Does news that FX market volumes are returning to pre-crisis levels mean it’s back to a flow business?
Throughout the financial crisis, FX trading volume dropped off markedly, although spreads more than made up for the flow declines. This in turn allowed major FX banks to still profit from FX trading. So with FX trading volumes coming back to pre-crisis levels, is currency trading going to again become a mostly flow business?
But will pick up in flows weigh on spreads?
Data released from the Bank of England today show that currency trading flows in the UK grew by 15 percent in the six months to April, taking the daily average to $1.747 trillion. Spot trading was a significant part of that, as the most basic spot products surged by one-quarter to $642 billion a day.
In the US, meanwhile, according to the New York Fed, daily currency flows grew at 11.8 percent to $754 billion in the six months to April—just short of the record $762 billion hit in October 2008. While continued global economic uncertainty has sparked much of the trading (along with central bank intervention) and implied vols for major currencies are still in the teens, the good news is that the trading is taking place.
The next question is will spreads stay healthy enough to keep FX trading as a profit engine for dealers? The hope for these banks is that the volume increase does not fully erode their spreads. Looking beyond spot, they also must factor in the impact of OTC derivatives reform. This impact will be enormous if the US Treasury decides not to exempt FX forwards and swaps from central clearing. But it will also be significant with the exemptions.
Whereas trades subject to margining will have credit charges stripped out of bid-offer spreads, non-margined trades for exempt instruments or end-users will maintain these charges, along with new capital and liquidity requirements for derivatives business, and sundry add-on costs. This will tend to keep upward pressure on spreads and perhaps introduce separate fees to offset the higher costs of doing business in FX instruments generally.
Downward pressure on dealer spreads is going to be felt, too, however. Corporates do have the opportunity to trade FX on electronic exchanges and access two-way streaming pricing, so this will make it difficult for any one dealer to seek to subsidize other parts of their FX business with spot spreads.
As a result, we may see further impetus for FX forwards, swaps and options trading to migrate to e-trading platforms, too, or traditional exchanges, to keep spreads tight—even if this migration eventually comes with some central clearing and margin component. Remember, exempt corporates still have the option of going to exchanges if they want, and they may well choose to do so if the lines between e-trading platforms (like FXall) and exchanges blur and the economics are right.
Plus, as recent market commentary from Citi has noted: “Although banks are sure to pass on added costs to their corporate clients, it is also likely that banks will compete more than ever for available flow business in order to earn bid-offer spreads.” Thus, it looks like we are indeed returning to an era where FX is a flow business and competition for volume between banks, e-trading platforms, exchanges and other non-banks will help reinforce this turn and take it beyond spot trading.