THE INS AND OUTS OF FX.

When volumes are low and trading is directionless is FX the low correlation alternative? Bob McDowall* looks at how the buyside is trading FX and whether it can be considered an asset class in its own right.

FX is traded not through an exchange (an exception being LMAX Exchange – see p.XXX) but through multiple venues and as a result there is no single price at any given time. This would not be a problem for exchange venues, but it is difficult to look over multiple venues and trading platforms because they are not synchronous. No one knows the price at an exact moment in time.

One increasingly popular solution to this problem is the use of benchmarks, which involves referencing the price by comparison with external models, and should include external transaction costs. For a dynamic market like foreign exchange, the prices are likely to come from one of three sources: internal pricing models, interdealer brokers, and client multi-dealer electronic communications networks (ECNs), which are electronic trading systems that automatically match buy and sell orders at specified prices. Slightly different prices are issued from different providers. Should the prices be referenced to mid-market or the best bid or offer price? Should the benchmark on the reference price limit the trade price or set the trade price?

Answers to these questions can be included in the client agreement, but at some point, benchmarks will become real competitive differentiators. Investors are not making large gains from their securities investments since the crash over five years ago, they have closely scrutinised the FX execution. As more modest investment returns have had an impact, investors are looking for other ways to add to total return, including modifying the way they execute their FX trades.

The FX market ranges from highly liquid such as G10 currencies and currency pairs to the less liquid “exotic currencies” of new and emerging financial markets. However, liquidity is enhanced both in response to the increase in trade and the more sustained economic growth and prosperity as well as the scale of trade with the G10 countries. Within the G10 currencies and currency pairs, the markets are highly liquid for short-dated foreign exchange contract maturities but become less liquid beyond six months forward and illiquid beyond 15 to 18 months forward. Moreover, the G10 currencies tend to be highly liquid across a number of geographic venues simultaneously as well as in their domestic financial markets. Exotic currencies tend toward illiquidity away from spot-dated contracts although that is changing.

Plugging in

Historically, banks and financial intermediaries have provided electronic access for commercial organisations in all segments to buy and sell foreign exchange on a pre-approved basis, both spot and forward. This mode of trading has enabled commercial organisations to settle commercial transactions as well as manage their foreign exchange and their exposure to overseas transactions by hedging their risk through forward purchases and sales of foreign exchange. These facilities have been extended to financial investors, financial institutions, and retail investors that buy and sell assets denominated outside the home or base currency and wish to lock in the purchase cost or sales proceeds by conducting a simultaneous foreign exchange transaction.

Retail and institutional investors who look to benefit not only from the FX market’s liquidity but also its volatility treat it as a separate, individual asset class. When it is traded as a commodity, spot and forward, it is particularly attractive for Islamic investors because it is satisfies the requirements of Shari’ah law.

Platform-based technology is a well-trodden and defined path for improving service and bringing administrative and operational efficiencies to buyside businesses. They have gained traction in the FX space as investors continue to search for higher yields. They are being drawn into what should now be termed “emerged” markets although the execution of the FX component has to be managed closely whether or not it is regarded as a separate asset class or merely a service provision (see p.xxx). In response to end investor demand for greater granularity and transparency, when they account for and report revenue and cost components, fund managers as well as administrators and custodians and other service providers require detailed analysis on a transaction by transaction basis of their revenues and charges. A platform can provide the level of data, which is auditable and capable of multi-dimensional analysis, as part of the service.

* Bob McDowall, is consulting associate to commercial think-tank Z/Yen – www.zyen.com