Foreign Exchange: A Perfect Storm of Growth
A “perfect storm” of market volatility formed to increase global foreign exchange trading volumes by nearly 25 per cent in 2004, according to research from consulting firm Greenwich Associates. In a new report, Greenwich identifies a new class of “professional” FX investor that has been riding the wave of volatility and generating much of the volume growth in FX.
The massive increase in FX trading volume seen over the past 12 months can be attributed in part to cyclical factors obvious to anyone watching the evening news: the war in Iraq, terrorism, fluctuations in the value of the U.S. dollar, and rapidly rising commodities prices. Also contributing to the volume growth however, were the active trading strategies employed by hedge funds and asset managers looking to capitalize on these high volatility levels. The migration of smaller banks from the professional interbank market to the customer market was another big driver behind the growth in trading volumes in 2004.
Financial institutions and non-traditional FX users are accounting for a growing proportion of foreign exchange trading volume. The changes that are occurring in global FX have been so profound that the market has begun to evolve from its original iteration as a by-product of international capital markets transactions to an asset class in itself.
While the relatively lacklustre performance of traditional investment markets such as stocks and bonds has encouraged an increasing number of “real money” asset managers and retail players to trade foreign exchange as an independent asset class, the most prominent members of this new breed of professional FX investors are hedge funds. When you combine last year’s dollar volatility with the drastic ups and downs in pricing for commodities – which are priced in dollars – you produce nothing short of a currency volatility bonanza for hedge funds.
Banks also accounted for a large portion of total FX volume growth in 2004. Among non-global banks, many adopted trading strategies that shifted their institutions into the role of “customer” banks, thereby inflating customer trading volume totals in many major markets.
While trading volumes have increased throughout the foreign exchange markets – including among corporates – it is too early to tell if the market can maintain this level of activity. Market conditions have attracted a swarm of active FX traders, but until volatility levels fall, it remains to be seen whether the development of this new class of investor is a temporary reaction to current volatility levels, or if it is a secular change to the composition and behavior of the FX investor base.
Europe accounts for the majority of global FX volume, or roughly 60 per cent in 2004, and the highest rate of year-to-year growth in average foreign exchange trading volumes was found in the UK. On a matched sample basis, average volume in the UK rose from $38.9bn in 2004 to $55.4bn in 2005 – an increase of some 42 per cent. Trade volumes in the US followed a similar trajectory, with average volumes rising 39 per cent from $39.2bn to $54.5bn. Volume growth in other regions – while falling short of that of the UK and the US – was nevertheless robust. Average continental European trading volumes rose from $35.4bn to $41.7bn, an 18 per cent increase. In Latin America, volumes grew from $15.1bn to $16.2bn, or 7 per cent. In Canada, average trading volume increased 4.6 per cent, from $18.6bn to $19.5bn, and average trading volumes in Asia ex-Japan rose from $20.9bn to $21.4bn, or slightly more than 2 per cent. The only year-to-year decrease occurred in Japan, where average trading volumes declined by more than 6 per cent.
There is one reason that the biggest increases in average FX trading volumes occurred in the UK and the US – a disproportionate number of hedge funds are domiciled there.
Electronic foreign exchange trading is growing in terms of both the number of FX users trading online and the portion of their total foreign exchange trading volume that they are executing electronically.
Between the growing number of eFX users and the increasing portion of total trading volume being sent through electronic systems, total e-forex volume has doubled in just one year – from $7.2trillion in 2003 to $15.7trillion in 2004.
Currently, 44 per cent of “top-tier” FX users trade electronically, a level that has increased steadily from the 39 per cent reported in 2003 and 32 per cent in 2002. Among these eFX users, the proportion of total forex volume executed electronically grew from an average 43 per cent in 2003 to 48 per cent last year. Seventy percent of banks traded electronically in 2004, as compared with 62 per cent the prior year, and the proportion of asset managers trading electronically increased from 37 per cent to 42 per cent. At the same time, the proportion of hedge funds trading FX electronically increased from 36 per cent in 2003 to almost 50 per cent.