The Bank of International Settlements (BIS), has just released a in-depth analysis of the recently released 2013 Triennial FX Survey, looking at the changing structure of the FX market, and drawing some conclusions.
Some of this was covered in our recent coverage of the 2013 Triennial FX Survey, some of the key points of which are shown here, but worth reading the report in full.
- Non-dealer financial institutions were the major drivers of FX turnover (much through the use of prime brokers)
- The reporting dealer market, by contrast, has grown more slowly (partly due to internalisation of flow by top tier banks), and
- Trading volume of non-financials (mostly corporates) has actually contracted
- In today’s market structure, electronic trading dominates. It is the preferred trading channel, with a share above 50% for all customer segments.
- Non-financial institutions mostly prefer direct contact with their relationship bank, either via the phone or via a single-bank platform.
- Financial customers are less loyal to their dealer often trade either directly with dealers electronically direct electronic price streams), or indirectly via multi-bank platforms and electronic brokerage systems that were previously the exclusive venues of inter-dealer trading
- Retail accounts for some 3.5-3.8% of daily FX volumes
The climb in FX turnover between 2010 and 2013 appears to have been mostly a by-product of the increasing diversification of international asset portfolios rather than a rise in interest in FX as an asset class in its own right. With yields in advanced economies at record lows, investors increasingly diversified into riskier assets such as international equities or local currency emerging market bonds. By contrast, returns on currency carry trades (narrowly defined) and other quantitative FX investment strategies were quite unattractive in the run-up to the 2013 survey, suggesting that they were unlikely to have been significant drivers of turnover.
The graph shows the breakdown of FX daily volumes by client segment.
Less Dealer-Centric: The FX market has become less dealer-centric, to the point where there is no longer a distinct inter-dealer-only market. A key driver has been the proliferation of prime brokerage, allowing smaller banks, hedge funds and other players to participate more actively. The evolving market structure accommodates a larger diversity, from high-frequency traders, using computers to implement trading strategies at the millisecond frequency, to the private individual (retail) FX investor.
Trading activity remains fragmented, but aggregator platforms allow end users and dealers to connect to a variety of trading venues and counterparties of their choice.
Importance of internalization: The declining importance of inter-dealer trading is the flip side of the growing role of non-dealer financial institutions (see graph above). The inter-dealer share is now down to only 39%, much lower than the 63% in the late 1990s. The primary reason is that major dealing banks net more trades internally. Due to higher industry concentration, top-tier dealers are able to match more customer trades directly on their own books. This reduces the need to offload inventory imbalances and hedge risk via the traditional inter-dealer market.
Who are the key non-dealer financials and what do they trade?
A significant fraction of dealers’ transactions with non-dealer financial customers is with lower-tier banks. While these “non-reporting banks” tend to trade smaller amounts and/or only sporadically, in aggregate they account for roughly one quarter of global FX volumes. Smaller banks do not engage in market-making, but mostly serve as clients of the large FX dealing banks. As they find it hard to rival dealers in offering competitive quotes in major currencies, they concentrate on niche business and mostly exploit their competitive edge vis-à-vis local clients. Like dealers, they extensively trade short-tenor FX swaps (less than one week), which are commonly used for short-term liquidity management.
The most significant non-bank FX market participants are professional asset management firms, captured under the two labels “institutional investors” (eg mutual funds, pension funds and insurance companies) and “hedge funds”. The two groups each accounted for about 11% of turnover.
Institutional investors differ from hedge funds not only in terms of their investment styles, horizons and primary trade motives, but also the mix of instruments they trade. These counterparties – also often labelled “real money investors” – frequently transact in FX markets, as a by-product of re-balancing portfolios of core assets, such as international bonds and equities. They were behind a large fraction (19%) of trading volumes in forward contracts (see table above), which they primarily use to hedge international bond (and to a lesser extent equity) portfolios. The management of currency exposure is often passive, requiring only a periodic resetting of the hedges, but can also take a more active form, resembling strategies of hedge funds.
Hedge funds are especially active in options markets, accounting for 21% of the options volume (see table above). Options provide them with a convenient way to take leveraged positions to express their directional views on exchange rate movements and volatility. Some of the more actively trading hedge funds and proprietary trading firms also specialise in algorithmic and high-frequency strategies in spot markets. Hedge funds were behind significant volumes in both spot and forwards, accounting for 14% and 17% of total volumes, respectively.
FX trading by official sector financial institutions, such as central banks and sovereign wealth funds, contributed only marginally (less than 1% according to the most recent Triennial data) to global FX market turnover. This small share notwithstanding, these institutions can have a strong impact on prices when they are in the market.
Trading of Non-Dealer Financials and the geography of FX trading
Full report available here