The increased size of the foreign exchange (FX) market over the last 30 years maybe one of the clearest signals of two large and dominant market themes, namely convergence and globalization. The rise of China as a world economic power, the dramatic flow of capital to frontier and emerging markets and the leveling off in interest rates, from 1982 highs in the U.S., all have made managing a portfolio of risk assets simpler, but perhaps now at the beginnings of U.S. rate normalization, coordinated global growth and populist politics, portfolio managers will find those themes less powerful and their risk more difficult to handle. The FX market has seen a notable shift in G10 vs. G30 currency volatility in 2018. The FX risk premia that usually describe the key drivers for FX movements have shifted. The FX carry trade has failed, the momentum trend trades lost in a sea of shifting volatility and the selling of such has been a scratch. Only one set of models appears to be working well when it comes to FX, value, which to many seems anachronistic to a market that trades in microseconds. Longer term information about PPP, GDP or terms of trade between nations seems to be a better signal for trading FX than chasing momentum, carry or selling spikes in volatility.
"What we have found is that technology is necessary to fill the gaps in risk management in FX portfolios, as diversification of risks is not enough"
The speed of transactions in a market appears to have become an important consideration in how risk management works. The Swiss National Bank unwinding of for the EUR/CHF floor in January 2015 led to a 30 percent move in CHF in less than four hours. The move surprised some investors and created months of havoc. The ability to manage such risks for any portfolio of international assets was called into question. The lessons learned by the SNB event were many – with constant monitoring of real-time markets one story, watching central bank and local actions another. But the key point was in diversification, as no one part of a portfolio should blow up the whole even if it moves over 30 percent. This pushed many to consider correlations of their investments and to rethink how central bankers view markets. The rise of volatility in 2018 is another example as FOMC rate normalization is taken as the reversal of the financial stability guarantees from 2008-2009.
What we have found is that technology is necessary to fill the gaps in risk management in FX portfolios, as diversification of risks is not enough. Correlations shift towards one across a portfolio in a crisis. This has been proven out many times beyond the great recession. Being able to identify when diversification starts to fail is the edge many want now. But being able to identify shifts in correlations and liquidity from mere noise and idiosyncratic movements is not simple. The ability to monitor the bid-ask spread across a universe of currencies (G10 or G30) and to measure how they correlate to each other requires sophisticated hardware and software along with co-location in big trading centers like NY4 and LDN5. This is not an arms race for market making, trying to find the dark pools of price interest to build out an order book, rather the push for TCA and a universal tape of FX volumes and pricing is proving to be essential to manage risks.
Many companies have started up as providers for trade cost analysis and collectors of real trade volumes. This business has been important in the last two years for more than just regulatory reasons like MIFDII or FX best execution regulations. Beyond the need for banks to act properly in making markets, the sell-side now has the burden to prove why they trade and with whom. The benefits of this huge set of data are not yet fully understood but TCA is a great first step in providing risk managers a view on global asset flows, how they are changing and where the liquidity is proving to be troublesome. This is the real leap forward for measuring when diversification begins to fail and highlights how electronic markets can eventually deliver more than arbitrage value to investors.
When you think back to why value is on the rise in FX, it highlights why technology has made longer term investing possible again. Growth and value metrics work in a constant state environment. The noise of rising volatility, choppy markets, has made many give up on such models. Those using smarter software to dissect the liquidity and correlation changes from the noise in prices will be winners in the new environment. Whether this continues or not will be dependent on the speed of change for central bank policy makers globally, but expect those that are monitoring markets 24/7 with filters for shifts in the bid-ask spread and how FX currencies correlate to each other to have the key advantage.