The changing face of foreign exchange
The last year has seen many changes in the FX market, with rising volumes and significant developments such as the acquisition of EBS by Icap. To many, foreign exchange has come of age as an asset class.
But where has this growth come from? Recent research from Greenwich Associates identifies that FX trading volumes, rose by 14% in 2005. While this growth figure is lower than the growth rate of 2004 (25%), significantly, the boost appears to have come from fund managers, pension funds and non-traditional FX traders, such as retail traders.
CLS has seen the number of third parties using the CLS Bank service rise by 30% in the last year, with 71% of this growth attributable to fund accounts, which now number over 400. CLS Bank is now settling on average over 250,000 instructions each day, with a gross value in excess of US $ 2.7 trillion
While volumes from the hedge fund community continued to grow in 2005, this growth has slowed down. Market commentators cite the lack of FX market trends as the key factor in lower volumes from the hedge fund community.
The inability to ‘read the market’ has meant the performance of those hedge funds trading currencies has suffered, in turn, reducing actively traded FX volume. All this has been set against the backdrop of a slowdown in the overall growth of the global hedge fund industry in the last year or so.
The rise in institutional and pension fund-related FX volumes can, in the main, be attributed to two key factors. First, that fund managers now view FX as an asset class in its own right, with the corollary being more active foreign exchange trading.
This, in some part has been caused by pressure on pension and other funds to deliver greater returns from their assets, which in turn has led to them looking outside their traditional asset classes of equity and bonds to other areas including foreign exchange.
As the pension fund deficit debate continues to roll on in the US and W. Europe, the pressure to achieve better performance intensifies and the attraction of alternative assets such as FX increases.
Secondly, FX related to cross border trading has increased with rising cross border volumes. This is a trend which is likely to continue, driven by the search for higher returns and helped by reducing costs on cross border transactions.
As the proportion of funds held “off-shore” has grown so has the requirement for fund managers to achieve best execution in FX. This is also fuelling the accelerating adoption of e-trading by this segment.
The other significant trend that has not been identified by recent data is that of program trading. The New York Stock Exchange claims that, on average, program trading accounts for more than 50% of all the trading done on the stock market.
While historically, this has been conducted by the sell-side, the proliferation of quantitative hedge funds has led to an increased influence in this area from the buy-side in FX.
These algorithm based trading models have evolved quickly from arbitrage only models to momentum models. These programmes represent a small proportion of daily average values in comparison to the equity markets but seem set for high growth.
This is all good news, but new participants to the industry should be aware of the settlement risk posed by FX. This risk is greater than in other asset classes as each currency must be delivered in its home country. Due to time zone differences, several hours can elapse between a payment being made in one currency and the offsetting payment being made in another currency.
With volumes in the FX industry at an all time high and with the majority of volume growth being delivered by pension funds, real money funds and retail traders, new participants need to examine their exposure to settlement risk.
While this type of risk is not unique, FX poses a greater challenge due to the sheer value of volumes traded and because of the need to deliver each currency in its domestic marketplace.
Whilst the market has shown strong growth and a diversification in participation, margin compression coupled with higher volumes has re-emphasised the need for operational efficiency.
Latest research from Instinet shows that investment managers are taking the initiative on cost control and transparency. Successes from investment in front office projects to improve efficiency have encouraged a growing impetus to pursue a similar focus on back office operations.
There is still much waste in back office operations caused by under investment internally and the legacy of inefficient operational processes. Research conducted by Omgeo, showed that a failed securities trade can cost a fund up to €340.
In the case of FX, a failed trade for a fund can cost $125- $150 according to our research with fund managers. Ultimately, this cost is passed on to the fund. Industry-wide automation to improve operational performance remains overdue but has had a chequered history in terms of gaining consensus, or indeed being implemented.
The study also found that firms are therefore increasingly focusing on enhancing their internal technologies, leaving external gaps as the greatest hurdle to overcome in the future.
Thus, while many firms have made significant progress, until all firms make a commitment towards achieving the ultimate goal of industry-wide automation, the overall efficiency levels that companies can achieve are limited by their less automated trading partners within the business cycle.
In the self-regulated market of foreign exchange there has been a consistent focus on both front office and back office costs in addition to greater scrutiny of risk management procedures.
As increases in volume through the strong growth in cross border investment and hedge fund activity, this cost and risk management scrutiny will only increase. The extension of the CLS service to the fund management community delivers a market standard for FX settlement to the investment and pension fund industries.
CLS addresses the settlement risk issue for funds with cross border investments, enabling pension funds and asset managers to demonstrate to trustees and consultants that best practice and ‘prudent man’ rules are being employed.
CLS offers the fund manager the opportunity to track the exact status of their FX transactions throughout the entire transaction cycle. Real time transaction and settlement information provides update reports of trade status, enabling full operational oversight.
Through pre-matching of each trade, the participants report the virtual elimination of failed settlements and related costs. This, combined with the PvP settlement methodology, or delivery versus payment (DvP) for FX, means that the fund principal is protected.
CLS multi-laterally nets all obligations for each value date, fund managers can significantly reduce their individual currency funding requirements to settle. This, in turn, decreases both liquidity charges and operational expenses. Funds can therefore demonstrate to trustees and consultants that they are delivering value for money to investors and reducing settlement risk.
Newton Asset Management has reported that the benefits in both areas have been tangible. Where CLS has been used, trading credit limits have ceased to be an issue, volume growth has been easily absorbed and the time saved on trade failure investigations and correction has been considerable.
Over the coming years there are plans to enhance the CLS Bank service, with the first new product being a complete end-to-end service post execution to settlement of cash flow positions for non-deliverable forwards (NDFs) and FX option premiums.
CLS Bank currently settles payment instructions related to trades executed in four main instruments – FX spot, FX forwards, FX option exercises and FX swaps. Extending CLS Settlement to NDFs and FX option premiums will mean that manual intervention will be eliminated from the process for both instruments.
CLS Bank will provide complete all-in-one straight through processing with considerable cost benefits, and an accompanying standard legal framework to govern the process.
Other possible services under review include the cash flow settlement for OTC derivative products and the confirmation, matching and settlement for same day FX instructions.Extending our product portfolio encourages greater participation and volume growth. This in turn reduces the unit cost of CLS Settlement for all instruments, and keeping this on a downward trajectory for all participants is a key priority for the company.
The ongoing outreach to the investment industry is part of a wider plan that will see CLS Bank look to deliver its benefits to a wider cross-section of the market.
CLS has become the market standard, and it is our goal to build on this achievement for the benefit of the market as a whole
Jonathan Butterfield
Executive Vice President, Marketing and Communication
CLS Bank International
Entry Filed under: SUPPLIER AND TECHNOFIN®, Clearing and Settlement, Custody, Forex Strategy, Online Trading, Securities
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