Hedge funds have been around since the 1940s. While they traditionally focused on equities and fixed income, in the late-1990s and early noughties they branched out into other asset classes such as credit derivatives, commodities and, in particular, foreign exchange. As the world’s largest over-the-counter (OTC) market, foreign exchange (FX) is attractive to hedge funds due to its deep liquidity, volatility, frequently trending markets and low-cost per trade. This, together with decreasing alpha in the traditional asset classes, has led to FX increasingly being viewed as a discreet and separate asset class in its own right.
Since 2001, the FX market has experienced strong growth in volumes and, on the whole, profitability. The most recent BIS triennial survey of 2004 showed that total FX market turnover grew 36.2 per cent to $19,000bn (€15,100bn) in a three-year period. Total turnover between banks and buy-side institutions grew by 77.8 per cent during the same period. More recent data from Greenwich Associates points to a continuation, albeit at a slower rate, of these trends with further increases in volume coming from retail client participation in the FX markets.
It is interesting to consider what impact this involvement by hedge funds is having on the FX market and it is frequently difficult to differentiate between cause and effect – the chicken and the egg syndrome. Is it the sell-side that is driving change, or is it coming from the buy-side; primarily the aggressive hedge funds? Did hedge fund behaviour cause change in the FX market, or did the evolution of the FX market itself bring about a change in the behaviour of the hedge funds. Would FX have evolved differently since 2000 had it not been for the strong participation by hedge funds?
To efficiently and profitably participate in FX markets, the buy-side institutions require certain pre- and post-trade services from the liquidity providers; principally an electronic market place with reliable real-time streams of executable prices (ECN or dedicated feed), and real-time, or close to real-time, processing and credit lines (efficient prime brokerage). Whether the hedge funds pushed for these technological improvements, or the banks invested in them in the expectation of winning the business is not known, but the two requirements go hand-in-hand. What is certain is that those liquidity providers who were in a position to provide these services were rewarded with huge increases in trade volumes.
Thus, to compete for this business, the larger global FX banks have invested heavily in technology: pricing engines; liquidity pipes and streaming executable prices with reduced latency; real-time position and risk management solutions; and exception-based STP processing solutions. This investment allows them to process and manage huge increases in trade flows and also to introduce the application of best practices to their business. It seems to have paid off – the current leaders in the FX market are the banks that have reorganised and internally streamlined their business and also invested in client facing and trade processing technology.
However, not all banks and liquidity providers are attracted to these hedge fund flows in FX and the debate around the value of this business is heated and ongoing. Some banks prefer to focus on providing value added business, such as human capital – relationships, research and providing their clients with ideas – rather than just brute force liquidity. Others have decided to focus on being niche providers, such as in emerging markets or structured products, where liquidity and volumes are lower but spreads wider.
In the high volume G20 FX markets, the hedge funds, inventive and resourceful by nature, have found new ways of taking advantage of this liquidity. Algorithmic trading, already well established in equity markets, has moved into foreign exchange. This new technology allows the buy-side to aggressively expand their presence in the FX market, allowing them to arbitrage and take advantage of remaining inefficiencies in the markets. As a result the flow business going to the liquidity providers has become less friendly and less profitable. This has prompted a further round of technology investment, as the banks also boosted their algorithmic trading capabilities in line with their clients and to protect themselves. Some banks have begun critically reviewing the attractiveness of this business, with a view to restricting liquidity to flows that they deem unprofitable.
Other types of players in the FX markets are also finding hedge fund flows attractive. A recent announcement by Chicago Mercantile Exchange and Reuters concerns the development of FXMarketSpace to target the algorithmic trading and large volume proprietary trading segments of the FX market. Both EBS and Reuters have recently set up prime brokerage businesses and CLS has cut its prices for smaller trades.
In summary, it is clear that hedge fund participation in the FX market has led to strong increases in technology investments, both by the hedge funds themselves and by the sell-side that serves them. Which came first is uncertain, but they are both closely connected and feed off each other. This is not the only game in town, and indications are that the influence and importance of the hedge fund flows is waning, but its effect on the recent evolution of the FX market has been significant.
Giulio Pignatti-Morano is FX & MM solutions manager at Calypso, a provider of trading and risk management technology to the capital markets.
