As the Canadian dollar tries for a third time in three years to ascend to parity and beyond, pension plan sponsors must be mindful, not just of the currency effects on their international holdings, but also whether currency is a source of return. (We’ll hold off on calling it alpha.)
It is for many newish investors, according to a recent survey by the Bank for International Settlements. In “The $4 Trillion Question: What Explains FX Growth Since the 2007 Survey?,” BIS researcher Michael King and Norwegian Central Bank researcher Dagfinn Rime, note that the foreign exchange markets have picked up since 2007, with a 20% rise to $4 trillion in daily turnover. Still, that’s not as fast as the growth between 2004 and 2007, when the rate was almost quadruple.
But that growth in trading demonstrates a certain resilience, King and Rime say. For whom, one might ask? They note that “85% of the growth in FX market turnover since 2007 reflects the increased trading activity of ‘other financial institutions.’ This broad category includes smaller banks, mutual funds, money market funds, insurance companies, pension funds, hedge funds, currency funds and central banks, among others. For the first time, activity by other financial institutions surpassed transactions between reporting dealers (i.e., inter-dealer trades), reflecting a trend that has been evident over the past decade.”
In the meantime, currency trading by governments and corporations – the traditional hedgers, or simply the folks engaged in cross-border mergers needing local currency to finance their acquisitions – has fallen by 10%. That could simply reflect lower economic demand, King and Rime suggest.
The growth elsewhere, they think, probably comes from the ease of electronic trading. “An important structural change enabling increased FX trading by these customers is the spread of electronic execution methods. Electronic trading and electronic brokering are transforming FX markets by reducing transaction costs and increasing market liquidity. These changes, in turn, are encouraging greater participation across different customer types.”
That said, all this new trading is concentrated across a few big bank platforms. “The largest dealers have seen their FX business grow by investing heavily in their single-bank proprietary trading systems. The tight bid-ask spreads and guaranteed market liquidity on such platforms are making it unprofitable for smaller players to compete for customers in the major currency pairs.” Greater participation, and greater concentration.
Interestingly, while currency trading did drop during the financial crisis, the authors suggest that one area where it was used was as a kind of hedge for other securities thanks to its comparative liquidity. “With limited market liquidity in various asset classes, many investors reportedly turned to spot FX markets to hedge risk exposures (‘proxy hedging’). For example, downside risk in US equities was reportedly hedged by buying Japanese yen, in European equities by selling the euro, and in emerging market equities using emerging market currencies. These strategies may have had limited success, but at least they were available – albeit at an increased cost, as bid-ask spreads for the major currencies widened.” At least there was some liquidity, as opposed to none.
As liquidity increases, so does the number of participants. Part of the burst in currency markets is simply that better technology has made it easier for retail traders to get access. They account for almost 10% of the spot trade globally – and 30% in Japan, thanks to the legendary Mrs. Watanabes. That may beat the rates on bonds, equities and real estate in Japan. For the rest of the world, it may reflect the lack of a horse to bet on.