Six Trends for Currency Markets
- Ivy Schmerken, Editorial Director at FlexTrade
- 24.01.2017 09:15 am trends
Political shocks such as Brexit and the U.S. election of Donald Trump jolted the foreign exchange markets in 2016, fueling more trading activity for hedge funds and bank trading rooms. Uncertainty around a stronger U.S. dollar and higher interest rates could drive more volatility into 2017.
FX market pundits are pinning their hopes on lighter regulations, the evolving landscape of liquidity providers, a more active buy-side, the transforming potential of blockchain, and the future role of humans in the process.
However, some participants were not entirely optimistic.
In 2020, prepare for “more volatile FX markets, less liquidity among banks and better [electronic trading] platforms,” predicted one panelist at the Markets Media FX Trading 2016 event.
Here are six topics to keep in mind for currency market structure in 2020:
1. The Volcker Rule & Liquidity
Regulations such as Basel II and Dodd Frank’s Volcker Rule have made it difficult for banks to warehouse risk, such that some traders were skeptical that bank-dealers could recover their clout as liquidity providers.
“That the Volcker Rule is probably on the chopping block as quickly as any other provision is largely because it’s causing the most trouble in terms of reducing the capacity of banks to compete,” said one person. At a minimum, more clarification is needed on pre-hedging activity, which one person said is treated as if it is a crime.
Liquidity was top of mind at the gathering of FX professionals, who expressed concerns about a GGP flash crash on Oct. 7 and whether such volatility spikes would occur in the future.
“I would agree that the kind of liquidity crisis we are seeing now will continue,” said Jack Drohan, president, ACI, The Financial Markets Association, who spoke on the FX Futures panel.
Traders mentioned macro-events like the Swiss National Bank’s abandonment of the Swiss franc’s peg against the euro on Jan. 14, 2015, which sent shockwaves through the prime brokerage community. Prime brokers raised fees on hedge funds and dropped clients, which may have contributed to the downsizing of global FX volumes.
Between 2013 and 2016, hedge funds and principal-trading firms reduced their FX spot trading activity from $580 billion three years go to $390 billion in 2016, according to the Bank for International Settlements (BIS) report released on Dec. 11.
2. Algorithms & Speed Bumps
In 2017, speed-based trading strategies could become less important to currency markets.
“The introduction of speed bumps in the form of latency floors by major inter-dealer platforms have made such strategies less attractive,” said the BIS report, which cited steps taken by ICAP’s EBS on its matching engines to prevent fast traders from detecting information on orders and then canceling their quotes on other venues.
In the report, BIS cited a shift away from high-frequency trading strategies that rely upon “fast execution and short-term arbitrage.” In particular, “certain algorithmic strategies primarily based on speed have reached a saturation point.”
As these trends evolve, 2017 could see a continued shift from aggressive latency-driven strategies to more passive strategies based on electronic market making.
3. Buy Side Goes Direct
“Buy side will trade with buy-side in dark pools,” said David Ullrich, SVP of Foreign Exchange at FlexTrade. FX participants contend that volume will increase if Dodd Frank is rolled back. “We’ve all seen the staff reductions at top banks in terms of experience, along with the rise of alternative sources of liquidity. I don’t think that trend changes unless there is a change in regulation,” said Ullrich referring to the Volcker Rule. But Ullrich insisted that the buy side will need to become more of a force. “Asset managers need to react more directly to the marketplace,” said Ullrich, who explained that the buy side needs the ability to post liquidity more directly to the marketplace rather than through a sell-side intermediary. As the buy side has a natural interest in the FX market for funding and hedging requirements, they add liquidity to the overall market, he said. As they control one side of the market — the buy or the sell — either side could be sufficed by a non -bank liquidity provider or the banks themselves,” he added.
Though large banks have less capacity to warehouse risk, Ullrich expects that “Virtual markets will pick up the slack,” referring to alternative liquidity sources outside of the traditional sell side. He also predicted that FX markets would become more integrated with credit managed across different tenors and spot venues.
One of the missing pieces of the equation is access to credit, since most alternative liquidity sources only allow for spot trading, but the asset managers need both spot and forward liquidity to manage hedges and rolls, he explained.
“Credit is the necessary ingredient,” said Ullrich in a follow up interview. Many participants at the FX event made reference to credit as being expensive and as an impediment. This could be solved if derivatives are posted to an exchange or if credit itself can be packaged and sold potentially, said Ullrich.
4. Revamping Post-Trade Infrastructure
With the growth of electronic trading and efficiencies from automating the front office, the focus is shifting to cost cutting in the back office. “There is still some inefficient use of humans in the post-trade area that can be replaced by technology,” said Jill Sigelbaum, global head of FX at Traiana on the FX 2020 panel. The back-office is still much like it was 25 years ago, she noted. “Though items are typed instead of written, there are still extra people, she said. However, this doesn’t mean that humans are being cast aside. Instead, humans would be repurposed to manage the technology that didn’t exist before.
5. Blockchain to the Rescue
Several FX executives predict that blockchain, the distributed ledger technology underpinning bitcoin, is going to have a big impact on delivering real-time clearance and settlement in currencies. Blockchain is a data structure that makes it possible to record transactions and share it among a distributed network of computers, as defined by The Wall Street Journal.
Many financial firms are experimenting with blockchain as a transparent way to store and verify transactions without a central authority, which could help to speed up and cut costs as well as replace legacy infrastructure.
For example, R3CEV LLC has signed up 70 banks that are committed to investing, or sharing ideas and experimenting, with blockchain. “They’ve [invested in blockchain] because of processing and the ability to allocate less credit and for the cost of credit to be less at risk,” said one FX industry executive. Credit risk has been an inhibitor to FX trading as it’s challenging for prime brokers to extend credit to counterparties that are simultaneously trading through multiple prime and executing brokers across multiple FX ECNs and other venues.
If blockchain can be adapted to facilitate real-time settlement between counterparties, then the ability to assess risk is quicker, reduced from two days to immediate, which leads to real-time executions and less margin and higher volumes, one attendee said.
“Credit will be freed up to a point where it’s monitored properly in sync with execution,” said another attendee.
6. Future of Humans: Directing the Algos?
While technologies such as big data analytics, algorithms and machine learning can potentially be integrated to make trading decisions, participants contend there is still a role for human interaction. “I don’t believe that human interaction is going away,” said one market participant. “Humans will make better use of machines or algorithms to enact the direction and desires of the person behind the algo,” said one panelist. “There will always be a place for someone who has the ability to deal with large clients and large orders,” said the person.
“You may need humans with different skill sets. But you still need humans,” said Traina’s Sigelbaum.
Buy-side firms will also look to technology to take on the mundane tasks that allows traders to focus on complex trades. “Technology will help the asset managers reduce workflow on routine areas, so they can focus attention on more important trades, such as larger size alpha generating trades,” according to FlexTrade’s Ullrich. “You’ll see heightened activity in trades that mater, which in turn allows for probably a tighter sales and buy-side relationship as well,” said Ullrich.
Reading the Tea Leaves for Currency Markets
While no one can forecast what 2017 holds in store for currency markets, there is recognition that foreign exchange markets will continue to evolve through regulatory changes, shifts in liquidity providers, speed bumps, technology innovations, such as blockchain, while humans adjust their roles.
At the same time there are loose ends that pose risks such as whether traders could expect the occurrence of another flash crash, or whether banks will continue to utilize ‘last look’ in their trading platforms, a practice that allows banks to reject quotes after they’ve been accepted, which concerns the buy side.
Meanwhile, buy-side firms managing international portfolios are paying more attention to currency hedging. Already the BIS study found that institutional investors, such as pension funds and insurance companies, raised their FX activity by nearly a third or 32%, up to $800 billion in 2016.
“If volatility is going up, asset managers may need to allocate more time into managing FX risk,” said Peter Lundgreen, CEO of Lundgreen’s Capital at the event.
With so many uncertainties, Trump’s market-moving tweets, and geopolitical risks in the world, it will be interesting to watch how these six trends play out.
This article originally was published on the FlexTrade FlexAdvantage Blog.
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