s just frozen there and waits for execution time. This is the sense I have.

RL, UBS With what’s going on in Ireland people have certainly focused in on that a lot more quickly. People as a whole tend to make a mistake and assume that the benchmark is Germany or the Netherlands. Actually, within Europe there is a complete standout of differences. The rest of the economies are in profound trouble and one tends to think that France in particular is on the right side. However, if you have a look at its current account and its trade that’s not the case. There are some profound weaknesses. In terms of the options available for them, it’s perhaps limited.

RO, Oanda The problem I see is that we are in dire crisis and we look for standard solutions. If we look at the whole global economy it has evolved, thanks to technology which no one ever could have imagined before. If we say what options are there, let me say what I would propose. The eurozone has the big potential to become a fixed-income market of a huge size, and the fact that different governments have different problems is also great, but why not do the following: Set up a fixed-income market where we pay second-by-second interest on bonds of these different governments? Create a highly liquid market where the yield curve doesn’t stop at one day, it goes down to one second, and just say" "Look, this is how we solve it." It’s an out-of-the-box idea.

JK, Amundi Let’s take that out-of-the-box idea for a moment. Would a changing of the landscape in that nature change the way that certain countries and certain central banks behave, particularly if we go back to what you said earlier, that China holds all the aces? It has closed its capital account, so in terms of how it interacts with the outside world, it has much more control. Would a technical change of that nature change the way that some of those types of institutions would view the eurozone? I am quite optimistic on the eurozone as a whole because there are two types of problems: either we have lack of demand, or we have a lack-of-supply problem. Historically lack of supplies was a problem but it can be solved. Like many emerging market crises, the crisis is centred on the product supply, the amount of debt that is looking to be financed is too great for the market to want to finance it, then funding costs keep on going higher, the issuers are exposed. But if you look at history, at the end Argentina and Brazil defaulted but they have come back now very strongly.

RL, UBS We have the minor issue of the default in the meantime!

JK, Amundi Yes, but at the end they come back. What I really worry about is lack of demand. Look at Japan, 20 years lost, and it is what people really worry about for the US, and that’s why the Federal Reserve needs to take this risk to implement QE II. It has already solved the first problem because during the Lehman crisis there was a problem of supply. It did lots of things, soft, but now he comes the second problem, lack of demand, and that might not really work because, look at Japan, it certainly didn’t work there. The reason I am more optimistic on the eurozone is that I don’t see a lack-of-demand problem, I only see the supply problem. Let’s look at Portugal, Ireland, Greece. They want funding; they can’t get it from the market at reasonable rates so they tap the economies that have a lot of funding through the bailout mechanism, which is effectively channelling money from the surplus countries to the deficit countries. That does solve the problem for the moment.

RL, UBS Spain is the one for me because we can deal with Ireland. The question that ultimately we’re going to face within Europe is nothing to do with Ireland, or indeed Portugal or Greece, that could be dealt with by the European Financial Stability Facility. People will switch their focus to Spain, and there is where I get worried. If the market takes fear with regards to Spain, then we’re in a world of pain largely because it’s such a big potential problem that I’m not sure how you address it, and I’m not sure that the surplus countries will be willing to. German chancellor Angela Merkel had enough problems with persuading the German electorate on Greece, let alone a transfer of the order and the size of Germany to Spain.

RO, Oanda Isn’t that the general problem? The real problem is just much bigger than we like to think about.

Sui Chung, Euromoney Ian, on what Richard and Professor Olsen just said, is there a build-up of fear in the market and a perception that the problems are more intractable than we like to think?

IOF, Deutsche Bank There is, without doubt. Getting confidence back into investors is one of the key things to do. Looking at what’s going on at the moment, as I said, a lot of the markets are trading on thin air and they’re getting some confidence back. If you look at some of those markets, they were always driven by the domestics and they’re not apparent at the moment. There is a definite fear. If you look at Ireland when you go over there, everyone has no clue about where the future lies, there is no confidence whatsoever.

Sui Chung, Euromoney In these thin-air markets who is active, who is still fairly active, because there is still activity? Volumes are very low, particularly low during the summer and they’ve come back up a bit. What types of investors and what types of players are still active there? Martin?

MW, Credit Suisse Corporates use these exchange rate levels in the euro/dollar to hedge their long-term exposures, and we’ve seen a lot of especially long-dated business from corporate Europe.

Central bank intervention

Sui Chung, Euromoney Just to go deeper into the intervention theme for a moment, does any of the panel think the central banks aren’t hostage to events? How much ammunition do they have?

JK, Amundi It depends on the countries. The reason the Brazilian finance minister starts talking about a currency war is because Brazil was in a very bad situation in terms of fighting the war. All countries have the right to intervene or not but their capacity to intervene differs. For example, in Brazil’s case it’s not effective at all to intervene because the country’s interest rates are so high. If they intervene it would be by selling bonds with the high Brazilian interest rate and buying US treasuries with a zero interest rate. This kind of intervention can’t be very effective for long. If we take Colombia, it doesn’t mean anything to intervene. The country cannot even borrow the Colombian peso in the short-term market because its money market is not well developed, so it depends on the country. China is in a very good position to intervene because it closed the capital account. That’s why some countries have the capacity to intervene, some not. That creates conflicts and that’s why some central banks come out and say they’re not happy.

MW, Credit Suisse And this isn’t confined to emerging markets. In Switzerland the central bank has reached the limits of what it can achieve in this regard, buying more than €150 billion, and now it has stopped intervening.

RL, UBS I would argue that the Swiss central bank was a lot more successful than the market gives it credit for, not least of which was because the volatility increased so substantially and you scan in the position to the volatility. There was also a misunderstanding from the market as a whole as to what the central bank was trying to do there. In terms of what is available to the central banks, it depends on what their objectives are, but the reality is it also depends on what inflation is and what the prevailing concerns are. I am minded of 2003/04 when pretty much every day the market said of the Bank of Japan: "They can’t intervene any more, they can’t intervene any more". Really? Why? If you don’t have an inflationary blockage you can do as much as you have the appetite for, and the Bank of Japan proved that quite successfully. It’s really defined by how much you are prepared to lose on the country balance sheet over a period of time, and what’s certain is that the BoJ’s purchases at 120 were quite expensive, but you can do as much as you have the appetite for, as far as currency and intervention is concerned.

RO, Oanda But don’t we have the issue that intervention is basically happening on two fronts, potentially currency side plus the treasury side, the government bonds? I find that’s a very toxic mixture doing both sides, and because it’s a static approach it will eventually backfire. You can win time but when the avalanche is in motion you’ll be hit by much more dire consequences than you would otherwise have had. The current static approach to the markets that the central banks are taking is very dangerous.

RL, UBS What would you see them do?

RO, Oanda What’s important is to take a dynamic approach, because if you study market behaviour in detail, it turns out that the equilibria are very short-term, so when you are there at these very short-term time windows and hold a little bit against them, you can have a very important impact which, if you wait and try to move when the big move has happened, that’s far too late. Like the surgeon, we are happy to say that we now make microsurgery, the same thing I would advise to central banks, both on the interest rate side and the currency side.

MM, Sun Trading I agree with that as well, with the application of technology and the modernization of trading central banks have a lot of newer tools available that they have not been exploring. It’s certainly a curiosity if nothing else. In the next couple of years I would see that turning into different sorts of actions and behaviours and experiments to see how they could affect the prices of their currencies and bonds.

Sui Chung, Euromoney Let’s move on to the other side of the actions of government and that of their role as regulators. Professor Olsen, would you like to kick us off?

RO, Oanda To put a little pressure on the discussion, regulators are trying to pull everything on to exchanges, and I would argue that the over-the-counter players should be far more active in preventing that happening. If we were innovative we could come up with a number of measures that would show the quality of the over-the-counter product. I find this is where we’re lacking, and I include Oanda as a very small provider within that scope, but it definitely has to be an invitation to the big players. We should think proactively and try to explain why it is so good.

RL, UBS One of the problems, or a consideration for market participants as a whole, is whether arguments will be received on the basis of "may the best argument win", or on the basis of what is believed to be the answer that will go down best with an electorate. That would be where I would disagree with you because I don’t necessarily believe that the audience with whom we are debating will go with the most clearly made argument.

RO, Oanda What I’m always struck by is that many of the regulators just don’t understand, and the time window you have in which to interact with them is so brief that you cannot educate them. I would suggest that we prepare what we think is the best educational material for the regulator, offer it to him in real time so he can absorb it, and then eventually he’ll just be better educated and when he comes back and implements the proposed regulations he’ll be better informed.

RL, UBS Again it comes down to the fact that you have regulators that have been burnt, and therefore what they’re doing is looking to adopt a belt-and-braces approach. So it might be that the belt we have is perfectly adequate, in fact more than adequate. The answer will come back: maybe the FX market is an exception, maybe it’s not.

Sui Chung, Euromoney Martin, in your experience of the debate and how it plays out, where do you sit? Do you think it’s driven by the politics and the electorate and thus that is the key dynamic, or do you think there is room for better education?

MW, Credit Suisse The FX industry has survived any crisis that has occurred – the biggest one was Lehman – without any dysfunction or any settlement issues. CLS works perfectly and has grown ever since, so for me the whole debate about having a central counterparty in the FX business doesn’t make any sense. If anything it would add to the systemic risk and not reduce it. I am quite optimistic and hopeful that eventually FX will be exempted from some of these decisions.

Sui Chung, Euromoney As has been said elsewhere, at every point in the crisis consumers have had two-way dealable prices, and that is a fundamental difference to the experience of colleagues in other asset classes.

MW, Credit Suisse The FX market is self-regulated. Settlement risk is taken care by CLS to a very large degree.

RL, UBS And an ever-increasing degree.

MW, Credit Suisse And the mark-to-market risk on forward contracts is taken care of by CSA collateral agreements. Counterparty risk is now collateralized. The self-regulation works extremely well, so why do we even have the discussion?

Sui Chung, Euromoney One area that puzzles and is intriguing to me is the idea of swap execution facility, etc. To me the four electronic platforms that are represented here fit that description. There are multiple users and multiple providers of liquidity. Yes, it is owned and operated by a bank, but there are lots of inputs coming in. Or is my interpretation wrong? How would you view it? Is Autobahn a swap execution facility?

IOF, Deutsche Bank I don’t think it’s clear, we don’t even know yet. What’s going to be included and what’s not going to be included is not clear. What is an SEF and what is not is not absolutely clear. I’ve written it down that one of the descriptions was a trading system in which multiple participants have the ability to execute by accepting the bids or offers from multiple participants. In other words, it seems to be that for maybe some of the products that we execute we’re looking at way too many platforms, but then you need to decide what way too many means. It’s too early to say exactly what is the degree of what the Commodity Futures Trading Commission will announce by the end of the year, and what that means, and what it means in the working environment will be something we’ll have to discuss at the time. What is happening, and I assume it’s happening across the whole market, is that all the market participants are talking to the regulators and talking to them strongly about what they think have been the strong parts and what are the weak parts, and what needs to be addressed and what doesn’t need to be addressed. Discussions around central clearing and the creation of the market-wide bodies that have been created so that people can communicate more can only be a good thing. That would show the regulators that people care about and want to continue to have a fully functional FX market.

RL, UBS As an aside, one of the things that the regulators are going to have to start thinking about is some of the implications of what they have initially proposed. By that I mean that spot is out of scope, Non-deliverable forwards and derivatives clearly will be; swaps and forwards nobody is entirely certain. But if you think about that, what happens with the maturity on a derivative contract? That becomes spot trade so it’s no longer centralized. Among the issues that we as institutions are going to have to address is the fact that, as Richard was saying, some of the knowledge base is something we’re going to have to help with from an education point of view as some of the implications might not necessarily be clear.

Sui Chung, Euromoney James, as a consumer have regulators asked you whether you think it works, doesn’t work, what you want to see changed?

JK, Amundi During the peak of the Lehman crisis yes, what we thought we’d need. But now with that sort of crisis passed and the FX market the most liquid, nothing happened. Too much regulation would just add too much cost to everybody, again because the cost would be passed to us.

Sui Chung, Euromoney And then to the end consumers: my pension, everyone’s pension.

MW, Credit Suisse European corporates have heavily protested and lobbied it in Brussels and at their governments. They would need to collateralize every single deal, which would be a huge burden to their cashflow and funding. That’s what was on the table for discussion – which in essence would be a drag and a cost to the world economy. These funds wouldn’t be there for investment.

RO, Oanda This is why I say they just don’t understand.

MW, Credit Suisse Absolutely.

RO, Oanda This is my conjecture. The situation is quite dangerous and we have to think beyond the current crisis and choose for the longer term.

Sui Chung, Euromoney As a member of the consuming side of the market, James, have regulators been in touch with you and asked: "Dear Amundi, as a consumer what do you think, how much is it going to add to your costs, would this work, would that work, what are you looking for?"

JK, Amundi No.

Sui Chung, Euromoney Zero contact?

JK, Amundi Yes.

Sui Chung, Euromoney Part of the regulatory drive we are experiencing is for increased transparency. Ian, how much transparency is there now and how important is it to have more?

IOF, Deutsche Bank Clients demand, and I believe get, a very good level of transparency. There’s a level where that doesn’t work very well for the client, and that’s when you get into the medium-size and some bigger tickets and you get into something where you have the warehousing, or in less liquid currencies where you’re housing that risk. Anything where from trade to tape is put in the wrong way, that will have a knock-on effect. If you have to announce to the world that a trade’s gone through too quickly, then you have to allow for the fact that that’s going to affect spreads or it’s going to affect your execution, without a doubt. There’s a lot of work that needs to be done in that respect as well. Transparency is a good thing but can anyone argue that full transparency is a good thing? I would say not necessarily, not for anyone that’s participating in the market.

MM, Sun Trading The clear thing is that it’s not the same thing as stability.

Sui Chung, Euromoney Transparency does not necessarily breed stability, particularly in the extreme cases of, as you say, the instant that anything gets done it has to be announced.

IOF, Deutsche Bank It’s not necessarily a good thing for the end user.

RO, Oanda I would argue that obviously certain information is private and has to remain absolutely private, but other information would be very beneficial. At Oanda we publish position information of our customer base on a normalized basis, so you don’t see that based on one customer we have a very big position at that level. But what we show is a kind of voting regime of what the positions are, and that I find is extremely helpful because it actually shows you when the market is getting locked into its own overshoot. This kind of information would be very easy to provide on a cooperative basis and could be of immense value, and would take a lot of wind out of CME or other of the traditional exchanges. I suggest one should be more proactive on that front.

RL, UBS Thinking of my previous employment, my current employer and in fact my previous-but-one employer, some form of disclosure of positioning was there on a normalized basis. There are concerns with that, not least of which is if you get a disproportionate or very large ticket it might be obvious who that might be, so there are sensitivities around that, so typically speaking you can’t break it out into segments, it has to be on an aggregated total client basis. But most banks do that. Deutsche does it, Citi does it.