Foreign exchange moves have important real-economy consequences – the last thing the struggling eurozone needs at the moment is further currency appreciation, for example.
For investment banks and hedge funds, the revival of FX uncertainty holds out the hope of a recovery in their moribund currency-trading revenues by contrast.
Last year was dreadful for FX traders at both banks and funds, as the euro against US dollar cross was becalmed and other currency moves took place too gradually to offer meaningful dealing opportunities.
Sales and trading revenues from G10 currencies for banks were just $7 billion in 2012, according to a study conducted by Coalition using data from 10 top investment banks by revenue. That marked a fall of 22% compared with 2011, in a year when overall fixed-income, currency and commodity revenues rose by 21%. The $7 billion total was well under half the $17 billion recorded during 2008, a year when currency trading proved to be an important factor in offsetting cataclysmic credit market losses for some dealers. Deutsche Bank, the leading foreign exchange dealer by market share, made at least half as much money from currency trading in 2008 as the entire banking industry managed in 2012, in an indication of how far margins have fallen.
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Deutsche’s FX revenues in 2008 were key to its ability to withstand calls to accept German state aid to cover its credit losses and maintain its investment banking business model, but it is far from clear whether currency revenues will be able to play a similar balancing role for sales and trading portfolio management in the future.
There are some grounds for optimism over currency revenues for dealers. Low volatility was the main driver of the decline in income in 2012, especially in the second half of the year, when options trading revenue slumped.
The collapse in the yen that developed momentum in the final weeks of 2012 as it became apparent that the incoming administration of Shinzo Abe would try to push down the currency has given a boost to volatility in 2013.
This should have goosed FX trading revenues for banks, and the scale of some of the currency shifts has certainly created opportunities for some of their biggest clients. The returns generated by some macro trading hedge fund dinosaurs have attracted attention. The fund that manages the wealth of George Soros is reported to have made over $1 billion from shorting the yen in recent months, with Caxton, Moore and Tudor also recording big gains after years of weak performance.
Banks need more than a few big paydays for speculative clients to revive their own revenues, however. Banks require either an increase in flow that is enough to offset the steady erosion of margins that has been seen in the currency markets in recent years, or a sustained rise in volatility that pushes out bid-offer spreads for long enough to reverse margin compression.
Volatility trading in the options markets by customers can be unpredictable, even when currency pairs are making big moves. The fall in the yen since November certainly caused a rise in volatility, but the outperformance of realized volatility compared with implied volatility was a surprise to many dealers, before realized quotes dropped sharply when the spot cross between the yen and dollar stabilized in late February.
Temporary volume increases alone are not enough to revive bank FX revenues, in an ominous sign for broad fixed-income profitability. Deutsche Bank disclosed in February that its fourth-quarter 2012 foreign exchange revenues had fallen despite record client turnover, for example.
Citigroup – number two in last year’s Euromoney FX survey – said that its own FX volumes in January were up by 70% from the year before, which should have been a big enough jump to revive revenue. But the attractions of the foreign exchange market for customers – liquidity, increasingly efficient electronic trading and elimination of pockets of hidden trading revenue such as off-market quotes by custodians – are all working against banks.
Banks can fight back against some sources of revenue dilution. When online brokerage firm EBS, a unit of Icap, gained a reputation for helping high-frequency trading firms to arbitrage the currency prices provided by banks, the dealers effectively took their toys home with them by slashing the amount of business they put over the system. EBS volumes fell by around 50% at one point before Icap CEO Michael Spencer effectively surrendered to the dealers last year by firing his EBS management team. Dealers are also resisting other attempts by high-frequency traders to increase their effect on FX flows in the knowledge that both policymakers and traditional buy-side clients share their concerns about the effect of computer-driven momentum trading on price provision.
Dealers have to walk a tricky line, however. They are understandably wary of accusations of collusion in setting market standards, given the current focus on the way banks fixed Libor settings for years. And they have to step carefully in deploying their own computing power to maximize FX revenues. Currency trading is after all an oligopoly, with over 50% of dealing handled by a group of five banks that comprises Barclays, Citi, Deutsche Bank, HSBC and UBS.
The dominant role of these dealers and the importance of their in-house online trading platforms recently led to speculation by clients and rival banks about the business plans of Barclays for its Barx system. At its long-awaited group strategy announcement on February 12, Barclays said that it intended to increase transaction automation rates in what it described as "low/no-touch" trading on Barx from 30% to 70% and enable client "self-service" rates to rise from 10% to over 50% through automation and "improved client experience".
Barx has played a big role in pushing down interest rate derivatives trading margins for rival banks in recent years. More aggressive deployment of the system in FX by Barclays could add to the pressure on returns in the sector for all dealers.
Trading heads at dealer firms will have to hope that renewed global tensions over FX levels spark enough currency conflict to allow for some old-fashioned profiteering on the back of big price shifts.
