Risk FX Briefing, Paris

European investment managers remain optimistic about the FX market’s performance in 2018, given the sentiment at the Risk FX Briefing, held on 13 June in Paris. Approximately 50 managers, investors and banks convened to discuss the latest trends in the FX industry and how they’re affecting the French investment management community.

Technology is the single biggest driver of the significant market structure changes taking place in currency markets today. Non-bank market makers have taken significant chunks of market share away from banks, who are retreating from deploying risk capital to markets as post-crisis regulatory initiatives impact business strategies.

Mifid II has driven an explosion in algorithmic execution from investment managers – i.e., the buy-side investment managers – which along with increasingly sophisticated execution and transaction cost analysis tools, are contributing to changes in the way clients and dealers interact.

Regulatory fines hitting large global banks in the industry as a result of past misbehaviours also have added to shifts in industry dynamics. and the FX Global Code of Conduct (FX GCC) is slowly changing the way market participants conduct business.

The two overriding themes of transparency and technology must therefore go hand in hand.

Central bank view

• Central banks pay very close attention to FX markets because they are vital monetary policy transmission tools in free-floating currency regimes; they influence monetary policy decisions and allow central banks to intervene in markets
• Central banks see two very rapid shifts in FX: market structure changes are shaped by technology, while conduct reconsiderations are due to the FX GCC
• FX has no single regulator overseeing it, and spot is most often outside the scope of regulators as it’s not defined as a financial instrument
• FX  is the world’s biggest market with over $5 trillion traded but the overwhelming majority of volumes are traded on a bilateral basis in OTC markets without a central marketplace
• FX futures currently account for only about 3-4 percent of total volumes but they’re set to grow according to the Bank for International Settlement’s (BIS) triennial survey of currency  markets
• Market actors interact in a complex way in the fragmented market through various channels, with aggregators and algorithms increasingly prevalent tools in execution
• Electronification of markets continues with some 70 percent of flows executed on e-platforms
• Artificial intelligence and machine learning beginning to play a bigger role in financial markets, but levels of use in finance remain well-below everyday tools
• Transparency in both conduct and technology must increase
• Market participants need to consider signing Statement of Commitments to the FX GCC, as central banks can impose market sanctions even though the document of 55 principles is voluntary
• Increasing algo usage on the buy-side means more market risk is shouldered by these market participants
• Liquidity flash events are becoming more frequent in FX markets, causing concerns for central banks

Algo execution on the rise

• Increased transparency requirements in both pre- and post-trade workflows as well as in execution is driving automation
• Best execution requirements have forced market participants to shift their focus from purely searching for the best available price at any given time to a more holistic view of execution quality
• Market impact and trade decay traditionally only evaluated by sell-side providers such as dealer banks for internal use, but post-Mifid II broker-provided and third-party transaction cost analysis tools are now available for the buy-side
• Pre-trade analytical tools and liquidity condition modelling allow buy-side market participants to evaluate potential outcomes for various execution styles, including algos and risk transfer
• Shifts in the make-up of liquidity providers has caused clients to shoulder more market risk as the ability of banks to warehouse risk declined and as most non-bank liquidity providers (NBLP) tend to operate on a shorter warehousing horizons than banks used before the financial crisis
• Market share of the top five biggest FX banks declined to around 40 percent this year from its peak in 2014 when the handful of dealers controlled over 60 percent of the overall market
• In 2018 the third largest liquidity provider in spot FX is XTX Markets, and there are six NBLPs in the list of top 50 biggest market makers in the world
• NBLPs are disrupting the market
• Algorithms are evolving from simple, mechanical execution tools towards intelligent, reactive and responsive systems that change behaviours according to market conditions and liquidity characteristics
• New breed of algos doesn’t just execute but takes charge of executing a programme, slicing and order and executing at a time that’s determined by the machine according to available liquidity
• AI is bringing another dimension to the technology revolution

FX futures gain traction

• The changing liquidity landscape has propelled liquidity risk to the top of asset managers’ list of concerns
• As buy-side market participants increasingly shoulder execution risk, they need to keep as many channels open as possible to be able to trade through market shocks
• Futures can provide an additional liquidity pool for asset managers to explore
• Futures are also getting traction due to the benefits centralised clearing offers and as a result of best execution requirements
• Asset managers also use IMM futures data for gauging market positioning
• Basel III capital requirements and uncleared margin rules are pushing up costs for trading FX swaps, forwards and options
• Cost pressures will drive clearing rather than a regulatory mandate
• According to a survey by Greenwich Associates, 50 percent of buy-side market participants have considered using futures as a replacement for FX
• An analysis of trading costs for OTC FX compared with FX futures showed significant potential savings for investors trading futures, with cost reductions of more than 75 percent
• Entities subject to Basel III costs could see even bigger savings as all counterparties face a central counterparty clearing house directly
• Liquidity has been building in futures with open interest rising steadily

Macro background – it’s quietest before the storm

• Implied volatility levels are near or at all-time lows in major currencies including the euro and sterling despite significant geopolitical and trade tensions developing
• Emerging markets currencies are starting to see tremendous and rapid moves, with the Argentinian and Mexican peso declining to all-time lows
• Despite the euro and sterling both carrying enormous political risks as a result of the situation in Italy and Brexit, respectively, even central bank decisions or developments from North Korea only cause moderate reactions in FX
• Even on the day following the Brexit vote,  implied volatility in sterling peaked out at 9 percent, while in 2009 and 2010, much more minor political events caused implied volatility to average around 14 percent-15 percent
• Exchange rates trapped in ranges, with no discernible and strong trends, which makes it difficult to justify the cost of options
• Two forces pulling FX : tightening from the Federal Reserve but a continuation of extra-loose monetary policy in other major economies
• Budget deficits are also tracing a divergent path: the United States is expanding its deficit, which is pushing the dollar lower, while the rest of the world is cutting them
• U.S. fiscal situation is deteriorating and monetary and fiscal policy is nudging the dollar in opposing directions
• Explanation for extreme calm lies in the correlation of the shape of the U.S. Treasury yield curve and volatility
• Fed rate hikes determine the shape of the yield curve
• In a recession the Fed cuts rates to a point where the yield curve steepens and volatility stays low
• As the central bank hikes again, there is a point where both the curve starts to flatten but volatility remains extremely low
• But history suggests that the Fed overshoots with rate hikes and causes the yield curve to flatten, which leads to an explosion of volatility
• Today markets are in the same place as they were in 2005 and 2006 in terms of the tightening cycle
• China’s heavy debt levels together with the Fed tightening are posing significant risks
• Oil prices and commodities are also heavily influenced
• Markets will remain boring for now, but as the Fed hikes take place the yield curve will flatten towards the end of this decade and cause a phenomenal explosion in volatility

The new market paradigm

As technology and regulation jolt markets into new behaviours and new ways of accessing markets, markets are becoming more efficient but this doesn’t guarantee that prices are in line with underlying values.

Best execution requirements have driven a lot of change in the behaviour of the buy-side but they also pose significant and new challenges. Technology alleviates these concerns and together with the changing mix of liquidity providers, everyday liquidity conditions are satisfactory.

However, flash crashes are becoming more frequent, causing concerns for both central banks and increasingly to buy-side market participants, as they take on more and more market risk rather than passing that on to banks.

The deceptively placid markets may not remain quite so calm for much longer. This could pose new threats and challenges to FX players and force them to explore new instruments and products, as well as to deploy more resources to understanding and managing market scenarios.

The pace of change is dizzying. The arrival of AI and machine learning and new technologies such as blockchain are allowing not just market participants, but individuals to transact and make everyday purchases for interbank rates.

Technology has also allowed the emergence of non-bank liquidity providers, who are radically changing the status quo. What used to require hundreds or even thousands of people to do in the past can be carried out today by a dozen individuals.

But in the aftermath of the financial crisis and a series of subsequent scandals, conduct is also firmly in focus, especially following over $10 billion of fines globally relating to FX misconduct. The FX Global Code provides a blue print through which central banks can impact and sanction un-adherent market actors, it has spurred a raft of disclosures about practices such as last look and it has raised the level of dialog between buy-and sell-side players.

Since Mifid II going live, some banks have seen a 100% increase in algo execution from clients as technology and automation provides the comfort of transparency and auditability as well. But as algorithms get smarter and more responsive, the importance of transparency around these tools and their behaviours is also on the rise.

In other words, algorithms should be seen as tools that can achieve more transparency, not less. Rules around the governance of algorithms also need to be considered, not just on a firm-level but also from a more systemic perspective.

Just as in banking, algorithms may in the future need to be tested on a macro level, in a co-ordinated fashion across the sector, to ensure that different strategies and different technologies can co-exist in a non-disruptive way.

The quiet market environment and extremely low volatility is unlikely to persist for much longer and as liquidity conditions shift and flash events emerge, those who take market risk need to think long and hard about the tools and instruments available to them to manage risks.

And these days, market risk sits increasingly with the buy-side.