The enormolls technological advances thal we have seen over the last 20 years have had a profound impact on how the FX market operates. Everything from backortice systems to trading has been affected by the changes, generally making things faster, more accurate, and more reliable. Bank dealers are now less likely to find "surprises" ilt the end of the day. having second-by-second access to their exposure. Technology has also enabled a new breed of competition to arise for the old-school voice brokers, namely electronic platforms like Reuters, FXAII, EBS, Currenex, etc.
Whereas before a trader was forced to make the rounds in an effort to find a price. he can now instantly see the best tradable bid/ask with a single key stroke. With all of the liquidity providers now imputing their best price into a common platform, it should in theory be a much better way of going about things, and for the Illost part it is. However, don't feel lOO sorry for the dealer, for there will always be a place for his trade. Although electronic platforms are great for "vani lla" transactions, if you are a fu nd trying to push through a large Mexican peso trade in early Sydney time. your only hope for success is contacting a good dealer that can make it happen. No e-platform wi ll ever make a market out of thin air.
A QUESTION OF NUMBERS
Technological advances have helped drive the growth in FX turnover, and although much is said of the tremendous volumes traded on a daily basis, the oft-quoted statistics should be taken with a grain of salt. The FX market is by far the largest and most liquid market in the world, with daily FX turnover estimated al around $2 trilliol1. If this seems like a lot to you, it is because it is. Compare FX volumes to the tiny $50 billion traded at the NYSE or the $800 billion traded in government debt and you gel an idea of the size of the market. yet the first thing to take into consideration when hearing that "FX turnover has increased 50 % over the last 3 years" is that turnover is measured in US dollars. A depreciating dollar will directly translate into ballooning turnover volume. l However, even if the figures are sOl11cwhal skewed, the fact remains that billions and billions arc being traded every day. So the question becomes. "Who is trading all of these thousands of billions of dollars?"
The truth is that nobody really knows, but it may be the case that turnover numbers are greatly exaggerated due to the multiplying effect of FX transactions and the use of notional funds. For example, when multinational X approaches their bank to trade 100 million euros for dollars, a two-way transaction lakes place, so the 100 million goes on both of their books. The bank then quickly contacts one of their counterparties to offset their exposure, which may in turn offset their exposure through the derivatives market. A single transaction can therefore set in motion a whole set of subsequent transactions totaling well over the original € 100 million in cash.
Although it is hard to tell exactly where these flows are coming from, what is undeniably true is that FX volumes have been steadily increasing. Volumes are in fact rising at such a tremendous pace that only a fundamental shift in people's perception of FX can explain the current situation.
THE NEW ASSET CLASS
As little as ten years ago. most asset managers regarded FX as an annoying side transaction that simply had to be done, and most did not panicularly care for it. If a large international mutual fund wanted 10 buy European stocks. they would simply approach lheir custodian bank and tell them to take care of it. This was a case of Ihe simpler the better, since in their minds their core competencies lay in picking stocks, Ilot the direction of the dollar. This may seem like a reasonable, approach when things are going well, but III times of uncertainlY and low yields,
every penny begins to matter.
After the bursting of the stock market bubble and 11 September, times got tougher for asset managers and lhey soon began to look at FX with kinder eyes. They realized lhal their FX holdings could actually be regarded as a separate asset class, which had to be "optimized" in their constant search for alpha (excess return).
This change in perception proved to be a radical shift for the investment com mu¬nity, and continues to be a major driving force in the FX markets today. More and more funds are now actively managing their FX exposure, either in-house or by employing a currency overlay manager (COM). This renewed the foclls on FX and the search for yield has in turn led to the resurgence of the carry trade,3 which in turn often leaves strong trends in its wake. In an age of low yields and increasingly competitive (efficient) markets, this new brand of FX participant is here 10 stay.
Black Wednesday, 1992
Perhaps the most infamous FX trade was George Soros & Co's short sterling bet that managed to ~break the Bank of England." By September of 1992. Soros and other speculators had begun to take increasingly large short sterling positions on the groundS that the UK economy was suffering from high inflation and a slumping housing market. At the lime, the UK had entered the ERM (forerunner to the Euro) at 2.95 Deutsche Mar1<.s to the pound, and the GBP/DM pair was allowed to trade a narrow range, with 2.n8 set as the bottom. If the rate fell below that level, the Bank of England would have to intervene in order to prop up their currency. On Sep.13th, now known as "Black Wednesday" several big players including Soros and Goldman Sachs realized thaI the BoE would nol be able to support the pound Indefinitely, so they decided to stage a massive speculative attack on the currency. The UK Chancellor tried to stir up some demand for the pound by raising rates not once, but twice in the same day, yet by evening it became obvious that they could not continue to prop up "Her Majesty" so they decided to throw in the towel and unceremoniously withdrew from the ERM. The pound was then free to trade outside of the fixed range and eventually fell to as low as 2.20 OM. The UK govemment is said to have lost around 3 billion pounds in their effort to prop up their currency, while Soros is said to have personally taken home around $1 billion in the process ...... not winning him many friends in the UK!
Moral of the story: When everything is in your favor, go for the home-run trade
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