Forex turnover results 2013 – or why you should worry

The BIS Triennial Central Bank Survey of foreign exchange turnover in April 2013 makes a fascinating read.

First of all, there is the rise in turnover volume: $5.3 trillion. Per day. By comparison: World exports in 2011 (the latest available number) were about $17.8 trillion. Per annum.

Second, there is the number of currencies traded which, as the following list shows, has increased markedly. The Mexican peso and Chinese renminbi are even found among the top 10 most traded currencies now.

Fascinating, but also deeply worrying. In contrast to other comments which emphasise recent changes, I would like to draw attention to some aspects of global foreign exchange trading which have not changed – and which, in a changed environment, should give more cause for concern than ever before.

The $5.3 trillion estimated average daily trading volume is a dramatic increase from $4.0 trillion in April 2010 and $3.3 trillion in 2007. However, in times of slow growth, low overall returns and widespread deleveraging the growing focus on the biggest, most lucrative and least transparent financial market outside the limelight of public attention should not come as a surprise.  As I stressed elsewhere, volatility in this market is high, and as a rule, fluctuations in exchange rates are more erratic than in interest rates or prices of other financial instrument. Furthermore, risks and rewards can be even higher in trading in emerging market currencies as past and current financial crises demonstrate. The latter may offer one explanation for the increasing number of emerging market currencies traded these days – and their growing exposure to financial crises rooted elsewhere.

$5.3 trillion is an impressive number, but the statistics hide the fact that still there is no information at all about the true market volume and its development.  As I wrote:

The foreign exchange market is largely an unknown quantity. … The only coherent source of information on market volumes is a survey conducted in April every three years by central banks and monetary authorities of countries with large and medium-sized foreign exchange markets under the auspices of the Bank for International Settlements. … Participants are asked to report all arm’s-length trades which means trades in which the dealer is indifferent as to the counterparty. For example, not included are in-house deals and deals with other offices of the same institution. Excluded are also deals of large globally operating firms within private corporate networks “bypassing” banks.

Beside the Triennial report, there are more frequent regional surveys conducted in Australia, Canada, London, New York, Singapore and Tokyo, but methods differ and results are not comparable.

The current BIS survey includes 1,300 banks and other dealers in 53 jurisdictions. Changes in methodology ensure a more complete coverage of offshore markets. In addition, a breakdown of counterparties sheds light on the role of non-reporting financial institutions. The latter contributed most to market growth and for the first time surpassed the group of reporting dealers:

These other financial institutions include

smaller banks which serve as clients to the large reporting banks; they have a market share of 24%, the biggest in this group;

institutional investors (11%);

hedge funds and proprietary trading firms or PTFs (11%), including counterparties that specialise in algorithmic and high-frequency trading (HFT);

official sector financial institutions (central banks, sovereign wealth funds …), which account for 1% of the market,

and others.

Banks still dominate trading as reporting dealers and non-reporting banks together account for 63% of global turnover. Furthermore, non-reporting banks behave similar to the FX dealing banks:

Non-reporting banks total foreign exchange turnover is $1,278 billion (reporting dealers: $2,070 billion), of which

$606 billion, the biggest share, is foreign exchange swaps (reporting dealers: $1,085 billion), followed by

$506 billion spot transactions (reporting dealers: $675 billion) and

$95 billion outright forwards (reporting dealers: $182 billion).

This mix of “classic” instruments with swaps dominating followed by spots indicates that despite the entry of new participants, and the emergence of new instruments and currencies, the fundamental nature of the market has not changed and is still imposing a constant threat to economies of the currencies involved. As I wrote elsewhere:

Both spots and forwards are leveraged instruments. The potential return of trades is not on notional amounts but on margins. Due to established customs, when a currency is bought or sold spot or forward, no accounts are debited or credited, that is no money actually changes hands, until settlement, and it is only the difference, i.e. the gain or loss, that has to be paid and settled. In combination with forex swaps both instruments offer a high degree of flexibility and profitability in taking positions which is one explanation for market size:

Dealers wanting to hold an open position for an undefined short time period buy or sell the currency spot or forward and then, when expectations do not fulfill in time or prospects continue to look favourable, prolong the position by a swap. As the Bank for International Settlement once put it: “...foreign exchange swaps are often initiated to move the delivery date of foreign currency originating from spot or outright forward transactions to a more optimal point in time. By keeping maturities to less than a week and renewing swaps continuously, market participants maximise their flexibility in reacting to market events.”

Traditionally, these instruments are straightforward means of betting on exchange rates. Nothing has changed in this respect. Banks still dominate the market, swaps still dominate trading and the focus is still on short maturities: Table 4 of the survey shows that foreign exchange swaps with maturities up to 7 days – which include very short-term swaps carried out as “tomorrow/next day” transactions – still account for 70.1% of swaps.

There is a mystery why traditional participants and activities in this market, and their role as motor of financial crises, are neglected by many observers. Media tend to focus on hedge fund activities, high-frequency trading and other side issues, while banks’ traditional lucrative wheelings and dealings are going unquestioned even (and in particular) in times of turbulence.

Beside the risks involved for the ailing common currency in Europe, two aspects give rise to growing concerns. One is overall financial stability: The latest figures indicate that smaller banks, which replaced the declining share of non-financial customers, now engage in the market in similar ways as the big ones – in a business which due to high volatility and thin margins traditionally is said to require big financial strength. If successful, the results may improve overall performance. If not, the number of bailout candidates may rise.

Another cause for concern is how emerging market currencies are increasingly drawn into the markets targeted by foreign currency speculation. Brazil and India are currently paying dear for their ranks in this league.

It seems, no lessons have been learned from earlier crises. The next time central bank agreements and foreign exchange interventions fail to “defend” or “save” a currency the following last entry in my timeline of the EMS crisis 0f 1993 may be remembered:

April 2/3 1994

From the FT LEX COLUMN: “There is a refreshing candour about Deutsche Bank’s admission that it does not expect much by way of earnings increase this year. Last year’s 23 per cent jump in group net profit owed much to special factors that will not easily be repeated.”

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Related articles:

FTT, Dodd Frank and forex stability on 2013/02/10

The home-currency problem in the euro area on 2012/02/11

Yuan fantasies on 2012/01/15

Crisis lessons on 2011/11/18

Corporate currency speculation on 2011/09/26

Financial Regulation of Forex Forwards and Swaps – Eight Questions and One Opinion on 2011/05/09