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Downsized FX markets may have significant implications for liquidity moving forward

Quarterly Review out today from the Bank for International Settlements 11 Dec

Say the BIS, the "central banks' central bank":

For the first time in 15 years, FX trading volumes contracted between two consecutive BIS Triennial Surveys. The decline in trading by leveraged institutions and "fast money" traders, and a reduction in risk appetite, have contributed to a significant drop in spot market activity. More active trading of FX derivatives, largely for hedging purposes, has provided a partial offset. Many FX dealer banks have become less willing to warehouse risk and have been re-evaluating their prime brokerage business.

At the same time, new technologically driven non-bank players have gained firmer footing as market-makers and liquidity providers. Against this backdrop, FX trading is becoming increasingly relationship-driven, albeit in an electronic form. Such changes in the composition of market participants and their trading patterns may have significant implications for market functioning and FX market liquidity resilience going forward.

This review explores the evolution of trading volumes and structural shifts in the global foreign exchange (FX) market, drawing on the 2016 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity.Central banks and other authorities in 52 jurisdictions participated in the 2016 survey, collecting data from close to 1,300 banks and other dealers.

For the first time since 2001, global FX trading declined between two consecutive surveys. Global FX turnover fell to $5.1 trillion per day in April 2016, from $5.4 trillion in April 2013. In particular, spot trading fell to $1.7 trillion per day in April 2016, from $2.0 trillion in 2013. In contrast, trading in most FX derivatives, particularly FX swaps, continued to grow. In addition, a number of emerging market economy ( EME ) currencies gained market share, most notably the renminbi.

Part of the decline in global FX activity can be ascribed to less need for currency trading, as global trade and capital flows have not returned to their pre-Great Financial Crisis (GFC) growth rates. However, conventional macroeconomic drivers alone cannot explain the evolution of FX volumes or their composition across counterparties or instruments. This is because fundamental trading needs only account for a fraction of transactions. Instead, the bulk of turnover reflects inventory risk management by reporting dealers, their clients' trading strategies and the technology used to execute trades and manage risks.

Renminbi turnover has approximately doubled every three years over the past decade and a half. Total daily turnover has reached over $200 million or 4% of global FX turnover. This makes the Chinese currency the eighth most traded currency in the world, overtaking the Mexican peso and only slightly behind the Swiss franc and Canadian dollar.

Along with the rise in the overall trading of the renminbi, its use as a financial instrument and to back financial rather than trade transactions has also increased. In the past, most of the limited turnover was in spot transactions. The Triennial reveals that spot now amounts to less than half of total turnover, while the share of FX swap trading has reached 40%.

Associated with this, trading among financial institutions is now much more prevalent, while the share of renminbi trading with non-financial customers has declined steeply, from 19% in 2013 to 8% in 2016 However, the prominent role of the CNY/USD pair has not changed: 95% of renminbi trading is against the US dollar, and there is no serious liquidity in any other CNY pairs.

The review concludes:

Such changes in the composition of market participants and their trading patterns may have implications for market functioning. While relationship-driven, direct dealer-customer trading on heterogeneous electronic trading venues delivers lower spreads in stable market conditions, its resilience to stress may be tested going forward. For example, non-bank market-makers may have higher exposure to correlation risk across asset classes.

There are also indications of rising instances of volatility outburst and flash events. Tentative evidence suggests that market participants rush to traditional anonymous multilateral trading venues when market conditions deteriorate. Hence, the risk-sharing efficacy of the evolving FX market configuration is still uncertain. Any major changes to liquidity conditions might have consequences for market risk and the effectiveness of the hedging strategies of corporates, asset managers and other foreign exchange end users.

Plenty more valuable reading to be had here

One simple take from this report confirms my view/lament of the rise in algo box robots (reactive) and decline in human wholesale traders (proactive) that dominated in my day as an interbank trader/market maker. The negative impact in liquidity/ price action of this worrying,but irreversible, trend is playing out more and more on a daily basis. Witness the p/a that immediately followed on the headlines from the ECB announcement last week prior to the presser.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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