Emerging Markets: A Platform for Growth
It is a widely understood fact of life that the foreign exchange market is consolidating around a handful of major institutions, and that liquidity and the lion’s share of the spoils will be held in those few hands. Informed opinion has it that those institutions unable or unwilling to achieve a place in that leading group will either withdraw from the business, or become niche players.
The problem with being a niche player is that the more successful an institution is, the more likely its market will be eyed by its larger brethren with the obvious consequences. This is not necessarily the case in emerging markets, however. The global banks of course have a large presence in this sector, but it cannot be said they dominate. If this were the case, there would be less need for white labelling solutions and the big banks would already have the local markets wrapped up.
Part of the reason for this lack of outright dominance is that the bigger banks have had to bear the brunt of many storms over the past few years, and many of them are domiciled in jurisdictions that require higher regulatory standards than some emerging nations. A senior banker spoken to recently noted that the emerging markets today have the feel of the mainstream FX market in the 1980s. Opportunities abound because the e-systems have yet to penetrate to any great degree and there is still a (diminishing) advantage to be had from local knowledge.
This could all be about to change, however. Increasingly, with a need to differentiate themselves and leverage more value from expensive e-systems and new products, the big banks are eyeing the emerging markets, supported by the supply side.
Underpinning the renewed move into emerging markets appears to be a degree of responsibility on the part of the banks. The senior banker notes, “Previously the emerging markets were merely seen as an area to make big money, there was little or no thought for the consequences of so much hot money moving in and out of regimes that did not have the capacity to handle the financial shocks – both positive and negative. In the transparent age in which we now operate, however, the need is to work with the regulators in these countries to provide a stable bedrock to build the market on.”
An emerging markets sales trader concurs, suggesting the Asian crisis taught a few speculators a hard lesson. “The banking and hedge fund industry wants to work with the regulators to ensure it doesn’t get caught out as it was in Malaysia during the last Asian crisis when the country imposed exchange controls. That, on top of the punitive interest rates seen in some of the Asian currencies, killed many a speculator.”
Notwithstanding the why’s and wherefore’s, if the emerging markets are to become a more stable environment that will attract long term capital and open up another investment avenue for traditionally risk-averse investors, it makes sense for the market and the regulators in these countries to work closely together. The sell and supply sides have the tools, the countries themselves the opportunity – it could be a perfect arrangement.
If it is to happen, how will it come about? And will it be a global phenomenon? The answer to the second question is probably no. As David Zezza, global head of emerging markets at Deutsche Bank in London, notes, “The correlations within the emerging markets have been diminishing, giving rise to doubts about the viability of the contagion theory. The recent Argentine default was an example of how contagion did not materialise. Although the default and restructuring of Argentinean debt is still a challenge, Brazil has yet to see any impact – contrary to what contagion theorists would have us believe.”
Zezza’s colleague, Sajid Javid, head of emerging markets structuring, EMEA, at Deutsche, suggests that new tools and products have played a big part in reducing contagion. “Not only did we have a lot more public information about events in Argentina leading up to and during the crisis, but the tools we were providing for our clients definitely helped, for example, many used the credit derivative markets to buy short term protection.”
Credit derivatives would appear to have changed the face of emerging markets. Javid points out that unlike the Russian default of 1998, the vast majority of default swaps related to Argentina settled cleanly and without a problem, something that added to the credibility of risk management tools being provided. “The ISDA 2003 definitions will further enhance this process,” he adds.
Zezza agrees, “There is no question that credit derivatives have been an incredibly important tool in risk management. Through past crises we have learnt a lot about what happens in financial markets and have designed products more effectively. An outcome of this is that many tailored products have standardised terms and conditions – not just credit derivatives but other credit products.”
An increasing sophistication on the part of emerging market clients is also being seen by Standard Chartered Bank, according to David Carr, global head of foreign exchange sales at the bank. “We are seeing more demand for structured products,” he says. “This is fuelled partly by our clients becoming more comfortable with these products and by our sales desks which are more customer-focused and respond to the needs of clients by tailoring products, as opposed to the ‘traditional’ approach of creating products and selling them to clients.”
StanChart is a good example of how banks can operate in the emerging markets alongside the global big hitters. It does not feature as a top 10 global bank, but is heavily focused on its strengths in Asia, the Middle East and Africa. This focus makes it widely recognised as one of the leading players in these regions, thus it has that most desirable of qualities in a bank – the ability to differentiate itself. As Carr notes, “Emerging markets is our core business, we have a strong value proposition to customers, good market position, solid customer relationships, wide range of products and a good appetite for risk and credit. Once you have these strengths it is easy to differentiate yourself.”
As noted, the emerging markets remain an area in which e-commerce has yet to penetrate to a serious degree. At the recent conference in New York, Robert Flicker, COO of global FX and commodities at JP Morgan, suggested that the jury is out on the value of e-trading tools in emerging markets. “From an emerging market perspective we have a good amount of business going through. But until emerging markets currencies can be auto-priced for most transactions, it will be difficult to scale dramatically on an e-platform as there are users of these platforms who query the system dozens or more times a day to see where the market is, and banks will find it difficult to manually price hundreds of transactions a day electronically to secure one or two deals. Until liquidity is sufficient to allow for automated pricing, it will be difficult for emerging markets price seekers to leverage e-platforms.
“A solution will depend on how quickly liquidity expands in emerging markets,” he added. “There is liquidity now, but certainly nowhere near the level of the G10 markets.”
Flicker believes that e-commerce systems currently provide most value in the pre-trade area such as research and the provision of information on market conventions for emerging countries. “Clients typically look to our platform for trade ideas, rather than auto-trading to enable them to get ahead of their competitors. This is especially the case when they are working out of time zone,” he said.
Although there appears to be a consensus that the full efficiency of automated pricing is some way off for emerging markets, there is little doubt that e-systems are being used more. Carr confirms this trend, suggesting that the key motivating factors are faster trade execution, fewer errors, price discovery and back office efficiency. “STP is a significant motivational factor,” he says. “It is a big efficiency gain for our clients.”
A good example of the benefits that e-commerce can bring to emerging markets can be found in Mexico and other areas of Latin America, according to Susan Gammage, head of treasury services at Reuters North America. “The peso is a great example of how we can work in partnership with our banks to bring efficiencies to these markets,” she explains. “Our community has grown tremendously, as has liquidity on Dealing 3000 Spot and Forwards Matching and this can be expanded to other countries in the region, such as Brazil where Spot Matching was recently launched.
“We look to create partnerships with the central banks and regulators to help engage liquidity providers and develop the local market infrastructure,” she continues. “Although it remains very much a country-by-country process, we see great potential in Latin and Central America. There is increasing interest from institutions that are creating new trading desks dedicated to supporting the region and this is an area that we can aid by providing the technological resources and infrastructure. This is an excellent opportunity for us because people are so familiar with Reuters’ products and know our reputation in FX.”
Brian Maccaba, CEO of Cognotec, reinforces this view of the Latam region, “When Latin America was seen as a safe and ‘hot’ region, we estimate that 15-20% of North American bank business through Cognotec was from there,” he says. “When the credit crisis hit, that obviously dropped off sharply, but we are beginning to see it coming back, slowly but steadily.”
Maccaba is firmly of the opinion that one cannot generalise about emerging markets, as different regions have different characteristics and are at different stages of the economic cycle. “The level of business from these markets is very much dependent upon the regional economic cycles and credit is clearly the dominant issue,” he says. “But there is very much an appetite for technology because the banks recognise these markets represent a very natural place for its deployment,” he says.
Cognotec is also seeing, according to Maccaba, an underlying trend wherein clients are building their platforms on a global basis, whereas they once did so on a regional basis. “Location is more of a front end factor rather than a system deployment factor,” he suggests.
Banks have also been looking at how they deploy resources in emerging markets. Zezza suggests that Deutsche’s structure is fairly unique in that it has a global emerging markets business with full product integration (except equities, although in some jurisdictions there are close links). “We have three large regional constituencies: Eastern Europe, Asia and Latam,” he explains. “From there we drill down to run local country strategies. We have seen a theme of convergence in regulations which has helped us develop client solutions.”
According to Zezza, Deutsche has three key focuses: product development in local markets; hedge and risk management exercises for foreign and domestic clients; and, he suggests as possibly the most valuable, promoting the benefits of the asset class. “Emerging markets is a crucial business and, we would argue, even more important in a world that is increasingly focusing on diversification,” he says. “Commodities and inflation-linked products are two key diversification classes, we suggest that emerging markets is a third.
“A key role is to educate clients in the products that are available – we do not take a proprietary approach to this business, it is very much a customer-facing role,” he adds.
For Carr, a key factor in StanChart’s success in emerging markets is a local presence. “We have been in some of these markets for 150 years,” he says. “Our presence on the ground in these countries enables us to differentiate ourselves and also make very quick decisions on issues such as credit. We understand these markets because we have a presence there.”
Zezza also preaches the benefits of being on the ground, albeit within a global business structure. “A global footprint is crucial,” he argues. “It’s tough to be a boutique in this business – we very much believe in the global model.”
The Chinese symbol for crisis is made up of the symbols for danger and opportunity. So what do the emerging markets have in store for us in the coming year?
In general, the mood appears to be ebullient; however, there are those with doubts over the sustainability of the currency strength in many areas. One such institution is HSBC, perhaps the only one of the top group of banks that is strongly identified with an emerging market region. David Lubin, chief emerging markets economist at HSBC in London, believes that two dominant global trends represent a very powerful influence on the outlook for emerging markets.
“When interest rates in the US are negative in real terms as they currently are, this pushes capital to emerging markets. This started happening in late 2002,” he explains. “The fall in real US interest rates goes a long way to explain the strength of currencies as diverse as the Brazilian real, the Turkish lira, the South African rand and the Argentine peso. In many cases, these currency moves have been reinforced by buoyant global commodity prices.
“An additional factor has been the big improvement in emerging markets’ balance sheets in the past five or six years, as countries have reduced their reliance on short term external debt,” he adds.
The problem facing the emerging markets, as far as Lubin is concerned, is that the positive scenario could be threatened in 2004 if US interest rates rise. “The Mexican crisis in the mid-1990s was a direct result of the Fed hiking in 1994,” he argues. “Although there are no crises on the horizon today, rising US rates could undermine the strength of emerging markets currencies.
“The question to be asked however, is, ‘Is that it? Is a US rate hike the only thing that will push these currencies into decline?’ I think the answer is no, since there are other factors at work, predominantly the changing balance of risk and return in many countries,” Lubin adds. “For example, in Turkey there has been a rapid widening of the current account deficit, from $1.2 billion in the first seven months of last year to $4.5 billion in the same period this year. This pace of decline has only been seen twice before and on both occasions it was a prelude to a big exchange rate adjustment.
“Added to this, returns are falling – the real overnight rate has fallen to 11% from 25% – and we are approaching an invisible threshold beyond which yields are no longer overly attractive and the cost of going short is reasonable,” he says.
Although Lubin stresses that picking the timing of such events is difficult, there appears to be a consensus in the market that the Fed’s next move will be to tighten monetary policy. If this does mean increased pressure on emerging markets, are we in for another crisis?
Zezza believes the world is much better prepared for downward pressure on emerging markets than before, mainly because of the improved risk management tools available. “Lots of people think about emerging markets and see volatility, defaults, political instability and inflation risk,” he says. “To us, that view is outdated. In terms of exit strategies, previously investors went into emerging markets bundled and market leveraged, but today tools exist to unbundle the risk.
“The cycle means that you will always come across bumps in the road,” he adds. “But the key to success is staying diversified and being selective. Investors now are in these markets for the long term because they expect they will see a good return over a period of years – there will still be occasional liquidity problems, we advise clients not to over-commit to any market.”
Zezza believes that a core factor in the sustainability of emerging markets has been a greater understanding on the part of local authorities and regulators of the product base on offer. “We have spent a lot of time working with the local regulators and governments, preaching the benefits of the development of local product,” he explains. “In Asia, for example, after the last crisis, the authorities recognised the need for deep and diversified local markets and set to work on allowing these products to be developed and used. We think this is a good thing because it is allowing a more efficient and robust market to develop.”
Nevertheless, many continue to find it difficult to think of emerging markets as anything other than an accident waiting to happen for investors. Optimism of the kind witnessed over the past year is nothing new, and too many times in the past, investors – or at least those too slow out of the blocks – have been hurt. However, there are equally enough reasons for optimism in the form of new risk products and the greater development of the credit derivative markets.
Certainly the industry is not thinking in terms of withholding resources from emerging markets. Standard Chartered’s Carr sees great opportunities going forward and says that the bank is in the midst of developing its commodities business even further. “The emerging markets are often very commodity-driven,” he notes. “Therefore the commodity markets are a natural growth area for us as we are seeing even more demand for exposure in this segment.”
Maccaba is similarly optimistic over the business prospects for Cognotec in the emerging markets, suggesting that the niche nature of these markets supports e-systems. “The nice thing about systems is that financial institutions do not have to deploy a lot of capital, they merely have to roll them out and reinforce them with a local sales force,” he argues. “Our policy is to work with quality banks and quality local players. There are a decreasing number of truly global banks, so there is increased demand from regional or national leaders for best of breed technology – this area is a really good fit for us because smaller banks are able to compete if they take advantage of technology.”
Perhaps the biggest factor in determining the depth and level of service available in emerging markets will be the need of those global banks to differentiate themselves and diversify their earnings stream. Zezza notes the market share gains made by Deutsche over recent years and suggests that the bank’s long term commitment to emerging markets – through thick and thin – plays a big part. “We have been in this business throughout, we did not pullback in any crisis,” he says. “Emerging markets is a very important market segment if you want to be a global player, we think this is where the growth is coming from – and it’s a segment that we are very committed to.”
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