FX Poll 1998: Plotting the death of settlement risk
"At the start of last year there were still a lot of wannabes in this business," says David Barnett, vice-president, trading, Europe and Asia, for Royal Bank of Canada. "Now it's pretty clear to everyone that there are a maximum of 20 major players. And within that group, the big boys are pulling away and the rest are scrambling to keep up with them."
A combination of bank consolidation, corporate mergers, the Asian crisis and the growing role of technology is responsible for this. For the top tier they present a new series of opportunities (assuming they don't fall victim to a vicious merger or takeover); for the rest, it's crunch time.
The introduction of the electronic broking system and Reuters' foreign exchange trading system in the mid-1990s has made dealing prices more transparent and driven spreads down. Now the internet is the next means of communication being developed. Most of the major banks have internet sites providing research, and several smaller companies, such as Currency Management Corporation (CMC), offer spot and options trading over the internet (CMC reported turnover of $20 billion for 1997).
But security issues have so far stopped most banks from establishing trading over the internet. The exceptions are SBC Warburg Dillon Read and Royal Bank of Canada, which are using software developed by Cognotec. "The idea is that our clients can access customer-specific websites which will give them access to the full range of services, from research to prices, and be able to execute deals," says Barnett. The site will be going live from the end of June.
With Emu taking even more business away, most expect the major players to be those with a presence in the major centres (London, New York and Asia) and the ones with more than just pure dealing to offer. "The theory that foreign exchange is a dying business is a fallacy," says Hal Herron, global head of foreign exchange for Deutsche Morgan Grenfell. "It is partly true in that technology is dramatically changing the nature of the flow business. But real relationships are now developing between us and our clients as we look at how foreign exchange can help them in other ways. The Asian crisis is a good example of this, as it showed how crucial it is to realize and manage currency risks."
As companies start looking beyond their national boundaries to define their success, the ability to offer a global service in foreign exchange is becoming more important. "Who corporates and investors view as their competition is changing," says Zar Amrolia, Deutsche's head of sales. "For example, a UK corporate is more interested in its hedging policy relative to other competitors in the industry sector in Europe or the US rather than other UK corporates." One consequence of this is the growth in size of some of the spot and options trades bankers are seeing. "Single spot trades of $500 million or $1 billion are quite frequent now," says Thorkild Juncker, global head of foreign exchange and commodities at JP Morgan. "These can be risky, with potentially good returns for the banks, but it will only be the largest foreign exchange firms more comfortable with risk which can execute these deals."
Changes in corporate strategy are also having an effect. The transparent pricing technology brings does away with the need for corporates to maintain a large clutch of banks to offer them forex services. So to optimize costs and relationships, the customers are cutting back. "When I started in foreign exchange in the 1980s, corporates used to have 40 core banks or more covering foreign exchange," says Alan Clark, HSBC Midland's head of sales. "Now they have cut back to 12 or even fewer." As the largest corporate customers and investors cut back their relationship banks, more business and more profit rests in the hands of fewer banks.
Consolidation in the banking sector is adding to this. "If customers have a limited number of banks and need to find another if two merge, then it works in our favour," says Roger Tarika, head of foreign exchange at Morgan Stanley Dean Witter in Europe. "Often they'll want to have an investment bank on the list, and might sacrifice a fringe relationship with a commercial bank."
One forex head says that the globalization of the market has exposed the weaknesses of most forex providers. "Those banks not in the top 10 or 15 have a big problem," he says. "They have global costs, but only regional revenues, and are being forced to reassess their forex strategy. I wouldn't be surprised to see some of the European banks pulling out of certain sectors."
Those most obviously affected are regional banks. The US regionals are all but out of the game; the top flight think of them more as clients than competitors. Bankers Trust also appears to be heading this way: its former head of foreign exchange in London, Achilles Macris, left at the start of the year, apparently taking early retirement. Competitors charge that he left after the firm refused his request to invest in expanding the business.
Other firms have no choice about reducing the size of their forex business. As a result of the crisis last year, several Japanese banks had their ratings downgraded with the result that some pension funds are now unable to deal with them. And for those Japanese institutions not affected by the downgrades, concern about operating costs and a relative lack of credit from customers have stymied their operations.
Meanwhile, although many European banks claim that monetary union is a catalyst for expanding their forex business, few are well positioned to do so. Well-established regional banks such as SE Banken still have a client base strong enough to bring in revenue. But those banks still in the process of building their investment and corporate banking franchise have a struggle on their hands. Commerzbank, Westdeutsche Landesbank and Dresdner Bank in Germany, and Société Générale and Paribas in France are all aiming to increase their international presence across a range of products.
Many have found it harder than they expected simply to replace the trading profits which they once reaped dealing in currencies which are now converging as part of the European monetary system (EMS). Everyone can name potential new money spinners: the Asian currencies, sterling, the currencies of the central European states which are vying for entry into Emu in the first decade of the next century, the rand, and the Anglo-Saxon dollar bloc (Australian, Canadian and New Zealand dollars). The last of these could provide a useful fillip to Royal Bank of Canada since the bank (which is set to merge with Bank of Montreal) recently bought from Société Générale the top-rated former Hambros bond teams covering these areas. The French bank had bought Hambros' investment-banking division at the end of last year, but always planned to sell the bond business.
Some advise caution in dealing in this list of currencies, however. Sterling aside, none of those other currencies can match what the EMS currencies had in terms of volume. "These are countries that many international clients will be looking at to diversify their portfolios once the euro is up and running," says Guy Whittaker, Citibank's head of global foreign exchange. "But one has to bear in mind that the economies and capital markets in such countries are smaller than most of those joining the first wave of Emu." The big prize for forex teams will come when the rouble is fully convertible "That will be a huge market," says JP Morgan's Juncker. "And it'll be a market for the long-term. Unlike some of its eastern European counterparts which are lined up to join Emu, the rouble won't be involved in convergence plays for a few years and then disappear."
In for a shock
So while Emu could well mean more volatility in these currencies as more trading is undertaken, it is only the big houses and the niche players who will be able to take advantage. Look no further than the recent events in Asia for proof of this. Until October the currencies of what were then called tiger economies seemed an unmissable opportunity. "Early last year, people woke up to the effects Emu would have on their forex business, and so moved to Asia," says Whittaker. But the newcomers were in for a shock as the region turned sour. "So many banks were saying that they could execute emerging-markets business in the first half of last year," says Rob Loewy, head of foreign exchange at HSBC Midland. "But in the eye of the storm in Asia, the 20 or so banks quoting prices very quickly reduced to a handful." Loewy and Whittaker agree on why: only those with the network, brand recognition, client base and on-the-ground research teams are the ones who can still offer a full service in the new, chilly climate.
It's not just the global players such as HSBC and Citibank that can benefit from this: Standard Chartered, the pan-Asian regional bank, made nearly $200 million in forex last year, half of it in the crisis. According to Loewy, it is the commercial banks that still hold the advantage in foreign exchange in the emerging markets: "Banks can't rely on investor flows alone to be profitable in Asia. It might work in the west, but in Asia it's the local and multinational corporates which are the mainstay for the business."
None of the European wannabes made a killing in Asia last year, none has a big presence in forex and few are likely to achieve one. Only one bank has managed to build up a full-service forex business from a narrow base in recent years - Deutsche Morgan Grenfell. Those contemplating similar moves would do well to look at Deutsche. It has risen through the rankings as a result of an aggressive hiring strategy. Former Citibanker Michael De Sa oversaw most of the restructuring, including the expense of hiring top forex staff. Now De Sa is running the bank's Asian business, leaving in charge Hal Herron, who ran Deutsche's Australasian business after joining when the German bank bought his previous employer, Bain & Co.
Herron is still doing some hiring, although not at the pace of previous years. But the cost of success has started to bite. Building up DMG, not just in forex, has been a huge expense; the firm's cost-income ratio last year was 88%. This has prompted the recent internal changes at Deutsche and the threat of 1,000 job losses in international investment banking. The changes have unnerved staff, and rumours of discontent abound. "We, and other banks, have been getting calls from staff who left us to join DMG," says the head of foreign exchange at a rival bank. "They are suing for peace and wanting to know if there's a job going for them." It is unclear whether this is because guaranteed bonuses have run out, because staff are unsure of the future given the recent mergers, and speculation about Deutsche's future, or whether it is just the usual inter-house carping of the hiring season.
Building a forex business is a tougher challenge now than it was when De Sa started in 1994. Setting up systems and hiring staff is extremely expensive, and the rapid growth in electronic broking has made transactions more transparent, and so tightened spreads. The return on investment for those starting up a forex desk will have to be found in areas other than pure trading.
The investment banks have a ready-made source of business for their forex desks, leveraging off their bond, equity and M&A businesses. This is how Merrill Lynch, Goldman Sachs and Morgan Stanley have risen up the rankings in the past two years. All three have been hiring: Roger Tarika, managing director and head of forex for Morgan Stanley Dean Witter in London, has doubled his - admittedly small - team to 47 staff since 1995. At Goldman Sachs, Geoffrey Grant, managing director in foreign exchange, says that the majority of hiring was completed last year. "Over the past two years we've steadily grown our presence in the foreign exchange market, especially in London, in a drive to become a full-service FX provider. We've not been particularly active in hiring in the last six months."
This is also a model Credit Suisse First Boston appears to be following. As with Goldman Sachs, CSFB's forex operation was traditionally seen as a derivatives boutique, "certainly before we merged global commercial and investment banking operations in 1997, the first such institution to do so", says Phil Vasan, CSFB's head of foreign exchange. "This merger has enabled us to deliver a smart FX service on a much larger scale." Rivals are reserving judgement. "They're good in Europe and Russia, but in Asia and the US it's patchy," says one. But Vasan has made some high-profile hires: Norman Weinstein from hedge fund Odyssey Partners to set up the proprietary trading desk, and Joe Prendergast, who has joined from Merrill Lynch as chief currency strategist.
The institution everyone is keeping a eye on is Donaldson, Lufkin & Jenrette. A successful US equities and high-yield debt house, DLJ announced at the start of the year that it plans to build a European equities division from scratch. And in mid-April the firm said it is to do the same with forex. Leading the charge will be Ken Gettinger, who ran the successful US forex operations for UBS.
As a result of the rising costs of growing a forex operation, the US investment banks might be the last that are able to leap into the top tier of 15 to 20 banks. They might not be able to achieve the flow of business of the large commercial and universal banks, but the big-ticket deals they win through crossover business with bonds, equities and M&A will ensure they have a presence: "Corporates and investors used to do their bonds with one house and their foreign exchange elsewhere," says Grant at Goldman Sachs. "Now more are looking for one house to do everything, which plays to our strengths." This view is supported by the evidence in this year's survey: Merrill Lynch, Goldman Sachs and Morgan Stanley have captured a large chunk of the market, but with fewer transactions than their commercial-banking counterparts.
The search for staff
The dark horse among the new entrants is Rabobank. The Dutch cooperative bank, which Arthur Arnold, chairman of Rabobank International, has described as a global niche bank, has spent the last two years building up its presence in investment banking. As a large guilder house, Rabobank has always had a presence in foreign exchange. But with Emu about to strip it of that niche, the bank's executives are looking for a new role. Competitors are not as generous to Rabobank as they are to DLJ. "Haven't they learnt from Deutsche's experience that the build-up costs are huge," asks one. "Starting from such a small base is very expensive. They've had to spend on infrastructure and systems, and hiring the people they have doesn't come cheap."
The head of foreign exchange is Michaeli di Stephano, who worked at DMG until following his former boss, Alex von Ungern-Sternberg, to what was then BZW in 1996. By 1997 Ungern-Sternberg left to run Rabobank's London operations and di Stephano followed. Rabobank's head of forex corporate sales, Margaret Croysdill, is another former DMG employee, joining Rabobank after a short spell at Hambros.
If di Stefano is hoping to emulate Deutsche's success, he had better be ready for the fallout as the costs mount up. And finding the staff is not as easy as one might think. Mergers and retrenchment have left staff feeling nervous about moving jobs, fearing that the last in will be the first to be kicked out. And, with the exception of DLJ hiring the former UBS team in New York, most of the main players are only moving between the top houses rather than joining up-and-coming forex houses. HSBC Midland, for example, recently lost two yen traders (yen trades, especially dollar-yen trades, have been big business for the major players over the past few months). The yen traders went to Citibank and Chase, two rival institutions with a similar position in the market.
So for DLJ, Rabobank and others, the message appears to be that there are huge opportunities in foreign exchange but the pitfalls are even bigger.