FX poll 2008: FX moves to centre stage
Foreign exchange has arguably held up better than any other financial market in the fallout from the sub-prime crisis. Will its robustness result in it being taken more seriously as both a business and as an asset class? And which banks have fared best in Euromoney’s benchmark industry poll?
|FX Poll results|
THE RESULTS OF the 2008 Euromoney FX poll may be taken as further proof that the foreign exchange market is in the rudest of health. According to the poll, reported turnover in 2007 rose 40% to $175 trillion from $125 trillion in 2006. Of course, the numbers are backward-looking and few would disagree that the FX market experienced an unexpected bout of frenzied activity in the wake of the sub-prime credit crisis. As a consequence, volumes surged through the summer of 2007, rather than ebbing away as they traditionally do through the holiday season; activity then remained high all the way through to the year-end. The evidence suggests that so far in 2008 there has been no let-up in trading. Discussion with several sell-side market participants suggests that activity in the first quarter is about 40% higher than it was in 2007. Hard evidence for this is provided by Icap, which reported that turnover on its EBS spot platform rose 41% in the first quarter of 2008.
So, far from being the commoditized product with limited growth that many have sought to describe it as, FX has seemingly proved once again that it is a thriving asset. Furthermore, with products ranging from simple to complex, it is a transparent asset that has something to offer everyone.
Over the years, FX has periodically had to face a "challenge" from many a new product. On occasions, this has resulted in resources being diverted to other areas that have promised, but not always delivered, better returns. But FX always seems to stage a comeback and it would seem that those in charge of sell-side institutions would have learnt that many of the higher-margin products that have attracted their business investment are simply not as reliable a profit stream in the longer term as FX.
"I’ve heard those pessimistic comments [that FX is commoditized with limited growth potential] since at least the pre-euro days of the late 1990s and the answer is a definitive yes to continued growth," says Zar Amrolia, managing director global finance and FX at Deutsche Bank. "We’ve been consistently growing by double-digit percentages over the past few years, and by high double-digit percentages more recently – that’s hardly limited growth. I believe the FX market is the most competitive market, and that drives innovation – whether it’s new clients entering the market, such as the algo traders and retail aggregators, whether it’s been product innovation on the derivatives product side such as portable alpha indices or beta replication, whether it’s using new mechanisms for distribution of pricing such as the internet or operational efficiencies such as prime brokerage and CLS. The talent entering the industry is immense and the macro trends of globalization and more increased trading of emerging market currencies means that the future is bright."
Dan O’Sullivan, head of global FX trading at UniCredit Markets & Investment Banking, agrees with these sentiments. "While FX has long been described as a commoditized product with limited growth, the market has continued to expand and should continue to do so well into the future, even within the context of the credit market turbulence of the last nine months," he says. "The limited balance sheet impact of a growing FX business line makes it attractive from a return on capital perspective."
Jeff Feig, global head of G10 FX at Citibank, almost snorts with derision when asked if FX has limited room for expansion. "Honestly, since the earliest days I have been in the market, I have heard that FX is commoditized with limited growth potential, and in the end we have outpaced most other products. As long as global trade continues to grow, markets continue to open and country investment and pension restrictions continue to abate, the FX market will grow," he says.
Not a risk-free business
The FX market has seemed to cope remarkably well with the credit crisis. But the turmoil has brought problems. "The sub-prime crisis has presented great trading opportunities for those FX players with superior people, technology and operational capabilities. However, it has also highlighted many of the risks involved in running a full-service FX business," says Deutsche’s Amrolia. "Those risks can at times of stress be greater even than the first and second order market risks we normally face: whether that’s gap risk in the prime brokerage business, surface risk in the options business or basis risk in the forwards business, or counterparty and settlement risk."
"There could be some threat to the market if we see fewer market participants from broker/dealers winding down or merging; this will definitely affect the volume growth we have been seeing over the past few years"
Feig agrees. "There is no question that the credit issues in the market have created both opportunities and challenges for our business. I think the key to getting through it was to have an active dialogue with customers about what was happening, what the potential impact on them could be and how we could act proactively to look out for their interests. We would then work with the customer to overcome some of the liquidity challenges we saw in the forwards and options markets," he says.
It does seem as if some market participants are trying to play down the impact of those problems that have surfaced following the sub-prime crisis. On more than one occasion, the forward FX (swaps) market has effectively disappeared, which also made it impossible to price options. "During the year the market experienced extreme price volatility coupled with a lack of liquidity, particularly in the options market," says Ivan Ritossa, head of global markets – trading, Asia Pacific, and global head of FX and prime services at Barclays Capital. "Despite this, however, the market coped reasonably well with pricing and limited liquidity available with only a few isolated cases of virtually no liquidity noted... clients continued to be well served... The widely based practice of collateralized-based trading ensured that the issues of counterparty credit were largely contained to a few high-profile failures."
It seems remarkable that counterparty credit has not become a big issue in what is essentially a bilaterally traded market. "Overall the FX market coped well, there was indeed increased volatility all around – especially in the carry-trade currency pairs – as well as temporary gaps in liquidity. But the market stabilized quite rapidly. Counterparty limits were strictly monitored all throughout the crisis but were never a predominant issue," says Lars Hakanson, global head of FX at Société Générale.
However, inevitably, issues have been raised. "The sub-prime crisis has highlighted a number of structural, market and client-related issues, and importantly tested a number of banks in the FX space," say Fabian Shey and Reto Stadelmann, global co-heads of FX & money markets at UBS. "Counterparty credit is always something we look at, in particular those client segments where flow is concentrated and areas such as private clients which hold specific reputational considerations for a bank like UBS. The same holds true in the interbank market where we continue to play a leading role in liquidity management due to our size in the market," they add.
"On this issue of pricing it is clear that spreads, volatilities and liquidity have all been significantly impacted during this crisis, but one of the positive messages we are hearing back from clients and counterparties is that they have been impressed with the consistency of service provision throughout this period," they point out.
Several people believe that settlement risk has once again emerged as something that market participants should be concerned about. "One key risk that needs to be addressed is the issue of settlement risk, both with non-CLS members and non-CLS currency pairs. With successive hedge fund and even dealer failures, this risk has assumed a new urgency in many people," says Deutsche’s Amrolia.
UniCredit’s O’Sullivan wholly agrees. "One significant fault line that has been exposed during this crisis has been settlement risk," he says. "Institutions are much more proactive than six to nine months ago in analysing and managing settlement risks with counterparties, both on the bank side and the client side. Prime brokers are much more actively managing the trading activity of clients in ways not seen before the crisis began to unfold."
"The profile of the business, our commitment to it, has always been high and always will be high"
Whether such fears will have an impact on the market remains to be seen. Similarly, banks have had the chance – and took it – to reprice their liquidity. "As we have seen with other products, I think FX has mispriced risk as well. I think market spreads quoted by banks do not properly reflect the risk involved. I think spreads are going to widen across the board and customers are going to have to deal on a proper spread," says Alain Delelis, head of FX Americas at Credit Suisse. "This will not adversely affect the growth of FX. Participants are just going to have to start paying for liquidity." However, the evidence suggests the market is far too competitive for spreads to ever widen out again on a permanent basis.
Overall, there is a consensus that, although problems have surfaced, few lasting impediments to business have emerged. "I would say that I was surprised that more fault lines didn’t get exposed. There were some extreme positions that might have created more discontinuity than we saw. We’ve spent many years talking about the liquidity mirage, yet the spot markets functioned effectively and handled tremendous volumes. We didn’t get any major electronic service disruptions that halted trading. Overall, I was impressed with the market function," says Citi’s Feig.
The future’s bright
There is no doubt that 2007 was extremely profitable for many FX participants, especially those that have the infrastructure in place to translate higher volumes into increased revenues. That infrastructure is a mixture of people and, increasingly, systems, such as trading and risk management platforms. Inevitably, some institutions fared better than others, which is only to be expected in what is meant to be a zero-sum game.
Looking ahead, the easy prediction to make is that FX will not be able to expand at the same rate as in recent years. However, while the pulling back of easy credit is likely to adversely affect the flow of business from margin traders, there is widespread optimism that strong growth will continue, driven by a new range of market participants.
"The resources necessary to be a leading provider of foreign exchange are quite significant, and reinvestment in information technology is perhaps the single greatest requirement"
"The future looks bright for FX as an asset class," says UniCredit’s O’Sullivan. "The globalization of the world economy, expansion of emerging markets and further developments in derivative products present significant capacity for growth going forward. The FX market has functioned well throughout this current crisis, and its balance sheet usage makes it attractive from a return-on-capital perspective."
Gerhard Seebacher, head of rates and currencies at Bank of America, is also optimistic. But he is slightly wary of counterparty risk.
"We believe the opportunities for the FX business are very appealing as a result of strong trade and investment flows globally coupled with active commodity, energy and equity markets – these market ingredients should deliver robust volume growth," he says. "It is important, however, that confidence in counterparty credits remains healthy in order to allow a broad participation in the market. The industry will need to continue to innovate around clearing and collateral management."
Eddie Listorti, head of fixed income, currencies and commodities at Dresdner Kleinwort, is also bullish but he does sound a warning about further market consolidation. "I remain overall optimistic for the FX market and see its continued growth but there could be some threat to the market if we see fewer market participants from broker/dealers winding down or merging; this will definitely affect the volume growth we have been seeing over the past few years," he says.
Taken more seriously
There is a good chance that the standing of FX has changed within many institutions, even if few market participants would be so brazen as to openly say so. Instead, there is a modest sense of satisfaction that FX has performed so well, as Mark Snyder, global head of sales & trading at State Street Global Markets, articulates. "State Street is even more pleased with our FX business," he says. "Its strength is serving the needs of sophisticated investment managers, hedge funds, sovereign wealth funds and central banks, and we have found these institutions have relied on us during the past seven months for our innovative research into investor behaviour, risk regime mapping and our ample appetite to provide them with liquidity."
Richard Leighton, global head of FX at Standard Chartered Bank, makes similar observations. "FX has been and will continue to be an extremely important business at SCB. I don’t think that there’s necessarily been any change in the perception of our business internally but recent developments have certainly shown our strengths," he says.
Fighting for investment
Privately, at least, many senior figures are optimistic that FX will now be more readily given greater resources. However, unfortunately this might only be relative to other areas, rather than an actual increase in spend. Even if some banks did make record profits in FX in 2007, in many cases the collateral damage done in the name of trading elsewhere has resulted in a generalized spending freeze. "State Street and other leading foreign exchange banks that have grown market share and revenues will continue to attract additional resources that are sustainable only if the businesses build upon last year’s success. The resources necessary to be a leading provider of foreign exchange are quite significant, and reinvestment in information technology is perhaps the single greatest requirement," says State Street’s Snyder.
"The talent entering the industry is immense and the macro trends of globalization and more increased trading of emerging market currencies means that the future is bright"
Ben Welsh, head of fixed income, commodities and currency at UniCredit, points out that despite its flavour of the month status, FX cannot afford to rest on its laurels. "Businesses are cyclical and resource allocation tends to follow the revenue," he says. "As such, it is safe to assume that if volatility collapses in FX then you will see FX businesses be downsized and other opportunities emphasized. However, FX as an asset class currently appears to represent potential for revenue growth in 2008."
FX is a market full of opportunities, but it is also extremely competitive. Those institutions that have neglected it in the past must now be shaking their heads in regret and wondering if it is too late to get into the business in a profitable manner. The days when FX was regarded as simply an ancillary service should be in the past and the winners will be those, like Deutsche Bank, that take it seriously.
"Deutsche Bank has long viewed foreign exchange as a strategic business," says Anshu Jain, the bank’s head of global markets. "Products such as foreign exchange, government bonds and cash equities afford an opportunity for daily dialogue with clients out of which can be built deep, trusted institutional relationships. Our foreign exchange business has a well-deserved reputation for being at the cutting edge of innovation in areas such as derivatives, e-commerce connectivity, algorithmic trading and index development. We take immense pride in the continued success of our foreign exchange business. Clearly, the team has done a masterful job over the past several months, but I would say that the profile of the business, our commitment to it, has always been high and always will be high."