FX saves financial markets

Working the financial markets has never been more difficult – or rewarding. With foreign exchange leading the way in a fiscal revolution, World Finance illustrates exactly how a proficient company really can change the rules of the game

 

Nothing can illustrate more vividly the increasing significance of the world’s foreign exchange markets than the ongoing turmoil in the eurozone. As spreads between sovereign bonds in the European Union (EU) behave in ways that would have been considered improbable – even impossible – even a few years ago, the search for safer realms to do business in the currency markets has become increasingly urgent.

Historic phenomenons such as the difference in the yields of ten-year bonds between two of the eurozone’s most powerful members, France and Germany, now the widest in two decades, have triggered a whole new philosophy of forex trading as investors struggle to interpret the immense forces at play. And which traders, regardless of how profound their expertise, would have predicted that 10-year spreads would widen so sharply in such renowned safe havens as Austria, Netherlands and Finland?

As Darren Williams, Senior European Economist at AXA-owned global asset manager AllianceBernstein – with currently boasts more than $401bn in assets – observed recently: “This is happening despite the fact that all three countries have credit metrics on a par with Germany, and that two of them, the Netherlands and Austria, have operated a de facto monetary union with their German neighbour since the early 1980s.”

Bigger future
With emerging markets playing a fast-growing role, the future in forex markets will clearly not be what it was. As Bank of England researchers pointed out in January, much of the interest in these relatively unsung currencies stems from fears about the richer countries of Europe. “Many emerging markets have been conspicuously resilient during the financial crisis, increasing investors’ appetite for the asset class,” the researchers argue, adding that the “higher perceived risk of many advanced economies [is] unprecedented since World War II.”

The currency universe is developing rapidly right across the spectrum, skewing previously held principles as more and more nations allow the value of their currencies to float in an enormous and swirling ocean like so much flotsam and jetsam. The turmoil in the eurozone has fuelled a global demand to understand how to navigate these waters.

Exporting companies, corporate treasurers, banks and the entire financial sector, investment firms and individual investors: all of them need to know what’s happening and where to head. One of the time-honoured axioms of forex markets is that they thrive on volatility and, as the eurozone reveals on an hourly basis, there’s certainly a lot of volatility around. The overwhelming bulk of research shows conclusively there will be a lot more in what can safely be described as the age of forex.

A trillion to one
Meantime, the forex ocean expands almost by the day. Average daily turnover in the global markets hit $4trn last year, according to a survey by the Bank for International Settlements. Other institutions put the figure somewhat higher. What’s certain is that it’s growing and the bulk of the trade is driven by banks of all kinds including central banks, governments, institutional investors, hedge funds, high-frequency traders and other financial institutions. Corporate treasurers, who are working the markets more than ever, and a new fast-growing wave of retail online investors account for the majority of the remainder.

Indeed, the influx of retail investors is one of the modern phenomenons of the forex market. By 2010 they accounted for 10 percent of trading in the spot market, or $150bn a day. Globally, the dominant nation is Britain, with nearly 37 percent of all daily trading taking place in the City and elsewhere in the UK, while the US comes a poor second with nearly 18 percent.

The main point of the Bank for International Settlements’ latest survey is that the current average turnover is 20 percent higher than it was just four years ago. And as volumes have grown, so has the number of market participants. In their wake has emerged a whole new class of quasi-banks specialising entirely in foreign exchange – intermediaries in the markets for companies, individuals and even many banks who have handed them the forex trading function.

Forex growth seems unstoppable, with more and more institutions and individuals entering the markets. According to a research paper released by the Bank of England, the forex ocean will double in size over the next three decades. That is, to more than $8trn, an inconceivable sum even a decade ago. However, at that immense level of turnover, there may be grave risks. As the researchers point out: “If – as the simulations presented in this paper suggest – global capital flows grow to dwarf those experienced in the lead-up to the 2007-08 crisis, the stakes will become higher still.” In short, the ebb and flow of such vast sums could destabilise entire economies as they nearly did during the financial crisis.

24 hours a day
But what is the forex market? In several ways it’s unique, and not just because it’s the biggest of all asset classes. It boils away 24 hours a day, weekends excepted, right across the world. It’s decentralised, having no central exchanges as in equities and commodities markets. It’s distinguished by much lower margins and much higher leverage – debt taken on in the hope of increasing profits – than other markets.

Basically, the market functions as a giant pool of swaps. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. So it’s all about the relative value of one currency as measured against another. And that judgement is made at the present time (the spot market), some future time (forward and options markets), and into the assessment of that valuation is invested some of the most complex research done on any of the markets.

As Harvard Professor Jeffrey Frankel explains: “In the spot market parties contract for delivery of the foreign exchange immediately. In the forward market, they contract for delivery at some point, such as three months, in the future. In the option market, they enter a contract that allows one party to buy or sell foreign exchange in the future, but does not require it (thus the word “option”).

Trading in cash
With $4trn washing around the markets every day, it’s hard to imagine that the forex market is one of the youngest, barely 40 years old. It started in the 1970s when the post-war Bretton Woods system of fixed currency rates began to crumble and the biggest industrial countries allowed their money to float on international markets, albeit nervously at first. One by one, the richer countries abandoned capital controls until by the 1990s nearly all of them had floated their currencies. Since then, scores of other nations have followed suit.

Back in the 1970s, practically all forex transactions underpinned the export and import of goods and services, where exchange rates were expected to be stable. Things now are very different, as Frankel points out: “Today financial transactions overwhelmingly dominate. When the exchange rate rises, it is generally because market participants decide to buy assets denominated in that currency in the hope of further appreciation.” Result? Volatility is the hallmark of the modern forex markets. And yet it seems that trade follows currency these days, rather than the other way around. In the first few years after the euro was established in 2001, trade within the eurozone shot up by 30 percent. The same phenomenon has been observed in African countries that formed currency unions.

As the market expands, its sheer immensity is attracting new corporate entrants who in turn add an extra dimension in terms of expertise. As Kim Fournais, Co-founder and Chief Executive of forex specialist Saxo Bank, explains, the forex markets practically breed innovation: “Clients want more transparency, better products, pricing and services.” In practical terms that means providers compete to deliver new tools to help fathom the undercurrents of the market in the form of technical studies, charts and research.

The collapse of transaction costs has massively boosted participation, particularly among retail investors. Thus in January UK-based HiFX, a specialist forex dealer established ten years ago with the express purpose of investing in technology to speed up transactions at lower costs, cracked the £100bn mark in total exchange traded. Claiming some of the fastest transfer times in the industry, HiFX’s record for a transaction is one minute from order to execution. It’s a measure of the inroads that specialist firms such as HiFX, which advised on or executed £9bn of forex dealings by value last year, are making on the giant retail banks that it has 2,000 corporate clients around the world including the British Post Office for which it runs the international payments division.

Today Germany, tomorrow..?
The ubiquity of electronic, online execution that drives down fees and the arrival of specialist forex firms which roll out new services on an almost daily basis progresses the forex market further. For instance, in January FOREX.com, the online trading division of New York and London-based GAIN Capital, launched a service in Germany that gives traders in that country access to 70 markets in forex, sharemarket indices and commodities. As GAIN Capital’s Chief Executive Glenn Stevens explains, Germany typifies the runaway growth in forex. “Last year trading in Germany increased by an estimated 30 percent and we’re confident this trend will continue into 2012 and beyond.”

For Kathleen Brooks, FOREX.com’s Director of Research, the eurozone turmoil is playing a big part in retail investors’ interest – indeed fascination – with forex. “Retail investors are increasingly aware of the importance foreign currencies play in global economics and the impact that currency values have on other forms of investment,” she says. And to keep them plugged into these fast-changing markets, FOREX.com’s service allows subscribers to download the software onto their iPads, iPhones and Androids. Last year, GAIN Capital measured a staggering 600 percent increase in mobile trading via such devices.

Pleasure-pain principle
Inevitably, the ubiquity of trading platforms has blinded some retail investors to the dangers lurking in forex markets. As the European Securities and Markets Authority (ESMA) warned late last year, a number of unauthorised and unregulated firms popped up and trapped the unwary. If retail investors are in doubt about the authenticity of a firm, regulated firms will appear on the registries of watchdogs such as the US’s Commodities Futures Trading Commission, the UK’s Financial Services Authority, Hong Kong’s Securities and Futures Commission and similar bodies.

Like any investment, losses are possible. “Investing in the foreign exchange market is not for the unwary or risk-averse investor,” explains ESMA. That advice particularly applies to leveraged derivatives transactions. “The higher the leverage, the more likely you are to lose your entire investment if exchange rates move in a direction you do not anticipate… So you should not invest money you cannot afford to lose,” the authority says.

All reputable firms will tell investors that forex is a zero-sum game – for every winner there’s an equivalent loser. However, the explosion in learning tools and research provided by the industry, specialist firms in particular, means that it’s much easier to acquire knowledge than it was even a few years ago to trade successfully in a greatly evolving marketplace.

In such a rapidly expanding market, World Finance recognises it can be difficult for the experienced and uninitiated alike to approach trading in the forex industry. The challenge is not only to identify the credible operators, but to assess which providers offer the best platform and level of service for an individual’s particular needs. In the face of mass marketing from all providers, there is little in the way of guidance to the industry.

Readers of World Finance can take heart then from the Foreign Exchange Awards 2012.

These accolades offer recognition to the excellence and achievements of winners in the field of FX trading. They also offer an assurance for quality of service provided by our winners, presenting an invaluable guide to the providers and companies of distinction in the industry. World Finance wishes all its forex winners the warmest congratulations and hopes that they enjoy and benefit from the mark of excellence that our awards represent.