Structural shifts upend troubled FX franchises

The foreign-exchange industry has been caught in a perfect storm of falling volatility, difficult trading conditions and regulatory challenges. Many of the senior figures in FX have stepped aside, leaving a new generation to come to terms with a radically different market.

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Zar Amrolia, co-CEO of XTX Markets

FX dealers hoping for a renewed bout of volatility have had their hopes dashed. Some now talk of a structural decline in trading volumes. Bank of England statistics show that daily reported UK foreign exchange turnover was just over $2 billion in October 2015, a fifth lower than a year earlier and the lowest daily turnover since 2012. 

Such declines are mirrored by the votes of 3,500 FX clients globally in this year’s Euromoney foreign exchange survey, with 2015 volumes down more than 20% compared with the previous year on a like-for-like basis. 

Towards the end of last year, the majority of market participants were convinced central banks were about to embark on a period of prolonged and protracted monetary policy divergence. The US Federal Reserve raised market expectations with talk of four interest rate hikes in 2016, in stark contrast to the European Central Bank’s monetary easing policies. 

But in a relatively short period of time, the market completely re-assessed its position as the Federal Reserve took a more cautious stance on raising rates. The subsequent end of the one-way dollar-strength story has led to a pullback in terms of trading volumes, volatility and risk positioning.

"People are now less convinced about the outlook for strong policy divergence, and consequently we see much narrower trading ranges in G10 FX," says Adrian Boehler, global co-head of FX at BNP Paribas. "If there is less clarity and lower levels of conviction among certain client segments, then this will naturally translate into lower trading activity."

The decline in trading volumes is also partly to do with the new randomness of market volatility, which has made currency markets more challenging. In previous years, volatility came when it was expected to come, with the release of economic data and policy announcements. 

"That has changed somewhat," says James Bindler, global head of foreign exchange at Citi. "The Swiss National Bank event and the flash crash in equities last year translated into more random FX volatility. Event volatility is greater than in the past, such as when the Bank of Japan cut to negative rates."

Structural changes in the marketplace mean longer periods of low volatility interspersed with shorter periods of higher volatility, leading to big, discrete gaps in the market, argues Chris Murphy, co-head of foreign exchange, rates and credit at UBS. "The move from voice to electronic trading and algorithmic-driven trading means that when a price is stable you get ample liquidity, but where there is a re-pricing in the market, all of a sudden that liquidity starts to vanish."

Events like the SNB’s currency peg removal and increasingly common stock market flash crashes have forced banks to re-assess how they let counterparties such as hedge funds use credit through their prime brokerage arms. The conclusion has been that credit was priced too cheaply. Now prime brokers are much more discriminating about which clients they extend credit to.

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Adrian Boehler,
BNP Paribas

The SNB event also forced banks to question the protocol governing electronic trading and the size of inventory they run to facilitate anticipated client business. "It may also have triggered some market participants to review their market-making strategy when it comes to derivatives in currency regimes, which are not classically free-floating," says Boehler.

FX market making has continued to become more expensive, says Russell La Scala, global head of FX spot trading at Deutsche Bank. "[This is] due to the costs of credit, separation of processes, compliance, legal, and the continual investment in technology."

Dealers therefore anticipate that this year’s triennial survey from the Bank for International Settlements will show a drop in global foreign exchange trading volumes of as much as a quarter from 2013. 

Passive alternatives

Such a steep decline in a notoriously low-margin, high-volume business cannot be explained away purely by volatility and the pullback in prime brokerage. Dealers point to the bigger long-term trend of global equity investors ditching expensive active managers for cheaper passive alternatives like index-tracking funds.

According to George Athanasopoulos, co-head of foreign exchange, rates and credit at UBS, there is an important trend for assets under management to move out of certain types of hedge funds into other alternatives. "This migration of assets is relevant for foreign exchange, it has definitely had an impact on the decline in volumes. Capital is moving out of portfolios that traded frequently into more passive vehicles, which impacts FX volumes."

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Mark Webster,
Standard Chartered

Investors are also exploring their counterparty options when it comes to their currency trades. The largest currency dealers still maintain their grip on the market, handling 48% of global FX trading, according to a recent report from Greenwich Associates. But Greenwich Associates’ survey of 1,600 global investors also found that 20% of volume was executed through non-bank liquidity providers, up from 16% the year before.

One such non-bank liquidity provider is electronic market making firm XTX Markets, which was spun out of quantitative hedge fund GSA Capital. Industry veteran Zar Amrolia joined its ranks in September after decades on the dealer side, most recently at Deutsche Bank. The B2B firm has already done several trillion dollars’ worth of spot FX through servicing banks and aggregators.

"The top 10 banks have enough critical mass to keep things ticking along nicely," explains Amrolia. "However there is a mid-layer who are too small to be big, are not really investing in balance sheet, headcount or technology but who are looking to service their clients more efficiently as markets move further towards electronic execution."

Non-bank players may be boosting their presence in foreign exchange, but on the dealer side many familiar faces have moved or quit the industry altogether in the wake of the foreign exchange rigging scandal of 2013

"The FX market is evolving very quickly. I think we are seeing a very natural process of renewal and soon we will see a different generation of people running this business," says Athanasopoulos.

However, one industry source describes it as a "bizarre situation", with newer industry heads seeking advice on everything from market structure to how to respond to regulation. "There’s been a clear-out not only of global heads but entire management teams beneath them. There are some very junior people who aren’t associated with poor conduct issues, but just don’t have the experience," the source says.