Special FX: the asset class that thrives on volatility
ft.com
By Peter Garnham
Published: February 5 2009 02:00 | Last updated: February 5 2009 02:00
At a time when many investment banking revenue streams are under pressure, one part of their business is booming: foreign exchange.
Senior executives are extolling the merits of the currency markets in trading statements for the first time in many years, reflecting a change in attitudes.
"FX divisions are among the most profitable in the banks. Ultimately in 2008, FX was a significant contributor to profits," says Scott Wacker, managing director of foreign exchange sales at JPMorgan.
Traditionally, forex has been regarded as less glamorous than other bank businesses such as equities or mergers and acquisitions.
But while other asset classes are being ravaged by the financial crisis, foreign exchange desks at the major investment banks have been enjoying record years.
The reason for the upsurge in profitability has been the return of volatility to currency markets, which has seen trading spreads widen and margins for the industry's marketmakers soar.
"Low volatility means a bear market for the foreign exchange industry and high volatility means a bull market," says Martin Wiedman, head of global forex sales at Credit Suisse.
Spreads offered to investors in the pound against the dollar are five times higher than before the eruption of volatility that followed the collapse of Lehman Brothers in September last year. In the forex options market, average volatility is now almost six times higher.
It is not simply that relative currency valuations have moved to extreme levels in the wake of the Lehman collapse. The speed of intraday moves has shot up.
In the spot foreign exchange market, three-month historical volatility, a benchmark that tracks the average range of trading in different currency pairs over three months, has increased markedly.
For euro/dollar, it rose from just over 10 per cent in the three months to the collapse of Lehmans to 24 per cent in the following quarter. Meanwhile, three-month volatility in dollar/yen rose from 11 per cent to 28 per cent, and in sterling/dollar it climbed from 8.5 per cent to 22 per cent.
Mr Wiedman believes that heightened volatility is here to stay and is unlikely to fall back to the exceptionally low levels prevalent prior to the credit crisis.
The unprecedented levels of liquidity swilling around global markets were partly responsible for keeping trading spreads tight, ensuring that currencies trended in relatively small ranges.
With the eruption of the credit crisis, that changed, however. Counterparty risk rushed to the top of investors' agenda, damping liquidity and prompting a flight to quality trading partners.
Furthermore, a large part of the market-making community was lost as the disappearance of Bear Stearns, Lehman Brothers and Merrill Lynch further reduced liquidity in the market.
On top of that, the deterioration in the global economy sparked a wave of deleveraging, which added to volatility as investors scrambled tohaven currencies such as the dollar and yen.
"The world has fundamentally changed," says Zar Amrolia, global head of foreign exchange at Deutsche Bank. "Risk premium and volatility have risen and the value of liquidity provision has risen."
There are several reasons that foreign exchange appears to be a good business for banks in the current climate.
First, there is little correlation between forex earnings and other parts of a bank's business.
Second, and perhaps surprisingly for a sector that is associated with wild price gyrations, forex has relatively low earnings volatility: earnings tend to be steady, growing and predictable.
Finally, capital costs are fairly low because the average duration of deals tends to be shorter than in other sectors, generally no more than one month. Forex, therefore, eats up less of a bank's risk capital.
"Foreign exchange is a highly liquid and transparent business which typically does not involve a huge amount of credit risk," Mr Wacker says.
According to the latest figures from the Bank for International Settlements, forex trading volumes average $3,200bn a day, which makes forex the world's largest financial market.
Forex trading volumes could suffer in the coming year given the capital destruction in recent months to banks' client bases.
However, analysts say forex is unlikely to suffer as steep a fall in volumes as, say, equity markets, simply because currencies are fundamental to underlying business.
The heightened volatility means the currency exposure of international asset managers and companies will rise. In other words, higher volatility does not just encourage risk-taking; it also triggers huge hedging demand.
In any case, increased spreads are likely to keep foreign exchange profitable for marketmakers, even if trading volumes dip, bankers say.
So far, at least, there is no expansion in the industry, which is perhaps not surprising given the cost-cutting that is occurring across the banking sector.
But dealers report that while banks have been busy cutting headcount in other areas, foreign exchange has remained relatively immune.
"Nobody I work with on a daily basis has lost their job in the last six months," says one London-based trader.
Indeed, bonuses are still being paid in the industry, even if at substantially lower rates than in previous years.
Observers say they expect the banks that have emerged from the credit crisis relatively unscathed to profit from the new foreign exchange landscape.
"If you are down and out for the count, it is not going to save you," Mr Amrolia says.
"But if you still have a pulse, you are going to have the opportunity to make some serious money in FX over the next couple of years." |
