Rising FX volumes and volatility signal return to business as usual in currency markets
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Rising FX volumes and volatility signal return to business as usual in currency markets

Increased activity and rising volatility have provided further evidence that trading conditions in the foreign exchange market are returning to the norms seen before the financial crisis.

The fragmented nature of the FX market means that, unlike in equity markets, exact turnover figures are not available. Indeed, the most complete volume survey, undertaken by the Bank for International Settlements is only released every three years – the next being due this September.

However, volume data from the world’s largest interdealer brokers provide a more timely snapshot of activity in the currency market.

The latest figures show trading activity on EBS, Icap’s electronic FX trading platform, has hit its highest level since November 2011, with average daily trading volumes rising 5.4 % in February to $149 billion. Rival Thomson Reuters also saw activity rise across its trading platforms, with average daily volumes rising 8.7% last month to $137 billion.

Meanwhile, FXall, the FX trading platform popular among asset managers and corporates, and acquired last year by Thomson Reuters, saw average daily volumes hit a record $110 billion last month.

That rise in activity came as volatility in the currency market heightened, with the dollar gaining ground as the Federal Reserve indicated optimism over the US economic recovery, and the pound and the yen falling sharplyamid heightened expectations of further monetary easing in the UK and Japan.

Elsa Lignos, senior FX strategist at RBC Capital Markets, says while an increase in trading volumes does not have any directional implications for FX spot prices, it does for FX volatility prices.

RBC, as can be seen in the chart below, compared FX turnover against average G10 one-month realized volatility.

 FX volume and volatility correlation returning to pre-crisis levels

The analysis shows that, before the financial crisis, there was a well-established positive relationship between FX volume and volatility.

“That may seem unintuitive given the post-crisis experience,” says Lignos. “At key risk-off moments, one would expect to see volumes dry up alongside a spike in volatility.”

Indeed, as the chart shows, that is exactly what happened in the period immediately after the eruption of the financial crisis.

In normal times, however, there has been a positive relationship between turnover and volatility. On a short-term basis, that can be explained by data surprises driving activity along with volatility. On a longer-term basis, a break out from a range could lead to higher volatility and increased activity from momentum traders and those with hedging needs.

As the chart shows, the FX market is now tentatively returning to a more normal world, in which higher turnover is accompanied by higher volatility.

Lignos says if the pace of turnover growth is maintained, it would, all else being equal, point to higher realized FX volatility.

“It’s a break with the post-crisis experience, but we may be entering a world where higher volatility can also signal a healthier market,” she says.

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