What drove last year’s high FX volumes? BIS Head of Banking elaborates

BIS Head of Banking Peter Zollner addressed the 53rd ACI Financial Markets World Congress with insight into global FX market activity

The Bank for International Settlements (BIS) has today elaborated in full detail on a speech which was delivered to the 53rd ACI Financial Markets World Congress 2014 in Berlin on March 29.

Peter Zollner, Head of the BIS Banking Department, focused on recent developments and dynamics which have been present in the FX markets internationally, commencing with dissecting the reasons for an increase in turnover to an all-time high of $5.3 trillion per day in April 2013, up by 35% relative to 2010. This was faster than the 20% rise from 2007 to 2010, but fell short of the strong increase in the pre-crisis period from 2004 to 2007.

Mr. Zollner drew a large proportion of data from the BIS 2013 Triennial Central Bank Survey of the FX and derivatives markets, and added his own commentary that there were a few reasons for the increase in turnover, including the intensive trading of yen pairs following the Bank of Japan’s monetary policy regime shift in early April 2013, which triggered a phase of exceptionally high turnover across asset classes. In the months that followed, particularly during the summer, the rise in yen trading partly reversed. Even without this yen effect, however, FX turnover would probably still have grown by about 25%.

Further reasons highlighted were the growth of investment in international assets. With yields in advanced economies at record lows, investors increasingly diversified into riskier assets such as international equities and local currency emerging market bonds.

“Over the past three years,” stated Mr. Zollner, “equities have provided investors with attractive returns, emerging market bond spreads have simultaneously dropped, and issuance in riskier bond market segments (eg local currency emerging market bonds) has soared. Not only did these three factors give rise to the need to trade FX in large quantities and to rebalance portfolios more frequently, but it also went hand in hand with greater demand for hedging currency exposures. This triggered currency trading as a by-product of investments.”

Mr. Zollner also considered the greater participation by non-dealer financial institutions to have impacted positively. “FX markets have traditionally been dominated by inter-dealer trading” he explained. “However, transactions with non-dealer financial counterparties grew by 48% to $2.8 trillion per day in 2013, up from $1.9 trillion in 2010, and accounted for roughly two thirds of the rise in total turnover during the period.”

The emergence of liquidity aggregation and algorithmic trading techniques has increased interconnectivity between a greater number of market players and enabled a more widespread sharing of risk among market participants, whilst, according to Mr. Zollner, also enabling quicker execution times and lower trading costs, ultimately resulting in an increase in total FX turnover. This has been very evident during the course of last year when several infrastructure providers such as TMX Atrium, Perseus, and DealHub continued to roll out solutions which allow participants access to global venues with minimal latency.

Mr. Zollner considered the more fragmented structure that emerged after the demise of the inter-dealer market as the main pool of liquidity to have potentially harmed trading efficiency by raising search costs and exacerbating adverse selection problems.

Yet, the BIS considers one of the most significant innovations to prevent this as being the proliferation of liquidity aggregation. This new form of aggregation effectively links various liquidity pools via algorithms that direct orders to a preferred venue (eg the one with the lowest trading costs). It also allows market participants to select preferred counterparties and choose from which liquidity providers, both dealers and non-dealers, to receive price quotes. This suggests that search costs, a salient feature of OTC markets, have significantly decreased. Widespread use of algorithmic techniques and order execution strategies allows the sharing of risk to occur faster and among more market participants throughout the network of connected venues and counterparties. Over the period 2007 to 2013, algorithmic trading at EBS grew from 28% to 68% of volumes.

The availability of new dealing technologies has redefined the roles of each of the major FX market players. Electronic trading in general and retail-oriented trading platforms in particular have provided FX market access to a broader range of end users and favour a more active participation of non-dealer financials.

In conclusion, Mr. Zollner addressed the delegates of the congress by touching on regulatory issues that have become a priority among governments with relation to OTC derivatives over recent years, mainly since the financial crisis of 2008. “It is inevitable that compliance with all these regulatory requirements will involve costs. But, even with capital holdings well above the minimum levels set in Basel III, the initial investments will reap benefits in the long term. For one, a more resilient financial system will allow the global economy to grow with fewer interruptions from financial crises. And also, when crises do occur, they are likely to be less severe than before” stated Mr. Zollner.

Therefore, the overall consensus gained by the BIS was that the growth in FX volumes to an all-time high of $5.3 trillion in April 2013 was largely driven by an increase in investment in international assets, requiring greater hedging of currency exposures as well as a growing role of non-dealer financial institutions consisting of smaller and regional banks, hedge funds and institutional firms.

Lastly, a further internationalization of currency trading (particularly the renminbi) made a notable contribution, as did a fast-evolving market structure driven by technological innovations such as electronic trading, liquidity aggregation and algorithmic trading techniques.

For more on the global Forex industry see the LeapRate-Dow Jones Forex Industry Report.

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