Forex trading ain’t what it used to be

Remember the glory days of currency trading?

Way back in 2013, when the Bank for International Settlements last reviewed the market’s structure, FX traders were feasting* on sweet, sweet fast-money volume around the Bank of Japan’s quantitative easing.

Ah, the memories. In the following years, we never knew if we’d wake up to retail-trader carnage after a Swiss franc un-pegging, cross-market carnage after a renminbi devaluation, or an analyst-stumping rally in the yen.

Things have calmed down a bit since then. While there’s been some, erm, excitement in the pound, the post-Brexit selloff was fairly orderly. And even the sterling flash crash was tame compared to the Swiss franc chaos, since it happened in the quiet and relatively illiquid overnight session — UK regulators have since focussed on a Citi trader in Tokyo who ~~just wanted to feel something again~~ might have “panicked.”

The BIS’s latest report on currency market structure, published Sunday, unpacks some of the forces behind the decline in transaction volumes.

Of course, there’s still more than $5tn of daily global currency turnover, according to the report. This April there was $5.1tn of turnover, down 5 per cent from the $5.4tn in the same month in 2013. The decline was primarily driven by spot currency trading, since derivatives and swaps volumes grew.

In the report, Michael Moore, Andreas Schrimpf and Vladyslav Sushko found a couple of reasons for the 15-per-cent slowdown in spot currency trading (to $1.7tn from $2tn three years ago). One of them is basic macroeconomics — growth rates for global trade and capital flows are below their pre-crisis pace, so there’s less need for currency translation.

Beyond that, the types of traders in the market have changed, as large institutional investors such as pension funds and life insurers become bigger players. In April, daily market turnover from that group was $800bn, up 32 per cent from the same month in 2013, according to the BIS:

While those investors tend to use lower amounts of leverage and take less risk, it’s not surprising that they’ve been doing more currency trading. Institutions in areas where long-term yields have until recently been negative — Germany and Japan for example — have been buying foreign bonds to eke out some semblance of a return, which calls for currency hedges. (Japanese life insurers have been buying significant amounts of foreign bonds, for example.) The BIS reports that institutional investors’ swap trading volumes rose 80 per cent.

At the same time, the hedge funds and high-frequency trading firms that use more leverage (at least intraday) were trading less. It’s no secret hedge funds have had a tough year, and some HFT strategies that rely just on speed to profit “have reached a saturation point,” says the BIS. Those firms do more trading in spot currencies than other instruments, since that market is standardised and therefore easier to trade quickly.

What’s more, the prime brokerage businesses that service hedge funds have been handling less trading volume, with a particularly steep drop in spot currencies (30 per cent). From BIS, with our emphasis:

…banks have been reassessing the profitability of their prime brokerage business in the wake of post-GFC regulatory reforms, low overall profitability and deleveraging pressures. A number of major prime brokers raised capital requirements, introduced tighter admission procedures and raised fees.
Interviews confirm that prime brokers have focused on retaining large-volume clients, such as large principal trading firms (PTFs) engaged in market-making (see below), while shedding retail aggregators, smaller hedge funds and some high-frequency trading (HFT) firms.

Even the prime-services providers that are looking to add new clients, such as Societe Generale Americas, say they’re planning to compete on service, not price. Essentially, that means that if hedge funds want a top prime broker’s commitment to provide funding and leverage, they won’t get it for cheap.

“We’re trying to be a focus player, and selective on what we’re offering” customers, said Antoine Babule, head of prime services for Societe Generale in the Americas, in an interview.

Babule also emphasised the importance of building relationships between prime services desks and their customers. That seems obvious, but it also helps underscore a change in the currency-trading side of banks’ business.

While more than half of currency volumes are traded electronically, a growing share of those electronic transactions are happening between two disclosed parties. Platforms where fund managers and pensions trade can sign on with just one currency dealer have become more popular, BIS found:

It might seem a bit odd to trade in a way that precludes price competition, but large institutions aren’t being completely irrational. They usually aren’t as fast as hedge funds and HFT firms, and they’re not trying to get an edge through trading. They’re trying to minimise costs. Often, the biggest bank-dealers can provide better prices by matching client orders internally, rather than sending them onto platforms with fast, savvy traders that are looking for an edge.

In the best-case scenario, it’s comparable to buying clothing on Etsy (just, you know, at high speed and in large volume). The buyer can get in touch with the seller quickly and easily if they’re unhappy. And if the buyer is willing to pay more, provide more information and wait a little longer than normal, they can get an order tailored specifically for them.

In other situations, though, it can be comparable to buying tickets from a single airline’s website. From BIS:

Moreover, banks are able to offer multiple price streams to different types of clients. This form of price discrimination allows them to extract higher rents from market-making and remain profitable as intermediaries.

That marks a contrast with the US futures market, where electronic trading is mostly centralised and anonymous.

That’s because the contracts are standardised, the platforms are highly regulated, and there are clear — and publicly available — rules for trading. That’d be comparable to buying clothing on Amazon.com. It’s tough to figure out who exactly is selling the item, but since Amazon handles the shipping and fulfillment processes, the seller is less important than the brand and the speed with which it’s delivered.

It should also be noted that the report’s data was collected before Brexit, when spot-currency trading volumes got a boost from the pound’s nosedive. (Banks’ fixed-income, commodity and currency trading desks certainly did.) BIS found that there was a spike in spot trading volumes using higher-frequency data from regional currency-trading surveys and trading platforms:

Still, volumes obviously are down from their peak.

So, ~~unless~~ until we get an abrupt change in any major country’s currency policy — we’re certainly not ruling it out, given the uncertain outlook about any future US “currency manipulator” designations — volumes probably aren’t going to return to their levels from the heady days of early 2015.

*and doing some “banging the close” as well.