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Where there’s risk there’s money

Filed in: , risk, foreign exchange, forex, euro, market, dollar, currency, yen, reward

Markets thrive on risk and the rumour of risk. But risk seems to be seeping away from the foreign exchange markets and it's becoming more difficult make money trading currencies.

Where there’s risk there’s money

Richard Willsher

Markets thrive on risk and the rumour of risk. But risk seems to be seeping away from the foreign exchange markets and it’s becoming more difficult make money trading currencies.

According to latest data from the Bank for International Settlements, turnover in foreign exchange trading is around US$1.5 trillion a day. Analysts reckon that this probably dipped last year by about 10 to 20 % in the wake of the euro. Nevertheless, even allowing for double and even triple accounting, it ought to be possible to make good profits in what has been described as “the world’s biggest vegetable stall.”

But that it seems that it’s becoming more difficult to do and the euro is certainly a factor. “The Euro has become a major component in our markets and has replaced the Deutschemark as the major European currency,” says Roger Poynder, UK president of the ACI, The Financial Markets Association. “Whilst there is still a certain amount of interest in the legacy currencies such as Deutschemark, French Franc, Italian Lire and Spanish Peseta this is mostly driven by maturing commitments of corporate clients… The majority of business that addresses European Risk is transacted Interbank in EURO and therefore already ignores the specific country risk that the individual legacy currencies provided.”

The euro has taken its place alongside the US$ and the Japanese Yen as the world’s most traded currencies. Trading between these currencies is predictably the largest and most frequently traded and while no one is alleging that dealing rooms are on their uppers, several macro factors have stripped away risk from these markets as Jim O’Neill, senior currency economist at Goldman Sachs explains,

“The single biggest factors are inflation stability and convergence. Inflation has continued to be low and converged in many parts of the world to the same level. The forex market thrives when inflation is low and diverging and there are obvious economic discrepancies between various parts of the world. They allow the leverage community [such as hedge funds] and proprietary traders to make bets on which way the odds are going. These days with the world economy in so much better shape it’s not so easy to do that.”

He adds, “If we continue with this fantastic world economic environment the FX markets will be more difficult. If inflation were to pick up, especially in the US we could see the old style market coming back and the hedge funds might, for example, rediscover their appetite.”

A further factor in narrowing trading spreads is the availability of information. Not only are vast amounts of economic, financial, political and other data available now as never before but a good deal of it is free to large numbers of people. The Web is increasingly the delivery channel and therefore to be able to differentiate a view of future currency movements or to establish competitive advantage through superior research is more difficult to do. While not impossible forex analysts admit that their market has become more efficient.

Nonetheless there are countries and indeed whole regions where volatility of political and economic drivers do allow for wide variations in currency pricing. In particular emerging markets and the smaller OECD countries. Citibank, the longstanding and undisputed leader in volume foreign exchange trading says it trades in 140 currencies. Most of these would be classed as “emerging market currencies.” There are no figures available to demonstrate how much Citibank and others make in such trading although the assumption, and it may be an erroneous one, is that they do well at it or they wouldn’t still be in the market.

Goldman Sachs for example reckons that its research capability allows it to profit in such markets. But as Jim O’Neill says it is not without its perils, “It’s very symmetric. It’s great when everything’s going well but it’s not a great game when you’re not. Which is all a function of equity markets and short term rates… If you’ve got really good research, you can still use that to take positions. If you are right 55% of the time or more you’ll do fine but I would say it’s got harder to do. “

Emerging markets plays could however become threatened in years to come if the blue-sky thinkers’ dreams come true. They argue that Asian markets could take on a single currency, just as Europe did. Added to which the first tentative steps have already been taken in “Dollarising” Latin America. Could this happen and what would the effects on the foreign exchange markets be?

“Following the introduction of the EURO, there has been renewed focus on the idea of a single Asian block currency,” says the ACI’s Roger Poynder. “Economists in the region however do not see this as a realistic prospect in the near future. The ‘rules of engagement’ would require a convergence of the various economies, and probably political views as well. Latin America faces similar challenges of discipline if they hope to achieve Dollarisation. The USA will require both political and economic strictures if they are to sanction such a move and unilateral Dollarisation does not appear a viable option.”

But then nor did the euro look viable until comparatively recently. So may be their could be a distant threat from this quarter to foreign exchange trading profitability. But a greater and more realistic threat seems to be the increasingly large regulatory fly in the ointment.

New capital adequacy rules are currently being considered and among them is the idea that a charge against capital should be made for operational risk such as that of forex settlement. In other words traders might be charged capital against their positions.

The issue then becomes one of return on capital. Is it more efficient for a bank to earmark its capital for forex exchange or for some other activity? And it is worth recalling that the majority of forex trading is carried out for arbitrage or speculative purposes, as much as 95% of world market turnover according to one analyst. Over the last couple of years while stock markets have raged banks of often chosen to invest in equities rather than forex.

The conundrum for banks has for more than a decade been how to comply with regulation and make money. But if you remove risk you also remove the scope for generating returns. In this respect there is good and bad news for the forex market just about to break.

Continuous Link Settlement (CLS) when it arrives next year will offer the market a system of settlement which will be virtually risk free; discounting system failure of course… What it will mean is that trades will be settled real time, on what amounts to a cash-for-cash basis and this will aid banks in managing their collateral positions more efficiently. The good news then should be that containing operational settlement risk should free up capital for other purposes, if a new Basle Accord agrees that is. On the other hand if risk is removed this should mean that margins will be pared even further. The BBA for example speculates that this will produce differential pricing in the market, low for those with CLS settlement , higher for those without it. Overall it seems likely that risk will reduce and consequently profits will fall further.

Eradicating risk and reducing the market to high volume and low volatility makes it ideal for electronic trading. As we go to press the electronic hosting system has been announced by seven of the world’s leading banks in addition to other services such as CMC, Volbroker, and others which already exist. Added to which as banking mergers proliferate dealing rooms are likely to decrease in number. While traders will be asking themselves if there will be jobs for them, banks will be questioning whether they can make money in the business. In the current analysis the nature of banking risk may already have changed and have become one of how much banks are prepared to invest in software in order to buy a marketshare of uncertain worth.