Do Fundamentals or Basic Instincts Drive FX Markets?

The Bank for International Settlements (BIS), Basel, Switzerland recently conducted a triennial central bank survey on foreign exchange (FX) and derivatives market activity. The last such survey was conducted in April 2010. As per the findings of this survey, global FX market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of US$4.0 trillion compared to US$3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of the FX market turnover. Spot turnover rose to US$1.5 trillion in April 2010 from US$1.0 trillion in April 2007.

Best Practices

Best practices in FX markets can be summarised in the following areas :

Pre-trade preparation and documentation

• Know your customer (KYC).

• Determine documentation requirements.

• Agree upon trading and operational practices.

Trade capture

• Capture or enter trades in a timely manner.
• Use straight-through processing (STP).
• Use real-time credit monitoring.
• Use standing settlement instructions.
• Review amendments.
• Closely monitor off-market transactions.

Confirmation

• Confirm and affirm trades in a timely manner.
• Be diligent when confirming by non-secure means.
• Be diligent when confirming structured or non-standard trades.
• Be diligent when confirming by telephone.
• Verify expected settlement instructions.
• Confirm all netted transactions.
• Confirm all internal transactions.
• Confirm all block trades and split allocations.
• Automate confirmation matching process.
• Establish exception processing and escalation procedures.

Netting

• Use online settlement netting systems.
• Confirm bilateral net amounts.
• Employ timely cut-offs for netting.

Settlement

• Use real-time nostro balance projections.
• Use electronic messages for expected receipts.
• Use automated cancellation and amendment facilities.
• Implement timely payment cut-offs.
• Report payment failures to the concerned.
• Understand settlement process and settlement exposure.

Nostro reconciliation

• Perform timely nostro account reconciliation.
• Automate nostro reconciliations.
• Identify non-receipt of payments.
• Establish operational standards for nostro account users.

Accounting and financial control

• Conduct daily general ledger reconciliation.
• Conduct daily position and profit and loss (P&L) reconciliation.
• Conduct daily position valuation.
• Review trade prices for off-market rates.
• Use STP of rates and prices.

General best practices

• Ensure segregation of duties.
• Ensure that staff understands business and operational roles.
• Monitor dealing staff activities and ensure that they compulsorily take annual leave.
• Understand operational risk.
• Institute controls for trades transacted through electronic trading (e-trading) platforms.
• Identify procedures for introducing new products, new customer types or new trading strategies.
• Ensure proper model sign-off and implementation.
• Control system access.
• Establish strong independent audit/risk control groups.
• Use internal and external operational performance measures.
• Ensure that service outsourcing conforms to industry standards and best practices.
• Implement globally consistent processing standards.
• Maintain records of deal execution and confirmation.
• Maintain procedures for retaining transaction records.
• Develop and test contingency plans.
• Prepare for crisis situations outside the organisation.

Latest Market Trends

1. High frequency trading

High frequency trading (HFT) in FX markets is a rapidly evolving phenomenon. It is brought about by advances in IT and the spread of e-trading. It is having a notable effect on the structure and functioning of the FX market and is prompting behavioural changes in other market participants. HFT in FX operates on high volume but small order sizes, low margins, low latency (with trade execution times measured in milliseconds) and short risk holding periods (typically well under five seconds).

2. Analytics

Analytics that facilitate FX market and its participants are also growing mainly in the following areas namely:

• Systems on Chips (SoCs): traditional offline analytics to in-line embedded analytics.
• Simulate real time from multiple sources and systems to predict the future.

Analytics is also getting into the cloud to enhance and facilitate high performance and grid computing.

Relationships

With the volatility and liquidity stresses seen during the recent financial crisis greater client interaction with sales desks at banks is occurring – as clients are seeking advice on executing trades in the new liquidity environment. Banks would like to monitor such transactions on a real-time basis and a one-on-one basis.

Data from the FX markets provide an opportunity to look at the importance of electronic execution methods across economies for different FX transactions and counterparties. They confirm that the prevalence of electronic execution methods declines as the complexity of the instrument increases. More than half of foreign exchange spot turnover worldwide is executed electronically, whereas less than a tenth of FX options are. When the electronic executions decrease, relationships take over; periodic customer interactions predominantly rule the market place.

With the ever-increasing volume of business handled in the market place and with every player trying to position aggressively to have a major share, there is a co-ordinated effort to win over the hearts of the customers. More and more players are willing to invest in efforts to ascertain the requirements of the market place rather than focusing on what they already have to offer. This sincere effort in checking up with the customers on their needs and expectations is building up the relationship.

Fundamentals and Basic instincts

Fundamentals drive business. When they are supported by best practices, we can see an orderly performance by participants in the marketplace. Even when the fundamentals are strong and best practices are followed, sometimes the participants may not post profits. These participants can comfort themselves that at least they may not be booking huge losses and facing life threatening reputation issues for themselves and their organisations.

Basic instincts drive behavioural finance. This theory dictates that markets might fail to reflect fundamentals under three conditions – irrational behavior, systemic patterns of behavior and regulatory limits.

Greediness and lax supervision have affected banks very badly in recent times – Nick Leeson of Baring Bank, Jerome Kerviel of SocGen and Kweku Adoboli of UBS to name few top rogue traders in the recorded and published history. It has nothing to do with the discipline of business but more with the attitudes, approaches and short-termisms of the people involved. The 6 May flash-crash also suggests that systemic risk is perhaps more likely to be triggered by this ‘rogue’ approach.

However, if the basic instincts are played within the boundaries of the fundamentals and respecting best practices and relationships, there is every possibility the participants might be performing well in the market place.