FX Markets: A View From Within
In a process that is spurring growth outside the scope of normal foreign exchange (FX) market participation, FX is increasingly being used to support other asset class requirements. With overseas investments continuing to increase as a percentage of investor portfolios, the requirement for currency conversion to support cross-border asset purchases, as well as the need to hedge currency exposures associated with those investments, is continuing to drive this secondary tier of FX growth.
FX has, for many portfolio managers and traders, traditionally been an activity of lesser importance. For instance, they have used currency overlay programmes merely to offset the currency risk arising from trading.
This practice still continues but currency overlay is also responding to the changes wrought by technology replacing manual systems. Similarly, the trading of FX as a discrete asset class is growing in importance, a popularity that is also largely the result of technological advancements. The growth of both activities is the result of key trends – trends that have affected both institutional dealing desks and smaller hedge and retail (day) traders. The enabling power of technology to widen and deepen market access is at the centre of this story.
FX markets are an integral part of a wider financial world market, with participants across all asset classes developing a more global perspective. Ten years ago, the majority of portfolio managers and traders would have traded mainly domestic fixed income, equity and commodities, with currency exchange requirements arising from limited cross-border trading supported via a manual currency overlay programme.
Today, cross-border trading is commonplace, to the point where even a bank’s retail customers will have an international dimension to their portfolio. As a consequence of this growing global exposure, accompanied by the economic turndown, there has been an increasing need to transact the currency arising from trading in underlying assets as efficiently as possible.
Manual hedging is quickly becoming too time-consuming, error-prone and expensive, with insufficient scalability to meet high volume requirements. The evolving sophistication of banks’ automated pricing engines means that currency trades arising from the trading of underlying instruments can be automatically priced, transacted and reported to counterparties and associated back offices with no need for manual intervention, thus saving time and money for bank and client alike.
Further, this automated FX pricing and execution capability can be easily integrated into traditional fixed-income or equity-focused electronic communication networks (ECNs). This technology leverage enables banks to seamlessly provide high-volume, real-time FX price execution in support of cross-border purchases, hedging or as a directly traded asset class.
Regardless of the underlying purpose of the trade, these transactions are part of an automated straight-through process (STP) resulting in dramatic reductions in administrative time, cost and errors, while facilitating real-time trade reporting for both the bank and client.
The trickle-down effect of this is that the cost of FX trade support is coming down, and with it the costs of accessing pricing and transacting trades for smaller clients. Thus, the needs of the big bank trading desks are enabling smaller and smaller trading parties to access FX markets for realistic and affordable transaction charges and at keen rates.
The growth in participants in the FX markets has in turn led to the growth of trading FX as a discrete asset class. FX has become very popular very quickly, partly because of the market’s inherent characteristics, which make the use of FX for the purposes of diversification very attractive. These characteristics include non-correlation with debt and equity markets, particularly with regard to volatility. This allows a portfolio manager to access alpha even when their traditional markets are relatively dormant. For an active portfolio manager, this opens up the ability to exploit cross-asset trading opportunities over and above opportunities that exist in discrete markets.
Again, the convergence of asset classes on the trader’s desk is the result of the pin-point accuracy enabled by the new generation of pricing engines. Banks now have the technology to tailor price based on sophisticated, flexible methodologies and criteria. These prices can then be distributed to a wide variety of end clients using a range of distribution channels, from proprietary bank websites to multi-bank portals or in-house trading applications.
Another important new characteristic is the continuing reduction in the latency associated with price display and execution: active traders and portfolio managers now know that the price they see – and can execute with a single click of the mouse – is the price they will achieve on settlement of the deal. Add to this the ability of pricing engines, and bolt-on applications, to perform position netting and margin calculation in real time, and it can be seen that the technology now exists to allow the most sophisticated trading strategies to be automated and thus transacted at a lower cost. At the same time, extra cash flow is freed (via margining) to enable a more efficient allocation of funds across the portfolio.
Technology means that traders and managers can now enjoy a situation where seamless cross-asset class trading is possible. For example, a hedge-fund manager experienced in cross-asset arbitrage will find new opportunities, as the price information from unregulated FX markets can now be fed directly into their modelling programmes, enabling a fresh perspective on the relationship between the volatility of discrete asset classes.
This may mean an equity-only trader will begin to build black box models using historical FX data. Such a model would be able to track event-driven activity and use programmable logic to analyse the relationship between events in the equity markets and subsequent activity in the FX markets, using the resultant data to trigger trading opportunities.
Increasingly, automated FX pricing and execution technology – working in co-operation with financial institutions – can enable trading opportunities like these by allowing banks to cost-effectively distribute scaleable, real-time pricing and execution to non-traditional FX market participants trading other asset classes – a first for the FX markets. However, it is clear that this advanced functionality has important implications for all tiers of the marketplace and all kinds of participants. How quickly these new opportunities are exploited will test the responsiveness and creativity of portfolio managers across all asset classes.