Recent trends in the foreign exchange and money markets
Speech by Mr Peter Zöllner, Head of the BIS Banking Department, to the 53rd ACI Financial Markets World Congress 2014, Berlin, 29 March 2014. The views expressed are those of the author and do not necessarily reflect the views of the BIS.
Let me start by thanking ACI for inviting me. It is a privilege for me to speak this morning at the ACI conference on recent trends in the foreign exchange and money markets. I was looking forward to returning to Berlin, but unfortunately a skiing accident has left me unable to travel, hence I am joining you by video conference today.
A lot has been said about the underlying factors contributing to the market turmoil that culminated in the financial crisis: the escalation of delinquencies associated with subprime mortgages, the prevalence of weak mortgage underwriting practices, a significant erosion of market discipline by those involved in the securitisation process, flaws in the credit assessment processes of the major rating agencies, inappropriate incentive frameworks, and so on.
Not surprisingly, the financial crisis has had a profound effect on financial markets. As a result of the widespread breakdown in market due diligence uncovered in the aftermath of the crisis, both FX and money markets are undergoing significant changes, driven by increased self-regulation and the introduction of broad-ranging regulatory changes on both sides of the Atlantic.
Today, I would like to describe some of the major trends that have surfaced recently in the FX and money markets.
I will start with some broad observations on the FX markets, followed by some thoughts on the money markets, before concluding with a brief discussion on some trends evident in both markets.
My comments regarding FX draw mainly on the BIS 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity1 (in short, "the Triennial"). The Triennial covers 53 countries and represents the most comprehensive effort to collect detailed and globally consistent information on FX trading activity and market structure.
FX turnover reached 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.
Main reasons for the increase in turnover
- One reason behind this increase in turnover was 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%.
- Another reason for the higher turnover is 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, 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.
- A third reason is greater participation by non-dealer financial institutions. FX markets have traditionally been dominated by inter-dealer trading. 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. I will explore the reasons for this shift in FX trading from dealers to non-dealer financials in greater detail in the next section.
- Related to 3 above, a number of technological advances (which I will also discuss at more length in what follows) have also contributed to the growth in FX volumes in recent years. These include the emergence of liquidity aggregators and algorithmic trading techniques.
We estimate that the $5.3 trillion per day reported in the survey month of April 2013 was a peak, indeed perhaps the most active period of FX trading ever recorded, so it is important to bear this in mind when considering the findings of the Triennial. Activity subsequently fell by $300 billion to $5 trillion per day in October. The decrease was primarily driven by a drop in spot transactions involving mainly euros and yen against the US dollar. The decline in euro trading extends a trend that began in the third quarter of 2011, while the fall in yen trading reflects a partial reversal of a sharp rise that occurred in late 2012 and early 2013. Anecdotal evidence points to an increase in FX turnover towards the end of 2013.
I will now explore in more detail the major players behind the FX turnover increase, highlighting the changing nature of their roles, as well as the aforementioned technological advances helping them to achieve such large increases in FX turnover.
Main institutional drivers of the increase in turnover
Trading in currency markets is increasingly dominated by financial institutions outside the dealer community ("other financial institutions" in the survey terminology). 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 the total turnover.
For the first time, the Triennial survey provides finer breakdowns for this category. Here, the increase in FX turnover has been driven mainly by:
- Lower-tier banks: A significant fraction of dealers' transactions with non-dealer financial customers is with lower-tier banks. While these "non-reporting banks" tend to trade smaller amounts and/or only sporadically, in aggregate they account for roughly one quarter of global FX volumes.
- Institutional investors and hedge funds: The most significant non-bank FX market participants are professional asset management firms, captured under the two labels "institutional investors" (eg mutual funds, pension funds and insurance companies) and "hedge funds". The two groups each accounted for about 11% of turnover.
Furthermore, the inter-dealer share has fallen to only 39%, much lower than the 63% in the late 1990s. This is the flip side of the increasing importance of other financial institutions, and has come about for two reasons. The first is that major dealing banks nowadays net more trades internally. Due to higher industry concentration, top-tier dealers are able to match more customer trades directly on their own books, which reduces their need to offload inventory imbalances and hedge risk via the traditional inter-dealer market. The second is the emergence of more sophisticated electronic dealing technology, incorporating liquidity aggregation and algorithmic trading, and which is also now accessible to a much broader range of market participants.
Similarly, non-financial customers - mostly comprising corporations, but also governments and high net worth individuals - accounted for only 9% of turnover, the lowest level since the inception of the Triennial in 1989. Reasons for the shrinkage in this category include the sluggish recovery from the crisis, low cross-border merger and acquisition activity and reduced hedging needs, as major currency pairs mostly traded in a narrow range over the past three years. Another key factor is more sophisticated management of FX exposures by multinational companies. Firms are increasingly centralising their corporate treasury function, which allows hedging costs to be reduced by netting positions internally.
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 also enabling quicker execution times and lower trading costs, ultimately resulting in an increase in total FX turnover.
The more fragmented structure that emerged after the demise of the inter-dealer market as the main pool of liquidity could potentially have harmed trading efficiency by raising search costs and exacerbating adverse selection problems. Yet, one of the most significant innovations to prevent this has been 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.
I now turn to a breakdown of the increase in FX turnover, concentrating on currency composition.
Currency composition of the increase in turnover
The survey shows notable shifts in the currency composition of FX trading, with the US dollar retaining its dominant position with an 87% share, rising from 84.9% in 2010, and the share of the euro decreasing from 39% in 2010 to 33% in 2013. However, two major themes stand out:
- The first one is the 60% increase in yen turnover relative to 2010, lifting its market share to 23%. As previously indicated, the monetary policy regime shift by the Bank of Japan triggered a phase of exceptionally high turnover, peaking in April 2013. However, yen trading had already started to rise rapidly in late 2012, as market participants anticipated Abenomics.
- The second theme, upon which I will elaborate further, is the significant rise in the global importance of emerging market currencies. The share of key emerging market currencies in total turnover increased from 12% in 2007 to 17% in 2013.
The ease and costs of trading minor currencies have improved significantly over the past few years. Transaction costs in emerging market currencies, measured by bid-ask spreads, have steadily declined and converged to almost the levels for developed economy currencies. As liquidity in emerging market currencies has improved, these markets have attracted the attention of international investors. The strong growth is particularly visible in the case of the Mexican peso, whose market share now exceeds that of several well established advanced economy currencies. Another important case is the renminbi, which has experienced growth of 250%, mainly due to a surge in offshore trading. China set itself the task of promoting more international use of its currency and introduced offshore renminbi (CNH) in 2010.
Internationalisation of the renminbi
While trading in renminbi represented only 2% of global currency trading last year (versus 87% for the dollar), international use of the renminbi has been increasing, with about 17% of China's global trade settling in its own currency last year compared with less than 1% in 2009. Trading and the allocation of central bank reserves in renminbi is expected to keep increasing at a sustained pace over the coming years. While the volatility of the renminbi has been very subdued for most of the past decade, and its direction rather predictably "one-way" under the tight control of its central bank, volatility has recently increased and the direction of the currency has become more uncertain. Furthermore, it is worth noting that the currency component of the financial reforms unveiled by the Chinese government last November (which detailed an ambitious and detailed plan for the next five to 10 years) was summarised by People's Bank of China Governor Zhou Xiaochuan as including a "transition to a market orientated exchange rate regime and a speeding up in the process of capital account convertibility". It is, therefore, not surprising that the renminbi should gradually become more volatile and its trajectory less "one-way".
So, in summary, the growth in FX volumes to an all-time high of $5.3 trillion in April 2013 was largely driven by: (i) an increase in investment in international assets, requiring greater hedging of currency exposures; (ii) a growing role of non-dealer financial institutions (smaller and regional banks, hedge funds and institutional investors); (iii) a further internationalisation of currency trading (particularly the renminbi), and (iv) a fast-evolving market structure driven by technological innovations such as electronic trading, liquidity aggregation and algorithmic trading techniques.
So let me now turn to money markets.
Recent money market trends
Global economic growth continues on a slow stabilisation path, supported by near-zero interest rates and balance sheet expansion by a number of central banks. To ensure a continued economic recovery, central banks have signalled their intention to keep short-term rates at low levels for as long as necessary.
Market participants are even more focused on central bank action and remain sensitive to any changes in short-term liquidity conditions as well as the economic outlook. Funding conditions remain generally improved. For example, three-month Libor-OIS spreads, which at the peak of the crisis reached highs of 200 and 350 basis points in the euro and US dollar markets respectively, have normalised over the past year (to just 12 and 15 basis points) as more recently has the bias in FX swaps. However, with the recent re-emergence of money market frictions, spreads have started to tick up, particularly in the euro market. Moreover, measures of near-term risk and uncertainty have increased in the past two months, as indicated, for example, by the flattening of the VIX futures curve.
With an ample supply of central bank liquidity, the trend of historically low money market rates persists. As a result, market participants continue to search for yield, whether it be in duration, credit risk or by diversifying into emerging market local bonds and equities. In addition, regulatory requirements continue to drive support for liquid assets, particularly in money markets. Therefore, the balancing act of liquidity, risk and return optimisation remains a challenge in the current low-rate environment, and is likely to persist over the short to medium term.
There have been two noticeable trends in money markets over the past quarter:
1. An increase in secured funding
There has been an ongoing sizeable shift from unsecured to secured funding by financial institutions, particularly in the euro area, as well as a shortening of maturity. In the unsecured market, banks' cash borrowings decreased by 44%, while their lending declined by 17%,2 with trading activity remaining concentrated on maturities of less than one week. Overnight transactions account for the majority of borrowing and lending activity in the unsecured market. The secured funding market's total turnover rose by 17%. Again, this was driven mainly by a large (27%) increase in overnight maturities, while the turnover out to one week also increased by 16%.
2. Changes in the repo market
The ICMA European repo market survey estimated that the market shrank by 8.2% over the second half of 2013 compared to growth of 8.6% in the first half. Despite the slightly positive year-on-year growth, the total market size remains below the levels observed in 2011 and before the crisis. Anticipation of future regulatory constraints is one reason for the continued contraction in repo books.
The composition of the repo market has also been shifting. As market confidence continues to recover, the share of directly negotiated repos has increased at the expense of electronically traded repos. Furthermore, the share of anonymous electronic trading cleared through central counterparties (CCPs) has increased, contrary to anecdotal evidence suggesting that banks were opportunistic in looking for lower haircuts in the uncleared market. One potential reason for this is the increasing tendency of Italian banks to trade through CCPs as a result of heightened counterparty credit concerns. In terms of collateral composition, there has been a notable increase in Italian collateral, and to a lesser extent Spanish collateral, while the share of German collateral was unchanged. However, the triparty agents noted that the biggest increase has been in French collateral, reflecting increased collateralised lending by US money market mutual funds to French banks.3
As banks continue to repay the liquidity facilities provided by the ECB, they have returned to the repo market for funding. The survey reveals that the market share of euro-denominated repos has recovered from 57% in June 2012 to 66% in December last year. As a result, collateral remains in high demand, not only from central bank holdings (due to asset purchases) and capital requirements, but also from banks attempting to secure funding.
Finally, I would like to make some comments on trends that are evident in both the FX and money markets.
1. The collateralisation of derivatives transactions, and the introduction of central clearing in derivatives and repo markets
The financial crisis demonstrated that improved transparency in the OTC derivatives markets, as well as further regulation of OTC derivatives transactions and market participants themselves, would be necessary to limit excessive and opaque risk-taking via OTC derivatives. Recent regulatory reforms are based on the widespread trading of OTC derivatives on electronic platforms and the clearing of these transactions through CCPs, and are intended to strengthen financial stability and mitigate the systemic risk posed by OTC derivatives transactions.
The advantages of this regulation are very clear. In addition to increased transparency, counterparty risk can be significantly reduced by moving to centralised clearing, with its combination of collateralisation and multilateral netting.
Interestingly, central clearing is also increasingly becoming the market standard in repo markets, despite the absence of any relevant legislation. The euro money market survey conducted by the ECB indicates that 71% of all bilateral repo transactions in 2013 were cleared by CCPs, compared with a revised figure of 56% in 2012. Furthermore, the ICMA European repo market survey showed an increase in anonymous (CCP-cleared) electronic trading.
The new derivatives legislation complements elements of self-regulation already introduced by market participants well before the onset of the financial crisis. For some time, the widespread use of credit support annexes (CSAs) has obligated market participants to post collateral against their derivatives exposures. However, it is very important that the margin requirements are calibrated to be sufficiently high to serve their purpose during periods of unusually high market stress, not just during the normal patterns of the business cycle.
2. Collateral management
Collateral management has evolved rapidly over the past decade with increasing use of new technologies. Moreover, since the financial crisis, it has emerged as a central means for market participants to reduce funding costs and counterparty risk. The introduction of derivatives legislation and the centralised clearing of derivatives have led to an increased focus on collateral management.
The banking industry's objective has been to become more active and efficient in the management of collateral across business lines, which requires a centralisation of expertise. Banks seek (i) a more efficient decision-making process, aided by increased transparency of available collateral; (ii) a reduction in operational risks on collateral transactions; and (iii) an enhancement of banks' capabilities to monitor credit policies and control the credit risks associated with collateral transactions.
Banks are investing heavily in collateral management and, with services such as cheapest-to-deliver algorithms, collateral optimisation and collateral transformation services, hope to generate significant profits from it. With optimised infrastructure and reporting capabilities, specialised collateral management staff and a scalable business model, commercial banks may be able to attract lucrative collateral management mandates from customers, or smaller financial institutions , who are unable or unwilling to make the high initial investment required.
3. Rebuilding confidence
In the wake of the manipulation of market reference rates by commercial banks, regulators have been increasingly concerned with reference rate reform, with a focus on restoring credibility and eliminating the risk of manipulation.
In addition to the investigation into the manipulation of Libor, wide-ranging investigations are now being centred on alleged collusion and rate manipulation around the time that FX rate benchmarks are set.
With respect to Libor, it is widely believed that any reliable reference rate should be (i) anchored to observable transactions, and (ii) more representative of underlying market conditions.
However, this raises problems of its own.4 As short-term markets remain quite segmented, particularly in the euro area, the relationship between market reference rates and the individual cost of funding has been significantly weakened. Furthermore, as bank funding has been gradually (but significantly) shifting from the unsecured market to the secured market, declining volumes in longer tenors and higher shorter-tenor concentration are creating uncertainty as to what truly represents an appropriate reference rate. For those interested in a more detailed analysis of this topic, a report published in March 2013 by a Working Group established by the BIS Economic Consultative Committee, and chaired by Hiroshi Nakaso (Assistant Governor of the Bank of Japan), reviews the issues in relation to the use and production of reference interest rates from the perspective of central banks.
Let me conclude with some general observations about regulation. The financial crisis exposed significant weaknesses in the resiliency of banks and other financial market participants to financial and economic shocks. As part of the response, the new Basel rules impose both qualitative and quantitative changes to capital requirements, in addition to minimum liquidity buffers. Furthermore, systemically important ("too big to fail") banks have been identified and will be made to adhere to even more stringent standards.
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.
1 I would like to express my sincere thanks to Andreas Schrimpf, co-author of "The anatomy of the global FX market through the lens of the 2013 Triennial Survey", upon which portions of this speech are based, and whose support throughout the drafting process has been invaluable.
2 Euro Money Market survey (ECB).
3ICI Money Market Fund Holdings data for January 2014: http://www.ici.org/research/stats/mmfsummary/.
4"Reference interest rates: role, challenges and outlook", ECB Monthly Bulletin, October 2013.