Op Ed: The February volume crunch

Frenzy, followed very shortly afterwards by apathy.

This is perhaps an apt description of the activities of many FX traders across the entire spectrum of the industry, including those trading on exchanges, those trading via OTC brokerages, regardless of region.

January’s polarizing market conditions which resulted in a number of bank FX desks and A-book FX brokerages having been exposed to negative balances whilst the B-book brokerages purportedly raked in a fortune have subsided and as companies continue to report their trading volumes for February, it is apparent that substantial reductions in volumes across the board have ensued.

The interesting dichotomy between the reaction by the entire FX industry to immediate and unpredicted losses and negative client balance exposure as a result of the Swiss National Bank’s removal of the 1.20 peg on EURCHF on January 15 and the total lack of reaction to the swingeing reduction in volumes which followed is most definitely a measure of how certain conditions which cause reductions in revenues have become accepted and others which have never been seen before have not.

In February, Saxo Bank, one of the first firms to have displayed its corporate position on January 15, experienced a 37.5% drop in volumes in February compared with January, and saw volumes contract to the lowest levels in over a year. Meanwhile, exchange-traded FX also slumped, with Japan’s Tokyo Exchange recording a 25.5% downturn in trading activity in Click365 margin FX contracts compared with January.

Back in the Western Hemisphere, exchange-traded FX activity echoed that of the Far East, with CME Group Inc (NASDAQ:CME) experienced a 24.2% drop in volumes compared with January, whilst compatriot and direct rival Intercontinental Exchange (NYSE: ICE) noted a 23% decline in contracts during February.

The question is: What is worse? A downturn in volumes which takes a long time to recover, as experienced during the first 9 months of last year thus resulting in stunted revenues for a sustained period of time, especially in times where volume is everything, as spreads are low and acquisition, retention and operating costs (remunerating IBs, capitalizing platforms and bridges) are high, or to have one sudden, unprecedented ‘black swan’ event which creates a huge and instant response, exposing some firms to risk but ultimately driving up market volatility and causing trading volumes to rocket.

January’s volumes were very high for most firms, and bearing in mind that the majority of the activity which contributed to the high volumes uccurred in just two weeks between January 15 and the end of the month, this effect can be multiplied if worked out on a pro-rata basis.

Indeed, many firms were subjected to losses, but some of them were not so high, for example IG Group Holdings plc (LON:IGG) only suffered a loss of approximately £30 million as a result of the events of January 15, but remains well capitalized and can reap the rewards should its traders ride the volatility wave, therefore this could be viewed as a positive outcome, as opposed to periods of low volatility and low volumes.

A calculation that must be made is the potential outlay of covering negative balances if extremely high volatility comes about, compared with the potential acquisition costs, marketing efforts and operational liabilities should a period of low volatility occur.

Many brokerages are now considering a hybrid execution model, which involves using A book liquidity for the most part but with the ability to operate a B book to mitigate exposure in times of high volatility. This has been talked about at conferences, in interviews, and is currently a major topic for discussion in boardrooms as well as between brokers and their liquidity and technology partners.

There has, conversely, been no such discussion thus far about what action to take should the market enter a period of low volatility once again. Last year, Barclays considered making a somewhat unthinkable 19,000 redundancies, several thousand of them being in the firm’s investment banking division, with FX traders hanging onto their positions rather than seeking pastures new due to Barclays’ attractive remuneration packages at the time despite the continually dwindling corporate performance, largely owing to low trading volatility.

During the second quarter of last year, HSBC reported a 34% downturn in FX revenues, therefore the opportunity cost is greater when viewing such a contraction over a six month period, than the potential losses due to having to write off negative client balances in just one day, then the following day watching the volumes soar as volatility creates market activity.

Very few FX firms reduced the size of their operations last year. On the contrary, many increased their operations substantially, buying entire client bases, and establishing offices in different global regions, all at a time when volatility and volumes were down. September’s return to high volatility was relatively short lived and provided a two month period of high revenues for many firms, but this is not sufficient to replicate the vast profits firms made during the sustained period of high volumes in summer 2013.

Would companies embark on acquisitions and mergers, expansions and ventures into new regions following a black swan event? Judging by the industry’s reaction to January 15, even those who did not lose substantial sums, it is likely that they would not, despite the potential damage done by such an event being less than a protracted low volume period.

Here is a conundrum: Low volatility which blights the market for several months not only affects revenues but also increases costs as firms need to expand sales teams, do more marketing, pay to acquire new clients (approximately $800 per acquisition for a client with a 6 month life time value and deposit of $4,000), conduct retention to re-engage dormant clients, capitalize a platform, motivate IBs, whilst competing with every other firm which is struggling to overcome the same challenges.

A black swan event may expose firms to negative client balances but, as has been clearly demonstrated by the trading behavior prior and subsequent to January 15, can bring vast volumes with no extra cost as existing traders cash in on the volatility and volume increases exponentially.

When it comes to the gravity of losses, or low revenues, it appears that all is a matter of perception.



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Op Ed: The February volume crunch


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