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Cash and don't carry?

Published in Automated Trader Magazine Issue 12 Q1 2009

Has the global economic crisis impacted on the FX market, and if so, how has that affected trading strategies? William Essex went in search of easy volatility.

To start with a cross-reference, there's a news story on page 11 about Standard Chartered Bank's implementation of a new customised dashboard designed to give their FX traders an aggregated view of liquidity over a range of ECNs. The new dashboard comes from Progress Apama, and in an interview connected with our news story, Dr John Bates, founder and general manager of the Apama part of Progress Apama, told our researcher: "Over the last two years Foreign Exchange market fragmentation has increased with the creation of new FX trading venues. The drive of algorithmic trading continues to influence FX and its growing popularity created a need for greater algorithm differentiation in the face of intensifying competition."

Dr. John Bates

Dr. John Bates

Fragmentation is one of the key drivers of change in a whole range of markets and asset classes at the moment, and a theme of this issue of this magazine, but the term has a specific and slightly different meaning in the context of FX. This is a huge market, for one thing, and although it is not exactly true to say that it is an unregulated market, it does dwarf any viable combination of the regulators who fulfil an oversight function in relation to any of the main FX-market participants. FX is also, to state the obvious, the underlying asset class for all global economic, commercial and investment activity, in the sense that any movement of goods, etc., from one currency area to another necessarily triggers an FX transaction.
Fragmentation in the FX market is not the (un)intended consequence of a regulatory initiative like Europe's MiFID.

There may once have been a Bretton Woods Agreement, and we may remember the ERM, but no Directive, from whatever source, can shape FX. This is fragmentation brought about in a "free" market by the spread of automation. FX has always been fragmented, in the sense that anybody can play, but now, to borrow an old buzz-phrase, anybody can plug and play. Bates mentions the creation of new venues, but they are part of a wider story: anybody who "goes global" effectively goes into FX. Here, Progress Apama's Dr Giles Nelson adds an indirectly relevant but nonetheless interesting point. "FX has not had the legacy IT infrastructure that, say, equities have had, so it has adopted far more readily to computer-based and algorithmic trading."

In FX, fragmentation is almost a steady-state phenomenon. Todd McDonald, global head of FX electronic pricing and trading at Standard Chartered, says: "One of the surprising things is how much fragmentation has persisted in the FX market. With the advent of technology, we assumed that we would come to one true marketplace a lot quicker than we have, but that's not the case." Part of this is that it's in nobody's interest to attempt a reduction in FX market fragmentation. Neither the exchanges, nor the buy side, nor the sell side need to aggregate the "point of sale", and consolidation is a meaningless term in this context. As McDonald says: "Fragmentation in the FX market has been around for years. It's an OTC market. It's always been that way." If technology can aggregate a satisfactory view of the market, who would be big enough or bold enough to take a lead in aggregating the market itself?

Todd McDonald

Todd McDonald

So. If FX is fragmented because, to put it colloquially, we can all do it, and it's becoming more fragmented because we're all connected, the next question is, where do we start? Or, to put that more soberly, in a context of global economic uncertainty, with banks collapsing, whole economies teetering on the brink, downside opportunities vastly outnumbering the upside, is this a good time to be taking a more pro-active approach to our FX exposure and possibly beginning to treat it as a potential source of alpha in its own right - and if so, where do we start?

Perhaps the answer to that last one is: buy a dashboard. Bloomberg has also launched a new dashboard this month (see picture overleaf), which combines a range of data sources with a range of analytics and a trading capability. We spoke to Philip Brittan at Bloomberg about the FX Dashboard. Brittan said: "The FX Dashboard allows everyone in FX to get all the key indicators at their fingertips. All data is in real time, and if you click on a bid:offer, you can trade it." Views can be customised, and users can create their own measures.
And then, fresh from reviewing some gloomy economic data for another story, we went on to ask Brittan about the prospects for the FX market. And Brittan said: "It's a great market, in absolute terms and relative terms. It's an unbelievably good market. FX is doing well, volatilities are high, volumes are strong, banks continue to report solid revenues and profits." And that's when the sun came out.

Dr Giles Nelson

Dr Giles Nelson

The substantive point to make here, of course, is that the FX market isn't going to roll over and die just because of some measly little global macro-economic catastrophe. It's too big for that. Brittan says: "It seems that increased volatility is here to stay for a while, the fundamentally necessary hedging and cross-border transacting that drive the FX market certainly aren't going away, and in fact with the elevated volatility we do see a number of people who are looking at FX as an asset class, as an investment vehicle to try to take advantage of some of that volatility."

As that suggests, all you get in FX is movement - volatility - and these days, there's a lot of it about. This is, to put it mildly, an auto/algo-friendly market, and one where, pretty much uniquely, every down triggers a corresponding up. But how best to get into it? If the economic crisis has pumped volatility into FX, has it also impacted on established trading strategies?

Philip Brittan

Philip Brittan

Yes.
Brittan says: "The only large statement is that as economies move towards zero interest rates, the concept of the carry trade is in difficulty. That's one tectonic shift." Carry trades don't give much back to the trader any more, and can easily be swamped by volatility. To this, McDonald adds the comment that: "It's going to take longer for rates to come down close to zero for some emerging-market countries, but we're getting there." Run your emerging-market carry trade now, while rates last.
But factor in the risk of sovereign default. This is still (surprisingly?) readily dismissed by many observers, even post-Iceland, but the perceived strength of currencies can be tied back to national/regional economic factors, and potentially adds a further dimension to risk and volatility. There's also the neat truism that even a very large and politically united state in possession of a massive budget deficit might be in line for a currency devaluation. With potential weakness at both the emerging and developed ends of the macro-economic spectrum, this looks like it could be a fascinating game.

But not a game played on credit. In a discussion of FX market movements towards the end of 2008, Mark Warms at FXall said: "There was an impact of the global crisis in the forward market, the FX swap market, and that is because it's a market based primarily on banks' ability to lend to each other. Fortunately, as LIBOR spreads have come in and central banks have taken actions to alleviate those concerns, we've also seen the liquidity come back in the forward and swap market and return to normal."
Although "normal" might be more plain-vanilla than it used to be. Making a similar point about the FX market today, McDonald says: "If you look at the speculative community, credit is an issue. If you look at something like spot FX, it's a perfect vehicle for people to express views and more efficient from a credit standpoint." Even in the FX markets, money, in the sense of the actual folding stuff, talks loudest.