Event Insights: Risk FX Briefing

Over 70 German investment managers, FX overlay managers, banks and corporates convened to discuss the latest trends in the FX industry at the second Risk FX Briefing held in Frankfurt.  

(Please note that the views expressed in this document summarise those of speakers and participants at the event and do not necessarily reflect the views of CME Group.)

Regulatory, cost and market structure changes are altering the way participants make trading decisions, while seeking better data and analytical tools and more efficient credit models.

Geopolitical risk continues to create uncertainty, with ongoing trade tensions, weakening US investment outlook, European elections and Brexit top of mind.

The New Market Paradigm

• The shape of the new market structure is becoming clearer, opening the way to an increasing volume of exchange-traded business. New asset classes and new solutions such as FX futures are seeing increasing take-up.
• Regulation and technology continue to be key drivers. Mifid II has had a substantial influence. With a greater focus on best practice and best execution, buy-side customers are getting smarter and more demanding.
• Sell-side firms are under pressure to automate businesses and to become more efficient, driving down costs to match the economics of the current market. Scale is a primary focus to safeguard business.
• In a bid to reach critical mass in terms of economics, banks are increasing volumes on multi-dealer platforms and hedging with clients, rather than other banks, to reduce costs.

Impact of New Market Structure on Liquidity and Execution

• The liquidity picture is changing, with more competition on spot products than on forwards.
  
• While top-of-book liquidity is stronger than ever, the depth of the book has shrunk. This has led to a change in execution style where splitting of big orders is more prevalent.
  
• Depth of liquidity is also a key concern for the buy-side. Risk transfer is still the dominant form for executing transactions but there is an increasing trend towards algo trading from other asset classes, typically in less liquid currency pairs.
  
• Non-bank liquidity is a key source for accessing markets, with new providers appearing in the list of market-makers.

“[Liquidity providers are dividing into] global giants and boutiques, leaving a squeezed middle of those who have a cost base which is too large but without the critical mass to join the top providers and achieve the necessary economies of scale.”

• For the buy-side seeking liquidity, the focus is on quantity and quality, with TCA analysis, broker assessments and workshops helping firms identify an appropriate selection of providers with the requisite credentials.
• Sell-side firms are also ramping up efforts on TCA and best execution, with some banks including spot as well forwards within monitoring programmes, despite being outside the current scope of Mifid II.
  
• Investors are becoming more demanding in looking at best execution and historical TCA results – providers’ structure and processes and ability to generate asset alpha are frequent paths of enquiry.
  
• It’s valuable for investors to develop relationships with CCPs across spot and forward desks, especially during times of market stress, when algo execution is likely to be less solid. Rather than risk distorting the market through multi-quote pricing by phone, a more accepted practice now is to opt for a single counterparty and hold them responsible for execution on larger deals.
  
• Clarification over reporting of swaps through Approved Publication Arrangements (APA) is a welcome development and has helped bring transparency and the opportunity to review data and processes.
• In measuring performance, benchmarks like the WMR fix are becoming less relevant. Market participants are more careful about simple one-month WM benchmarks and trying to take into account factors like FX basis in different currency pairs at different periods.

Enhanced data and analytics needs

• Participants are adding algo trading to their FX armoury and exploring the potential of blockchain, artificial intelligence and machine learning to enhance systems and processes and drive better insights from data.
  
• A key challenge for the sell-side is to automate the end-to-end process including the downstream side and back-office settlements. There have been major advances in front-office automation, pricing and risk management, but there are armies of people still sending and chasing payments round the world.
  
• Data analysis is becoming increasingly important. Mifid best execution is a useful process forcing participants to analyse every trade to become better at predicting market moves and managing inventory. For the buy-side, TCA analysis could potentially tell you which broker to use, at what time of day, and which streaming price for different currency pairs.
  
• Banks are also using digital labs and other specialist units to partner with fintechs and accelerate onboarding of key technologies such as blockchain, artificial intelligence, machine learning and natural language processing.

The evolution of FX hedging

• Developments in currency hedging have resulted in more nuanced programme designs and sophisticated implementation methodologies. Key considerations include cashflow management, competitiveness of currency trading, forward contract collateralisation and reporting detail.
• FX futures are gaining in prominence as German asset managers seek new sources of liquidity and a cheaper alternative to FX forwards.
  
• Clearing is a major challenge due to the cost of margining. The likelihood is it will be mandated in the future which will focus attention on margin management.
• Buy-side firms are supportive of bringing more business from OTC into the listed space. The higher the transparency, the lower the cost of trading for the buy-side. The expectation is it will follow a similar path to equities becoming more commoditised 10 to 15 years ago.
  
• Rather than trading FX forwards, another emerging dynamic is for buy-side entities to trade spot themselves, agreeing a fair basis in competition with a sell-side firm, and then switching this position into an FX future.
  
• Many investors now consider both the strategic and tactical aspects of currency hedging – defining the long-term portfolio hedge ratio and the ranges within which this hedge ratio may vary.
  
• In the future there will be a place for exchange-traded instruments, with demand from smaller clients willing to implement a standardised hedging product option, driven by quantitative signals and with simple, transparent execution.

 “Investors are looking for something that’s very hard to deliver – outperformance, at low cost and with minimal risk.”

• Clients’ due diligence processes typically focus on the past and present, but not on the future. Instead of questions around regulatory requirements, compliance policies and producers, investors would be better asking how providers will cope with changing liquidity, the cost of resourcing, and research and technology needs in the front and back office.

Central Bank View

• Two years on from the launch of the FX Global Code, momentum is building around its goal to build more fair and transparent markets.
  
• The current list of 700 signatories to the code includes the 30 largest banks, EU central banks, and selected sovereign wealth funds and supranationals.
  
• Progress on the buy-side has been slower with one-third of the 30 largest asset managers, and around 10 corporates from sectors like aerospace and oil.
  
• Key benefits for the buy-side are seen as the opportunity to review internal processes, reassure stakeholders, reduce compliance risks, enable more rigorous appraisal of dealers and promote integrity in the market.
  
• Some buy-side firms have expressed reluctance to incur the costs of adherence when the sell-side were responsible for the wrongdoing. In the ECB’s view, both sides’ participation is needed to improve standards and firms should see it as an opportunity to review policies and influence best practice.

Geopolitical Risks and their Impact on FX Markets

• At the 20-year anniversary of the euro, several factors are driving volatility in Europe. The region stands divided, with substantial changes to come including Brexit, eight European country elections, and a change of personnel in the European parliament, the European Commission and the ECB.
• The US dollar is still the dominant currency in FX but the outlook has changed. Last year the dollar was buoyed by the Federal Reserve’s tightening stance, optimism about the US economy and lower expectations for the eurozone. But Fed chairman Jerome Powell surprised everyone with a return to a more neutral policy, a lack of forward guidance, and likely swifter shrinkage of the balance sheet. The likelihood is the dollar may have peaked.

“[The US and Europe are] converging to a kind of no-man’s land on monetary policy”

• Sterling isn’t considered to be undervalued. In the event of a no-deal Brexit, a drop of 10% GDP could be expected in the UK and the prospect of sterling trading at less than one euro.
• Emerging market (EM) currencies came under immense pressure over tightening liquidity conditions last year, so the end of US monetary tightening is good for EM currencies as a whole.
  
• EM markets should no longer be considered in one basket – the outlook between countries can vary dramatically. The big sell-off at the end of last year means there are now opportunities to be had that are purely value-driven, but the outlook could vary for the rest of the year.
  
• There are high interest rates in Turkey and Argentina. In Asia, ASEAN countries behaved quite well during the EM change because they had a strong China behind them.
  
• The Russian ruble often moves ‘lock step’ with oil prices, but US sanctions have distorted the picture. Russia has some of strongest macro fundamentals of any EM currency – a current account surplus, a large net international investment position, a strong fiscal policy – but foreign investors are less keen that each disagreement seems to lead to President Trump increasing sanctions.

“There continues to be a kind of political risk premium in the ruble and that makes it hard to forecast.”

• Future geopolitical risks to watch out for include the level of private debt in Europe, the growing US debt, especially government debt, and the possible extremes of President Trump’s international trade tactics and re-election campaign.

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