FX Volumes Continue Climb, Despite Financial Crisis and Hedge Fund Retreat
Global foreign exchange (FX) trading volume increased nearly 15% from 2007 to 2008 as an increase in activity among companies and large financial institutions more than offset the sudden collapse of hedge fund FX trading.
This rate of growth represents a sharp falloff from the 30% increases in FX trading volume logged in each of the prior two years. For most market participants, however, the past 12 months felt nothing like a slowdown. To the contrary, sustained levels of high volatility and an influx of investors seeking liquid markets and a ‘plain vanilla’ asset class produced a boom in FX trading that kept the market in expansion mode despite the sharp contraction among hedge funds – which had been one of the main sources of FX market growth in the past two years.
Hedge funds were the biggest drivers of growth in global foreign exchange markets from 2006 to 2007. During that period, FX trading volume generated by hedge funds increased 180% and hedge fund trading business grew to represent 20% of global FX volume. From 2007 to 2008 hedge fund trading volumes contracted some 28%. However, these declines were more than offset by increases in trading volumes among large corporates and other financials. “This growth pushed the size of the FX market to record levels,” says Greenwich Associates consultant Tim Sangston. “And thanks in part to a huge spike in trading volume that occurred at the end of the fourth quarter – after Greenwich Associates completed our research – 2008 was a record year for many of the world’s major banks in terms of FX trading revenues.”
In fact, FX represented one of the few sources of steady profits for global banks last year. Banks that were at times struggling for survival due to losses incurred in other businesses benefited from both the increase in FX trading volumes and a widening of FX trading spreads – a widening that significantly increased trading costs for customers. “Even though global FX remained among the most liquid markets in the world, this liquidity is no longer free,” says Greenwich Associates consultant Peter D’Amario.
Several factors are pushing spreads wider in foreign exchange. The increase in volatility and the reduction in the number of existing dealer desks have had a natural widening effect. New concerns about counterparty risk are also contributing. Over the past 12 months, banks have become much more careful in selecting the clients with whom they choose to trade. “The greater significance of credit risk is certainly having an effect on dealers’ decisions about the customers with which they are comfortable dealing,” says Greenwich Associates consultant Woody Canaday, “and those clients that do make the cut are often seeing wider spreads.”
Although the global financial crisis has for the most part not interrupted liquidity in foreign exchange markets, it is having a profound impact on corporate FX trading flows. From 2007 to 2008, corporates allocated 37% of their FX trading volume to dealers on the basis of existing lending relationships, up from the one-third of the business allocated primarily to lenders in 2006-2007. “To a large extent, the change in market conditions is making credit provision a standard minimum requirement for banks looking to win FX trading business from companies,” says Greenwich Associates consultant Andrew Awad. “Companies are using every tool at their disposal to secure access to affordable credit; and FX trading business can be a valuable asset in that regard.”
In fact, Greenwich Associates research reveals that the list of the world’s top 10 foreign exchange dealers by market share is comprised of nine commercial banks and only one (former) investment bank, Goldman Sachs. Among the large universal banks that dominate global FX trading, Deutsche Bank and UBS top the list with market shares of 10.8% and 10.0%, respectively, followed in rank order by Citigroup, The Royal Bank of Scotland and Barclays Capital.
Over the past 12 months, trading share from Lehman Brothers, ABN AMRO and Merrill Lynch came up for grabs. Partially as a result, several large FX dealers such as Deutsche Bank gained trading business, leading to an increased concentration of market share among the world’s top 10 foreign exchange banks. “The ability of individual banks to capitalize on this opportunity by seizing this market share was dictated to a large extent by their own balance sheets and the market’s perceptions of their financial condition,” says Greenwich Associates consultant Frank Feenstra. “Likewise, we can expect further shifts in FX trading market share based on the continuing troubles of some of the world’s biggest financial institutions.”
Although foreign exchange trading customers continue to give Citigroup the market’s highest scores for overall FX service quality, the gap between Citi and its nearest competitors is narrowing. The number two- and three-ranked firms on the Greenwich Quality Index – HSBC and J.P. Morgan – both made significant improvements in their overall service quality scores from 2007 to 2008.