denominated assets held within portfolio
overall currency exposure which can be managed by outside currency manager.
Hedge funds
Trade foreign exchange as a separate asset class
Speculate using computer models
Buy and sell foreign-denominated assets within the fund.
Central banks:
maintain foreign currency reserves and will adjust weightings of currencies
are responsible for inter-government and institutional settlements
may intervene in the market to affect the value of the domestic currency.
Sovereign wealth funds (SWFs)
Sovereign wealth funds (SWFs) are state-owned investment funds. SWFs are focused on longer-term returns and can generally hold a wide range of currencies and assets, which translates to more diversification versus central bank reserve managers. About 66% of SWFs are largely funded by oil and gas exports while non-commodity SWFs are typically funded by transfer of assets from official foreign exchange reserves and government budget surpluses. Examples of major funds are Abu Dhabi (ADIA), Kuwait (KIA), Government Fund of Norway and the Chinese SAFE Investment Company.
Commercial banks
Spot trading
interbank market making
servicing client orders
speculation.
Forward trading
interbank market making
speculation
works with money market desk to manage bank’s balance sheet funding.
Option trading
interbank market making
speculation.
Private individuals
speculation
sale and purchase of overseas assets – usually property
hedging currency exposures.
Banks’ share of global foreign exchange
Over the past 25 years a combination of large bank mergers and aggressive trading practices has effectively muscled the small banks out of the foreign exchange market, although traditionally they had supported it. It is now estimated that the top ten banks account for over 75% of foreign exchange transactions by volume and the top five somewhere from 50% to 60%.
Trading is increasingly being done over electronic platforms (e-trading) and this means that concentration becomes even more pronounced, with the top three platforms (Deutsche, Barclays, UBS) estimated to account for around 60% of the business. Indeed, the banks’ focus is on enhancing electronic trading platforms to attract the customer. It has taken a long time and considerable expense from the big players to build up this infrastructure. This creates huge entry barriers or at best a serious challenge for aspiring new entrants.
These multi-dealer trading venues are commonly referred to as electronic communication networks (ECNs) and formed the second phase of the electronic revolution led by Reuters and EBS with electronic inter-dealer brokers in the mid-1990s. EBS and Reuters Match are still the primary funnel for foreign exchange business.
The major banks’ emphasis is in fact not so much trading in a proprietary manner but to attract transactional and trading flows, i.e., volume. Foreign exchange is considered a core product for the major banks. There is very little capital required to support the business, which is essentially an off balance sheet product.
Furthermore, the product is for the most part short-dated, extremely liquid and client-driven, which adds to its attractions. This in turn generates an impressive return on capital. It is generally recognised that for banks to offer a full service, scale is required; first, to provide liquidity and, second, value- added services, such as technical research, that differentiate them from the pack.
It should be emphasised that the key issue is not so much about price, as, for the vast majority of time, there is not much difference in this respect amongst the major banks. It has more to do with the provision of liquidity to their customers. This boils down to the willingness and ability to quote prices in virtually all conditions and in the required size.
Foreign exchange, however, is still relationship-based and while customers use e-commerce tools (dealing platforms) in volatile markets, ideas (market colour) can only be provided direct from the dealing room. This is invaluable.
The BIS figures in Table 3.2 show that the foreign exchange market continues to grow. It is without doubt the largest and most liquid market available, and is likely to be spared undue regulation in the future, unlike derivatives. It is apparent, however, that liquidity, if we take turnover as a proxy, is limited to a small group of currencies and is concentrated within a very small number of banks. I shall be talking more about liquidity later, in chapter 11.
The underlying message of this book is that with floating exchange rates comes extreme volatility and with that comes an increasing need to hedge or manage that volatility. The data we looked at above (again, in Table 3.2) suggest that hedging is indeed increasingly employed, with vanilla products (spot and forwards) still the favoured method. I will discuss these vanilla products in depth for this very reason.
The growth of sovereign wealth funds, hedge funds and international funds in general has certainly driven foreign exchange activity for portfolio diversification and trading. The foreign exchange market is probably going to be a larger focus for investors in the years ahead given all of the above and because increasing government debt issuance globally will require some element of overseas buyers.
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