FX debate (part one of two): Alpha quest drives FX market growth


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Volume and profits in the FX market have grown more consistently than in any other part of the financial markets. New entrants and existing users still cannot resist the promise of diversification and excess return.

FX debate: The changing face of overlay (Part two)

FX debate: Participants

Executive summary
• The FX market is being transformed as new players seeking alpha enter it to compensate for low returns elsewhere

• Lower transaction costs as a result of IT innovation and the use of algorithmic trading mean that the quest for alpha in FX is more practicable

• Both active leveraged trading strategies and increased involvement from central banks as active asset managers in FX have boosted the markets

• Emerging market currencies are playing a bigger role since the arrival of the euro shrank volumes, but liquidity risk is often overlooked

• Electronic trading is playing a growing role in run-of-the-mill transactions and this has opened opportunities for specialist services and advice to be offered over the telephone

• The changing character of the market has placed new demands for focus and relevance on FX research

Euromoney: There have been transformational changes in the foreign exchange world. Users of FX are taking the view that FX is not just a sideline to their main activity, but something that can, at a minimum, be done more efficiently and, at a maximum, generate alpha. FX may add incremental returns in what many believe will be a period of low returns from the stock and bond markets.

HB, JPMorgan: There has been a huge increase in the number of new pools of assets handing out mandates in the currency markets over the past 12 months. People who had never thought about currency as an area where value could be added are now buying into it. The UK public sector is one example.

AE, Millennium: People know that if they diversify their assets they’ve got inherent currency exposure. The majority have now come to the conclusion there is value in actively managing that. Therefore there’s been a proliferation of new mandates from a variety of sources. The UK is certainly one source, but the US has increased – Canada, Asia and southeast Asia too.

RG, UBS: In addition, consultants have played an important role. Their support has led pension funds and local authorities in particular to manage their international exposures more actively.

JS, Deutsche Bank: The growth of the market is fuelled by spread compression. With much lower transaction costs the hurdle to create alpha from FX has been lowered. Algorithmic clients are prime examples of this phenomenon; they now have many new strategies that offer promising returns with lower transaction costs.

GK, Bank of America: The leveraged accounts have been a key growth area in the FX space. Our prime brokerage team are on track to book 500,000 tickets this year and more than $3 trillion in volume, and that’s just the prime brokerage group. That’s a lot of FX turnover.

Euromoney: One key group of FX market users you haven’t mentioned is central banks. Do you see any change in their behaviour compared with a few years ago?

JS, Deutsche Bank: Like the rest of the market, central banks are changing dramatically. There used to be a handful of countries that treated FX as an asset class rather than a political tool. Because central banks reserves have grown dramatically their constituencies are pressuring them to invest these reserves effectively. The result is that more central banks are incorporating practices from the professional asset management industry such as treating FX as an asset class.

AE, Millennium: Central banks have become much more clever and intervene less. In this they’ve been helped by a market which itself has become more efficient and where monetary policy is more predictable. There will be extremes when you will hear of central banks becoming involved but to steady the ship rather than to materially affect the exchange rate.

MS, Pareto: Yes, and this is because the focus of central banks has changed a lot in, say, the last five years. Their remit now is to manage inflation rather than to manage the currency.

HS, RBC: Exactly, currency management is just a by-product not an end in itself. We treat central banks as another form of institutional investor. They’re large money managers, focused on increasing returns. Because of the meagre returns that they’ve been earning in government securities, playing with FX as an asset class isn’t as important to them because they’ve got a lot of work to do in terms of the diversification of the cash assets that they’re managing.

HDH, Overlay: Some years ago hedge fund and currency managers thought central banks were very good partners with which to lose money, and that’s not true any more. They are definitely changing their philosophy on currency and they behave much more like investors rather than regulators.

RG, UBS: Central banks have become far more transparent. They’ve had to intervene less because there has been lower volatility in their respective country’s economic fundamentals. For instance, GDP and inflation have been far more predictable and therefore the reason to intervene has changed. That doesn’t mean they have been less active. On the contrary, many have been seeing currency management as an alpha source.

AE, Millennium: But Rob’s right – they haven’t needed to intervene. Even the central banks of emerging market countries have in general reformed considerably. They’ve become less populist and more reformist. Central banks are more market aware and know well what they’re doing and the impact they make. It would be naive to think they wouldn’t come back in extreme circumstances, and they can exert a pretty powerful influence, as the Bank of Japan did only two or three years ago.

RG, UBS: Yes, and were we to return to a global inflationary environment, central banks would become even more active than they are today in currency management.

The rise of emerging market currencies

Euromoney: Another key change over the past few years is that we’ve seen roughly a dozen fairly important currencies disappear to be replaced by the euro, and another 10 or so are moving in that direction. How has that affected the marketplace?

AE, Millennium: It’s creating opportunity but it’s also creating real risk. I know of very few customers or banks that can be said to like 10% moves on a day. It is invariably a sign of a rush to exit losing positions as opposed to making money on winning ones. This sort of volatility also highlights how quickly in periods of crisis liquidity dries up. However, there is no question that the development of these previously illiquid emerging currencies into real tradable instruments is a huge positive in the long run.

AB, HSBC: Evidence would suggest that the euro has been a good move. It is obviously very liquid, and also some of the emerging-currency pairs have become fully convertible and fully tradable. But Alan is right. There are risks and if a crisis or event occurs to make investors want to liquidate their positions, they can’t always do it. So there is price risk and event risk associated with the growth of the emerging markets. But for us it just seems a natural evolution.

RG, UBS: Our analysis shows that the impact of the euro decreased volumes in FX by about 9%. At the same time, though, other factors, such as the need for more currency diversification, more risk acceptance, and a move into emerging currencies have countered that decline in volume. In addition, the governance of these emerging market economies is clearly better, and the regulations and the financial intermediaries involved are on a very much stronger footing. As a result we have seen far more investment into those economies. The underlying assets have done well in equities and bonds, and, as Andrew indicated, that has had a knock-on effect on FX.

MS, Pareto: Wasn’t that reduction in volume partly artificial? If somebody wanted to trade lira against the dollar previously they would’ve gone through the Deutschmark. That one trade would have been two trades before, whereas from euro to dollar is just one trade. So although the volume looked twice as big, in fact the end result is the same.

RG, UBS: That is partly true but we have also experienced the end to active currency management between the euro constituent currencies themselves. In some cases, out of performance necessity, this has led to managers seeking return in other currencies and EM has proved an ideal opportunity.

HB, JPMorgan: Have spreads narrowed in emerging markets noticeably?

GK, Bank of America: Certainly pre-May I think the answer was yes. Since May-June, I think spreads have widened to reflect the more gappy moves in the markets and reflect both the buy side and the sell side substantially reducing their value at risk in these markets and thereby reducing liquidity.

AE, Millennium: That’s a very good point. Before the Asian crisis, everyone looked at foreign exchange and their VAR, which in effect allowed them to take huge risk in Indonesia, for example, and some other Asian currencies. That changed post-1997. I believe that attitude crept back into the market last year when there were huge positions in emerging markets, because the VAR models were giving them confidence that the risk was justifiable. It didn’t take into account liquidity in a crisis situation, and I think April/May 2006 was a very good wake-up call. It’s good news for foreign exchange that the market’s recovered some sense of normality, and people are now much more aware of the liquidity constraints in times of crisis.

GK, Bank of America: But did the lack of liquidity in May create the crisis or did the crisis create the lack of liquidity? Since there were no buyers of Turkish lira or local assets, Turkish lira moved about 12% in May. The market spent months going in the “double door” then everyone tried to get out the “revolving door”.

Electronic execution

Euromoney: As well as changes in the make-up of market participants – and indeed linked to that – there is the proliferation of electronic trading platforms and strategies. What was a telephone market is becoming electronic. How far has this process gone and what are the effects?

HS, RBC: With the proliferation of electronic usage, whether it’s a proprietary bank platform, Reuters, EBS, multi-bank platforms or other types of delivery channels, clearly telephone delivery is not a new service and within the next three years it might only constitute, let’s say, 25% to 30% of the deal flow that RBC would see, and I think that will be the same for other banks. What we’re trying to decide within RBC is how to get clients to pay for what’s going to become a premium service. Providing telephone delivery to clients means a very personalized level of service, whereas electronic delivery is much cheaper.

RG, UBS: There has been a significant transfer of business from the traditional lines towards electronic and I envisage that trend will continue. At UBS this has allowed us to improve productivity and broaden our coverage footprint. We now have to benchmark our clients to both the service they require and the service we can productively provide. A transaction-driven service is clearly differentiated now from a more proactive, intra-day coverage model. Our clients clearly understand the level of service they are going to receive, which does vary both between segments and inter-segment. Often, a large portion of the conversation you’ll have with a client is either immediately before or immediately after a price is asked, and there must be additional value in those conversations. It’s an opportunity to find out what your clients need and how you can provide a more effective service. So there’s a balance to be drawn between that and a price-driven, transaction-borne service.

AB, HSBC: I would add that it’s the nature of your client base and the nature of your institution. We’re certainly in no rush to abandon traditional means of delivering and executing foreign exchange because that’s what many of our clients ask for. There’s obviously a tier of clients looking for highly sophisticated, very forward-looking e-services, but it’s an extremely varied business with some unique requirements at the other end of the spectrum, and it’s essential that we’re able to deliver that. We are committed to delivering FX to all our clients, regardless of size, geography and how they wish to execute.

GK, Bank of America: We believe there’s a difference between those looking for best execution and those looking for more of a value-added conversation. We’ve placed a lot of emphasis on the risk management side of the exposure for those that are looking for best execution. We all know the spreads are narrowing, and volumes are going up at a greater rate than spreads are narrowing, so we have to know how to transfer the risk from client to risk manager. We see real-time and systematic processes as key components. With FinLabs, we’ve put a lot of resources in that area. The phone conversation becomes more important to the people with some discretion in their execution process. They’re almost different equations within the overall business line.

Euromoney: It’s not just the client type that makes the difference though, is it? It’s the product. For the highly liquid currencies, electronic makes sense but what about exotic options and the more esoteric emerging market currencies? Can electronic platforms deliver then? Don’t clients need the value added and the advice?

HS, RBC: That’s a very good point because while this could be developing in the way that equity markets have developed, foreign exchange is not an exchange-traded product. It’s an over-the-counter marketplace, so there will always be room for information asymmetries and execution asymmetries.

AE, Millennium: From the customer side, we are looking for risk transfer and best execution, but for us it will be a long time before we do the majority of our execution electronically. When we want to execute, we’re looking to transfer the risk as efficiently as possible with a bank we trust and that understands our business.

HB, JPMorgan: I would agree with Alan. We’re a price-taker, but we’re also looking for information. We have noticed that the banks often struggle to explain what’s just moved the market, because something’s gone through in a way that no-one can understand any more. For the banks to keep adding value in the area of being our eyes and ears in the marketplace, they will have to make sure they stay on top of where all that flow is coming from, because it does seem to be getting lost down electronic portals now.

Euromoney: So who’s using the electronic marketplace and why?

GK, Bank of America: Thirty percent of the EBS volume is now algorithmic, so that’s clearly a large increase, and we think that could go up towards 60% or 70% over time. We entered the algorithmic space fairly early on and there are clearly a lot more people thinking there’s money to be made, particularly in the market-making side.

HS, RBC: They think around 50% of the total volume in FX markets is traded electronically, through a number of different electronic media.

GK, Bank of America: Once you add STP it’s probably closer to 70%, but there are a lot of block trades taking place over the phone, and then split, so I would think it’s less than 50% in total.

But how would you characterize that 50% or 70%? What kind of trades? What currencies? Who’s doing it?

HS, RBC: The bulk of the volume that goes through electronically is in the more liquid, easily tradable currencies and the more vanilla products. Those big-volume trades would be from clients who are just trying to get the best price.

AB, HSBC: I think the growth of algo trading has really driven the growth of the FX markets in the last 18 months and daily volumes are certainly indicative of that. On top of the normal commercial and speculative ebb and flow of the market, algos have really made a difference.

Euromoney: And to what extent is this changing the relationship between customer and bank?

JS, Deutsche Bank: Deutsche has a very open attitude towards electronic business. It is good for banks when our processing costs are lowered as well. We do find a difference between anonymous volume and volume where the counterparty’s name is known. The latter affords us the ability to price clients tighter that deal with us properly.

GK, Bank of America: Even in EBS it is not immediately clear whether you’ve dealt with EBS Prime Broker or the bank itself. It’s becoming less transparent. Anecdotally, the EBS Prime Broker counterparties have more impact on FX rates than the EBS Bank counterparty.

AE, Millennium: But you prefer someone to trade over the phone, I assume.

JS, Deutsche Bank: I prefer to know whom I’ve traded with. I don’t enjoy extending liquidity in spots where I don’t know who I’ve traded with because I can’t assess their worth.

AE, Millennium: If a customer’s decision to deal with a bank is based on price alone, then trading exclusively on electronic platforms might make sense. We are looking for partnerships with our banks, where we can access various resources of the firm including day-to-day market coverage, published and customized research, etc. We therefore need and value phone contact.

HS, RBC: Well, it comes back to who will pay for it. So you’ll get to the 80/20 rule, the point where you’re going to make 80% of your revenue from 20% of your high-value clients.

RG, UBS: Every client segment is involved in e-commerce in some way. At the retail end of the spectrum e-commerce facilities are paramount to them, as this has allowed them to participate in the market in a significant way. Banks require a price-driven service and little else. However, when you consider the hedge funds and the real money side of the equation, they require much more than just an e-solution even though I believe this service will be vital to their respective business evolutions over the next few years.

Algorithmic trading

Euromoney: We’ve mentioned algorithmic trading, but could someone explain what we are talking about. Who’s doing it, who’s not, and why?

GK, Bank of America: Algorithmic trading itself means a few different things. It means electronic market-making, ie, black box, leaving bids and offers on a continuous basis and trying to earn the bid-offer spread. That has worked because the cost of doing business in the FX space has fallen so dramatically in the past few years that you can afford to transact more and at higher frequency. APIs – direct pipes between the customer and the bank, to either leave bids and offers or be a price-taker – have speeded up. A computer system does it much faster than a human being. Added to that, short-term breakout-style models, which are also very systematic, are almost taking the other side of the market-making positions. Market-making and looking at breakouts are the two largest components within the algo space.

JS, Deutsche Bank: There are two defined areas where algos have an impact. The first area is intra-day or intra-minute, and that’s very exciting for a small section of clients and all banks. The second is that there are now more places to store FX risk. The alpha producers are winning bigger and bigger mandates, and there are more and more people investing in FX as an asset class. The new money in the market adds liquidity but may also extend range-bound market conditions.

Volatility trends and effects

Euromoney: We seem to be in a very low volatility world. Why is this and what does it mean?

HDH, Overlay: We are certainly in the lowest-volatility environment of the past five years. Some say it’s because the central banks are trying to neutralize the markets. Some others say it’s because the US dollar is in a range-trading environment because of conflicting macroeconomic factors. I also think the options market might also have a detrimental influence to overall volatility. Many players have adopted strategies to systematically sell options or sell volatility through exotic products. This obliges market makers to delta hedge more frequently and within a tighter range, thus reducing potential moves. Market makers of exotics have also more volatility to sell when implied volatility moves down.

GK, Bank of America: Algo trading is another reason. Algo means market-making, and if you’re leaving bids and offers in markets, it is inherently adding liquidity, and the more liquid the market the less likely it’s going to be volatile. And given that there are definitely sovereign interests around behaving in a similar way within a larger range, there’s a lot of incentive to keep volatility down within the FX market. Algo works pretty well when you have euro/dollar implied volatility at 7%. It will be interesting to see what happens when euro/dollar implied volatility is 20%.

HS, RBC: Yes, I completely agree, because at any given price point there’s a greater supply of volatility to be sold. And it’s not just in foreign exchange. If you look at implied volatilities in equity markets and in government bond markets, there’s definitely a trend to lower volatility overall, even within periods of higher experienced volatility, because there’s a greater number of sellers and buyers at any given price point that aren’t traditional market-makers.

GK, Bank of America: The changing philosophy of central banks has also contributed to lower volatilities. Reserve accumulation is seen as a good thing and as a way to hold back “those FX guys” who want to push currencies around. Central banks inherently don’t like volatility, and in that respect they feel they have probably won their battle.

HDH, Overlay: I wouldn’t take these models as responsible for lowering the volatility. We are running a high-frequency model, and there are limits to the system. It had been performing very well until August, and after that, when the volatility collapsed, it could not perform, because the daily range on most currency pairs was too small compared with the trading spreads. If you are in a range of 30 basis points in the order for the day, even with a high-frequency model, if the spread is large, so on 200, let’s say, it’s 4bp each trade, that means 8bp out of 30, the manager can’t make money. So algos are very interesting as a diversification, but I don’t think they will kill either the market or the volatility of the market, because of the liquidity of the global trading cost of those programmes, if they are large. All the programmes above $100 million will have this capacity problem and this trading cost problem.

MS, Pareto: I’d like to ask: when you make a broad statement like “volatility is very low”, how is that measured? There’s a big difference between measuring volatility by the minute or by the day or by the month, because it doesn’t scale as it should do.

GK, Bank of America: On an outright basis we all know if you look at your volatility chart, it’s low across most currency pairs. However, compared with actual volatility, implied has generally been trading too high. The market has struggled with this theme.

MS, Pareto: Yes, but when you look at intra-day movements, they can be quite high.

JS, Deutsche Bank: We’ve looked at intra-day movements, and daily fixes. Theoretically the volatility should be equal but empirically they are not. We’ve also looked at the linkage into the volatility market, and the connection seems more complex than the implied volatility surface would indicate.

GK, Bank of America: But even so, US dollar/G7 currency pairs have remained expensive. Some of the more successful, option selling, systematic models have made money over the last 18 months or so, as volatilities have continued to trend lower and actual volatility has also trended lower. But we all know it’s the traditional picking up pennies in front of the steamroller.

MS, Pareto: Well the simple rule used to be that currencies trend. If it moves one direction one day, it’s more likely to move that direction the next day. Volatility mean reverts, therefore if volatility has come down it’s more likely to go up. Fifteen years ago that was the simple rule of thumb, but now volatility is not being priced to go back up.

HS, RBC: I don’t agree with that, because if you look at what realized or historical volatility is relative to implied, it’s below implied, telling me that the market is still bidding for implied volatility. So therefore the historical volatility is low relative to the implied. Someone’s prepared to pay more for volatility in the future than has currently been realized or seen. That’s what we look at, and we are going through a historically low period of realized volatility relative to implied volatility. However, both are at historically low levels in absolute terms as well.

AB, HSBC: You firstly have to differentiate between a market that’s based on momentum or mean reversion. You then have to look at the other side of the equation, the moment to moment the transactions are taking place, which are really IT-driven. These are two separate segments of the market and we have to be clear which one you’re referring to.

JS, Deutsche Bank: The price the market charges for the volatility of volatility is extremely cheap. This conflicts with the steep volatility curve, which is just like a steep interest rate curve. It means you expect volatility to go higher in the future, but you have the volatility of volatility at record lows. It seems the volatility market is predicting conflicting futures. One says volatility is going to stay low and the other volatility store predicts the return of vols. This paradox will be answered in the next six months by either having that implied curve go extremely flat or the price of volatility of volatility go up quickly.

RG, UBS: Again, low volatility points to a lack of event-driven, market-driven or politics-driven surprises. Once the longer-term environment picture becomes more uncertain and less trending, volatility will break higher.

MS, Pareto: We have in the past had periods where volatility has been low, but markets have still trended. So for a statistician, if you’ve got some serial correlation, the short-term moves can be very very small, because the volatility is low, but the cumulative movement can be quite big.

RG, UBS: It’s clear that this is an unusual environment. By just raising the question as to “whether”, not “when” volatility will move higher suggests to me that participants are becoming too sanguine and that a breakout or reversal across many asset classes, not just FX, is around the corner. When this happens I do not expect algorithmic models will be able to suppress volatilities should they wish to.

MS, Pareto: If volatility is being held down by this upsurge in program trading, you can’t have that environment because they won’t permit it, but they can’t suppress volatility against a long-term trend.

RG, UBS: I don’t think there is a single wall of money out there today that can indefinitely suppress a currency movement.

What happens if volatilities go back up?

GK, Bank of America: A lot of the duration of capital allocated in the algo space sits intra-day or a couple of days...

AE, Millennium: ...so the real risk to algo trading is if volatility spikes I assume, because they are suddenly making prices in a different volatility environment that their systems may not have adapted too?

GK, Bank of America: ...to the extent that there will not be much drawdown taken on the position, any loss-making position is likely to be cut quite fast. But a higher-volatility environment will be an interesting test for the market. It will require wider stops and smaller position sizes and will be the time that trend-following makes a resurgence in foreign exchange markets.

FX research

Euromoney: With all these new entrants in the market, with the quest for absolute returns and with the emergence of new currencies and new electronic trading strategies, presumably there have been big changes in the research you produce and consume in FX?

AB, HSBC: We see more differentiation on some of the quant research that’s being developed now, not only in providing a big edge on emerging market access but also proving very valuable to regulator’s policy-making. The more high-end intellectual product seems to be making a much bigger difference than the traditional generic research.

GK, Bank of America: I also think that the line between FX and interest rates and commodities has blurred. We’ve ended up merging our interest rate, commodity and FX research into one product under Bob Sinche. I would agree also on site visits and visiting policy-makers is definitely a key factor. We arranged a investor tour in Mexico after the election in July. Investors wanted to be there to meet the policy-makers. It’s a big deal.

AE, Millennium: FX research is essential to us but we don’t want research that continually changes because short-term expectations change. We want to be able to follow the thought process of that particular economist or strategist, so we can understand if they’re wrong why they’re wrong. We look for intellectual stimulation, consistency, and it’s important to understand the culture of the house that we’re reading. Certain houses stymie people’s intellectual views because they want to have a house view. Other houses will allow their various economists to say whatever they think. It’s also helpful when banks organize events where we can meet officials from various countries and discuss their opinions face to face.

HB, JPMorgan: A lot of banks have become very useful to us as aggregators of data. Some have fantastic historical databases of information, options and prices. That’s stuff that our PhDs can take and work with and pan there for gold.

RG, UBS: I also think it’s increasingly important to have some sort of predictive element to your analysis, and that’s slightly different to forecasting. Over the past few years we’ve tried to capture the flow that we see across the bank, not just in FX but in equities as well and, by analysing those trades, we try to predict where the currencies will go as a result of the impact of the flow we’ve seen. At various times in the cycle the flow in equities does have an impact on currencies. Certainly our analysis has predictive elements based on historic flow and the intensity of that flow, and it is therefore possible to get fairly good predictions of where currencies are heading in the short to medium term.

Euromoney: Is the gross supply of FX research adequate and appropriate? In equities, for example, you might not need yet another report on BP or the Ford Motor Company, but on the other hand there are a number of small-cap companies that don’t get followed by anybody. Does this imbalance apply to FX research?

GK, Bank of America: I agree with Alan that you need to know the analyst and the areas of their expertise. People expect Bank of America to know what the US economy is doing. Post-merger with Fleet Bank, and now with coast-to-coast retail banking we do get some insights with our consumer and corporate relationships across the US. We have our niches in emerging markets, and you have to concentrate on what you think you do well.

HS, RBC: I agree with that, because you may be a great commentator on the US economy, but if your clients won’t pay you for it it’s not worth producing. That’s the ultimate focus. Clients want unique insight. You need to turn your attention to the things that clients will pay you for, be that bespoke research, flow data or special situations.

HDH, Overlay: We value banking research in two ways. The emerging markets are very important for us, because they involve completely different investment processes. But some banks have also contributed a lot towards the education process of clients in active currency management and that’s very important for the industry.

AE, Millennium: Yes, banks can add more than just research. Before clients make their decision on whether they want to allocate capital to a mixture of systematic, fundamental or technical fund managers they have to fully understand what they are trying to achieve in terms of risk reduction versus alpha creation. Banks and consultants have been significant players in this education process.

RG, UBS: I agree with Alan. Of all the services we provide, apart from perhaps price and idea generation, education is the one that the clients consistently say has the most reward for them. Provision of a broad, multi-asset education programme is a key differentiator for our clients.

Euromoney: Harriet, do you read this stuff? And if you do is electronic delivery best?

HB, JPMorgan: I’m fairly representative as being extremely lazy when it comes to going through my emails so if there is someone who knows enough about us to say, “This piece will be particularly interesting to you”, I will value that.

AE, Millennium: An important part of a salesperson’s job is to act as a filter for their own firm’s research to ensure they highlight what they believe is important. As Harriet said, if they understand each of their customers’ different frameworks and flag what is important, they become very valuable counterparties.

Return strategies

Euromoney: With all this research available, who’s doing well at the moment?

JS, Deutsche Bank: On DB’s FX Select platform it’s the mean reverters that performed best in the recent past.

GK, Bank of America: Looking at the systematic models that have made money in the past 18 months, it hasn’t been the trend-followers. It’s been the very short term types, who will not accept large draw-downs, so either make some money quickly or cut the position.

AE, Millennium: In April and May discretionary did well but recently major currencies have been range bound and predominately only the carry traders have performed. However, we do not believe these low levels of volatility are sustainable and trends will resurface later on in the year.

Not every currency pair is in a range. For the moment the US dollar is, but certainly not for ever, and if you focus on some of the crosses a number are trending and misvalued such as some of the Far East Asian and Scandinavian currencies. It’s our job to identify them.

MS, Pareto: But what will happen if the fundamentals get more mismatched and there are pressures? Will you get a trending market again or will you just get low volatility with pressure building up.

HB, JPMorgan: I think it’s because the systematic money going into these trend-following strategies is there to be on the opposite side of the algorithmic trade. The algorithmic trade is the range bounding force the systematic money is trying to offset. That’s what the dynamic is. The trend-following money has struggled because the algorithmic money has come in to trade against the trend-following money.

Euromoney: Thank you all very much.

FX debate: The changing face of overlay (Part two, February)

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