The Last Look…
Posted by Colin Lambert. Last updated: January 9, 2024
A lot of publications like to kick a new year off (happy 2024 everyone by the way – hope it’s a good one) with predictions offered by industry participants that tend to be well-intended but ultimately self-serving. The “We think X is going to be a big trend this year, which just happens to coincide with our business model” type of stuff. We’re built differently, so I am coming out swinging by predicting that too many LPs will get it wrong this year and miss out on significant potential revenues.
It was noticeable to me at the tail end of last year how many people at LPs were just a little downbeat. In part this could be because the moronbusiness model at their firm demands a year-on-year increase in revenues, no matter how good the previous year was, but there was also the sense that many felt they weren’t really maximising opportunities.
I have previously put this down to the volume-driven, broker-type model operated by many LPs who have taken their lead from the equities markets when building their risk management processes. Without doubt, internalisation has, at the extremes, taken away opportunities for maximising profits from certain types of flow. The more successful LPs have, to a degree, worked this out – there has to be a risk element in the FX trading business – but others haven’t.
For the latter, 2024 could be an even more difficult year.
This is not a prediction of increased volatility – I have no idea how that is going to play out in 2024, but given the fragile geo-political world, I suspect vol won’t decline that far – rather it is about a seemingly-unstoppable trend in investing markets, the march of the ETF.
I had a lot of conversations with people outside of FX in the last few months and the one thing that all were very excited about was jumping on the ETF bandwagon. It is not hyping it up too much to say that some seemed to think it was the only growth game in town – package up specific investments and kick them out as an ETF. Of course, this all sounds suspicious to a regulator still scarred by investment packages in the first decade of the century, but there is no doubt that the investment industry sees the product as the next big thing, or rather the next even-bigger thing.
Where does this all fit into FX? Well on the downside, these passive-type investors tend to like using a benchmark for their currency trading, which could make the 4pm London Fix even sillier than it currently is, but on the upside, it could create more hedging flow generally. More pertinently it will be predictable and fixed-timed hedging flow, which typically offers more opportunities for those LPs willing to truly warehouse the risk for more than a few seconds or even minutes (and of course, they would make money from handling any fixing flows).
If there is an extended boom in ETFs, it could represent the cherry on the cake for the firms willing to adjust their spot FX business model
The ETF people I speak to barely acknowledge currency risk, they tend to be too busy coming up with the next idea or calculating the latest valuation of the underlying products, which means there could be – if my conversations are signalling a continuing boom in ETFs – significant value for the FX LP.
Those LPs strong in processing and handling custody-like transactions will probably have the best chance of grabbing the flow, but who is not to say the investment firms, with their dedication to best execution (accepting the obvious blind spot), will not try to push the business out to a wider group of providers?
There is no way of tracking this beyond the triennial survey from the BIS which picks out different client segments’ flows, but it will be interesting to see whether my conversations with the LPs sound any different in 10-11 months as they did over the last two or three.
There is a broader opportunity there, I believe, for an institution willing to allocate more risk capital to the FX business to better manage flow – in addition to, as noted, volatility being a feature of this year. If there is an extended boom in ETFs, however, this could represent the cherry on the cake for the firms willing to make that leap of faith, and adjust their spot FX business model again. After all, it’s not as though the model hasn’t worked before…