The value of FX Flows


What’s the value to a bank of seeing client FX flows?

Any FX trader worth their salt, will swear there is value in seeing ‘certain’ client flows, and greater value if you see it first, and can act on it fast!

Intuitively we know this value derives from the intelligence asymmetry gained by the trader or more correctly today, by the bank’s pricing engines, in terms of their ability to rapidly analyze client flows, and ‘deduce’ trends based on historic flows from that client, and the aggregate of flows from that client’s segment and integrating or matching those against uncorrelated flows from different client segments.

But can you measure this intelligence asymmetry in some way, other than by proxy through the P&L?

I have just been reading a very interesting empirical study by the Bank of International Settlements (BIS), published in March 2013, which looks at this exact topic. The FT actually covered this back in May, but I guess I must have missed it then.

The study called ‘Information Flows in Dark Markets: Dissecting Customer Currency Trades‘, looks at the flows from UBS over a ten year period (from Jan 01 to May 11) across four key client segments, which are:

Financial Clients: Asset Managers, Hedge Funds
Non-Financial Clients: Corporate and Private Clients

The paper addresses a number of related questions, including:

  1. Do large dealers have an informational advantage from seeing a large portion of customer trades?
  2. How does risk sharing take place in FX? Do customers systematically trade in opposite directions to each other, or is their trading positively correlated and unloaded onto dealers?
  3. What characterizes different customer groups’ FX trading, ie do they speculate on trends, or are they contrarian investors? In which way are they exposed to, or hedge against market risk?

The study found that:

  • Order flows are highly informative about future FX rates, providing significant economic value to the few large dealers that have access to these flows
  • Customer groups systematically engage in risk sharing
  • Differ markedly in their predictive ability, trading styles and risk exposure

In terms of analyzing the predictive content of client segment flows, an interesting (and perhaps obvious) finding is that:

  • Asset managers flows are associated with permanent shifts future FX rates, suggesting that their order flow is related to ‘superior’ processing of fundamental information.
  • Hedge Fund flows are merely associated with ‘transitory’ exchange rate movements, and their impact on future FX rates is less permanent, and tend to reflect short-term liquidity effects of large trades
  • Corporate & Private Client flows , however seem to reflect largely uninformed trading
  • Asset Managers also tended to be trend followers, with regard to past currency returns
  • Private clients, tended to be ‘contrarians’
  • Flow from most customer groups tended to be ‘negatively’ correlated over the short-intermediate term, suggesting that different groups of end-users engage in active risk sharing among each other.

To measure the economic value of the predictive content of order flow, the study used a simple portfolio approach.

The study found that currencies with the highest lagged total order flows (strongest net buying pressure) outperformed currencies with lowest lagged order flows (strongest net selling pressure) by about 10% pa.

A zero-cost long-short portfolio that mimics:

  • Asset Managers’ trading behavior yields an average excess return of 15% pa
  • Hedge Funds’ flows yields an average excess return of 10% pa
  • Corporate flows yields an average excess return of 0% pa
  • Private Clients’ flows yields an average excess return of -14% pa

And to think in the good old days, when asked why a currency pair was falling, you could simply say that there were more sellers than buyers”!

 

3 Responses

  1. Great post!

  2. […] the more astute banks are looking beyond cost to measure the ‘value of client flows‘ across distribution channels”, and then optimise the value of those flows by seeking […]

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