As fears grew over falling currency values on the back of stumbling economies, companies and investors rushed to hedge themselves or take advantage. That led currency to blossom throughout 2008, even as equities, commodities and credit withered.
Trading boomed during the second half of the year. The average daily electronic spot FX volumes on interdealer broker ICAP’s FX trading platform EBS (electronic broking services) were up 18% in 2008.
As a result, while FX generally contributes about 25% of a bank’s revenues, last year it made up a far greater proportion as other asset classes shrunk, sources said without giving specifics.
In such an environment, plain meant profitable. The business of trading currency spots, forwards, swaps and vanilla options soared, while bid-offer spreads widened dramatically amid the distress. The revenue from these vanilla products more than offset the collapse of interest in more opaque structured FX instruments.
It was a heady time, yet it looks to be coming to an end. Strong FX trading in the last months of 2008 is not representative of what lies ahead, with the environment likely to be distinctly more challenging this year.
Trading volumes are coming down, while wide bid/offer spreads on vanilla FX instruments look set to narrow throughout the year, leading to fewer and less profitable trades.
And as the volume of vanilla FX trading tails off, banks will still not be able to turn to structured products, prime broking or proprietary trading to boost their profitability because the prospects there are even more grim.
“If you ask me whether revenue for 2009 will be as good as 2008, I think it’s going to be tough,” says Arie Adler, head of Asia-Pacific foreign exchange and money markets for UBS in Singapore. “I don’t think spreads are going to widen more, nor is volume going to be higher. We will be happy if we achieve 2008 results.”
It’s bad news for many banks that only enjoyed success in their FX and rates businesses in the latter half of last year. As FX volumes fall, observers predict that the number of effective players in this market will continue to thin out. Dominant houses should grow stronger, while smaller rivals lose market share.
Asia’s FX shake-up is just beginning, and fewer players are likely to be standing by the time it ends.
An unmatched year
Trading volumes during 2008 didn’t spike by accident. Global deleveraging saw hedge funds and other investors trample over each other to exit emerging markets in a flight to safer securities.
Corporates also found themselves pressed into hedging to prevent currency volatility from wiping out their entire profits.
Banks had been relishing the growth of FX volumes in recent years because it meant more trading opportunities. The Bank for International Settlements found in December 2007 that turnover in traditional FX markets had increased 71% to US$3.2 trillion between April 2004 and April 2007.
The problem was that while volumes ballooned, the intense competition among banks kept bid-offer spreads on the most popular trades razor thin, often at just one or two basis points (bp).
Spreads were still competitive at the beginning of last year, but widened on average by a once-unimaginable five-to-10 times after US investment bank Lehman Brothers collapsed in September.
Bankers refer to this spike in spreads as an unexpected gift, which highlights just how abnormal the situation is. The widening is the result of fewer market-makers and fewer trades.
To put that in perspective, spreads on most FX instruments are two-to-three times wider compared to what was common in early 2008. This translates into an increase in revenues for banks acting as intermediaries.
And that income has helped to offset the drop-off they have seen in other areas of the business, which understandably they hope it will continue to do.
“I think that increased FX flow business and therefore revenues due to a back-to-basics mindset will generally compensate for a drop-off in revenues from structured products,” says Richard Leighton, global head of FX at Standard Chartered in London.
But the good times can’t last. Bankers are steeling themselves for 2009 as economies grapple with recessions and all the signs point to a sustained drop-off in FX trading. ICAP registered a 31.56% year-on-year drop in electronic over-the-counter spot FX volumes on its EBS platform in November.
The impact is already being felt. South Korea recorded a record 32.8% drop in exports in January, while Japan saw a 35% decline in December. Fewer exports mean less need for trade-related exchanges.
Hedge funds, which are responsible for a lot of market activity, have also started to close down or are scaling back in Asia. Citadel Investment Group shuttered its Tokyo office in December and cut staff across Asia. Meanwhile, GSO Capital Partners, Blackstone Group’s credit-orientated hedge fund, is understood to have shut its investment desk in Asia. According to data provider Eurekahedge, 160 hedge funds closed in Asia last year.
This is unwelcome news for those banks relying heavily on FX business. Market participants reckon that vanilla deal volumes at present make up 60% of their business.
Some bankers argue that profits will remain high because spreads remain wide by historic levels, but even those who say so concede that revenues are on a downward trajectory. “Flow will come down but spreads will offset a large portion of that loss in revenue,” admits one insider at an international bank.
Many are not even that hopeful. Tarun Anand, former head of global strategy for the shuttered foreign exchange broker FX MarketSpace, predicts that bid/offer spreads will continue to narrow, just as they started to do in the months after Lehman’s collapse.
“Corporates are so used to 1bp spreads,” notes Anand. “It’s going to be hard for banks to offer them 3bp if markets stabilise and volatility comes down.”
“It really depends on the model you have,” adds a banker at a large FX institution. “Large flow houses should have no problems, but niche structured houses could be in trouble.”
Structured product short-fall
The biggest challenge for banks in 2009 is to make up for the short-fall from the decline in structured product sales.
Back in the heady days of 2004 to 2007, banks earned handsome margins from marketing complex structured instruments using derivatives to punt on currency movements. One senior banker reckons that structured products made up between 50-70% of FX revenues in 2007.
But dramatic moves in currency markets, the collapse of counterparties and the impact of excessive leverage caused huge losses and means that few retail investors or corporate managers will touch the products any more. Volumes dropped more than 40% last year, and are expected to head further south.
“Investment banks were selling products to clients that weren’t good for them and some have been losing tonnes of money,” says the senior banker at an international institution. “For example, the target products meant essentially that the client’s profits were limited and their risk unlimited.”
Banks are now hawking instruments that use less leverage or cap possible losses, but have found little interest because the fear of exposure to opaque instruments is too great right now.
Treasurers and senior corporate officers who spoke to Asiamoney confirm they have no appetite for structured products. “What we want is cash-flow neutral, up front, so I rather pay a forward rate,” says Johnnie Tng, chief financial officer of Ascendas India Trust.
A treasury manager in Korea insists that vanilla cross-currency swaps are all he needs. “A few years ago the banks approached us to use structured products, but we decided that it was too complicated when we started to analyse it, and we stuck to the plain instruments.”
The lack of interest is forcing banks to cut their teams back. UBS announced in January that it would exit the exotic structured products business in fixed income, commodities and currencies. Trevor Nathan, former head of FX structuring for Asia at Barclays Capital, left his firm in November, while Rig Karkhanis, head of Pacific Rim FX and local currency trading at Bank of America-Merrill Lynch, departed in January.
Aside from structured products, investment banks have used their capital for proprietary trading or to support prime broking. But as they struggle to cut their losses and risk exposure, all such bets are off.
“In terms of prime brokerage, less leverage is going to be available in the system and so it’s logical that this area will shrink,” says an insider at a large international bank.
Anand predicts that it will be hard for banks to have a good 2009. After all, they had branched into more lucrative areas such as proprietary trading and prime brokerage because they couldn’t make enough profit on 1bp spreads, “but now they can’t rely on those businesses anymore.”
FX winners and losers
With FX revenues tailing off, a further thinning out of firms active in the FX arena is inevitable.
Maintaining a strong FX business requires a major risk management operation, good computer systems and most importantly a broad client network with faith in their counterparty. Fewer and fewer banks boast these resources, and as the spreads on FX trading squeeze in again, more may find that the costs and risks of maintaining an FX business are too great.
To some degree, this is already happening. Simon Nursey, global head of currency options trading at BNP Paribas, observes that the number of players in the market is dwindling. “It will continue this year as things consolidate and participants look more at the cost of their business,” he said.
The likely winners are easy to spot. The likes of Deutsche Bank, Barclays Capital and J.P. Morgan should continue to enjoy strong FX volumes as others fall by the wayside. They have a global footprint which makes them well-placed to thrive.
Asia-focused banks such as Standard Chartered and HSBC should also do well as they appeal to risk-averse clients in local markets who often perceive them as having escaped the worst of the credit crisis.
“Traditional corporates and institutions go for the safest bets because they don’t want to be in an ugly situation like we saw after Lehman,” says Anand.
The likely losers will, for the most part, be smaller banks. However, some market sources are also keeping a close eye on Citi.
The US bank enjoys an entrenched position with corporates across Asia, who voted it top in Asiamoney’s FX poll in September. But its financial problems are well documented. It has been bailed out by the US government twice since October to the tune of US$45 billion and is having to carve chunks off its own business to pay its way.
Clients are unlikely to desert Citi en masse, but some of its clients concede that counterparty risk weighs heavily on their minds.
Tng, of Ascendas India Trust, uses Citi for all his FX transactions. While he praises the bank’s execution capabilities, he notes that counterparty risk is a concern: “We have been looking at diversifying our hedges into other counterparties. We rely on our hedges, which we put on for at least 12 months forward, and so I have to make sure that my counterparties will survive.”
Other banks that could falter are those which have not traditionally been strong in FX. “The bigger banks are well positioned to take on the risk and additional business, but the second-tier is probably going to find it hard to grapple with counterparty risk and supporting their customers,” says the insider at the large bank.
Such predictions look to be materialising for at least one smaller European bank, which according to one regional treasurer has been unable to quote on cross-currency swaps since October.
Volatility and rising volumes in the foreign exchange market acted as a saviour for otherwise ailing banking operations in 2008. But as spreads tighten and sophisticated products continue to be viewed with fear, it is unlikely to happen again for some time.
In short, expect more staff cuts in FX before the good times return once more.