Fast forex moves raise liquidity worries

For a market that trades a notional average of $5.3tn a day, foreign exchange is currently bedevilled by a perplexing problem: what has happened to market liquidity?

In recent months a series of dramatic and unforeseen intraday fluctuations - even in popular and widely traded currencies - has led forex investors, bank traders and analysts to question the mechanics of the market.

At its heart is a question of whether the vast over-the-counter (OTC) market, long dominated by just a handful of large investment banks conducting trades, is in a cyclical decline or just the latest to be affected by new technology and tough regulation enforcing change.

The broader concern is that declining liquidity will fuel more sudden forex moves and destabilise the market. According to Standard Bank's G10 currency strategist Steven Barrow, "volatility and spikes borne out of aggressive reactions to perhaps not very startling moves can drive currencies away from fundamentals".

Many fear it is already happening. Matthew Cobon, a fund manager at Threadneedle Asset Management, left his office late on March 18 when the euro was worth $1.08. At the end of his 15-minute trip home, the euro had jumped to $1.10. It took place in the hours after US Federal Reserve chairwoman Janet Yellen signalled a not-unexpected dovish approach to monetary policy. And yet, says Mr Cobon, "there was little traded on the spike to $1.10". The following day, the jump had been unwound.

CLS, the London-based, US regulated settlement system used by much of the forex market, recorded a 16.5 per cent fall in February average daily volumes compared with January - though that month did witness extreme volatility caused by the Swiss National Bank abandoning the Swiss franc's peg to the euro.

Together with a widening of the bid-ask spread on trades, this leads Mr Cobon to conclude that forex liquidity is "greatly reduced".

Glenn Stevens, chief executive of Gain Capital, an online forex platform, says the moves are nothing unusual for long-time traders. "Currency trading goes in and out of fashion," he argues.

However, like others, he acknowledges there are potential seismic shifts under the edifice on which the whole market is built. That notional $5.3tn market is dominated by large investment banks that trade the overwhelming bulk of deals privately between big customers and themselves.

A series of market and banking reforms, as contained in Basel III and the US Volcker rule, has reduced the ability of banks to take trading risks on to their own balance sheets for any length of time. Wholesale banking balance sheets supporting traded markets have decreased by 40 per cent in risk weighted terms since 2010, according to a recent report by Oliver Wyman and Morgan Stanley.

Technology costs are also constantly rising in a market in which 80 per cent of volume is traded electronically. As a result some banks are acting more like agents, simply executing trades in the market immediately, while others are just losing market share.

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At the same time, the market also faces unprecedented scrutiny into its workings following allegations of rigging of key industry benchmarks by several big investment banks. The investigations are continuing.

That may also be affecting customer behaviour. A widely watched annual survey of more than 2,600 market participants by Greenwich Associates, a US capital markets consultancy, last month found financial institutions and companies were broadening their share of FX dealing through a greater number of dealers.

The FX scandal "has also made some firms more hesitant to provide clients with "market colour", for fear of running afoul of regulators, thereby diminishing some of the value clients derive from interacting with major dealers on the telephone", the report said.

Many see venues into which dealers pump their prices - so-called "multi-dealer platforms" - as a solution to the problem. Platforms like EBS, Thomson Reuters and Hotspot are not owned by banks but by market infrastructure providers like exchanges. Providing participants with a marketplace with a greater number of counterparties would offset any decline in activity from banks, proponents argue.

Others say the problem is less down to the mechanics of the market and more due to the actions - or lack of them - from central banks.

"In terms of structural direction, [lack of liquidity] makes very little difference. The trend is still the same," says Roger Hallam, chief investment officer for global currencies at JPMorgan Asset Management. Nevertheless he expects the speed at which trends unfold will quicken.

For others, the current moves are a combination of steady central bank moves and a more anonymised, electronic world.

"We have seen a lot fewer participants in the market and the participants we see have less variety. Everybody has the same sort of view," says a currency manager for one prominent hedge fund. At crucial moments, participants "rush to the same door to unwind positions".

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