The Last Look…

It has become fashionable in some circles to bemoan the lack of opportunities and profits available in FX markets, but there is one small segment of our industry that is performing strongly – and has done so for most of the past 30 years.

As FX markets have evolved, more and more firms have built business models predicated upon volume – it was always the case for the voice brokers, but over the past 10-20 years it has become the fashionable model for banks as well. Regulation has played a big role in this, without doubt, but so too has a diminishing appetite for risk, which is a pity, for if you look at the performance of currency CTAs over that period, it would seem the embracement of risk would have paid off.

This train of thought was kicked off by a story I penned last month about currency traders leading the sub-indices included in the Barclay CTA Index, managed by BarclayHedge, which led me to looking further back. In the last 30 years, the Currency Traders Index (CTI), which is a decent proxy for returns from FX trading I would have thought (and as always, happy to be corrected), has had just three down years, one of which was -0.08%, the worst of which was -1.21%.

First up, this surely highlights the importance of currency in an investor’s portfolio? Naturally, this index has not outperformed the S&P 500 over the last 20 years (I couldn’t be bothered to go back further – it’s equities!), but notably, with one exception, 2017, the CTI has been positive during S&P down years, and that was the -0.08% year. Other than that, 2022, which saw the S&P lose 13%, the CTI was up 8.98%; 2008 saw the S&P down 33%, while the CTI was +3.5% – you get the drift.

A large factor in this is clearly the skill of the currency traders – and they are traders largely, not managers – although it is notable that the number of programmes in the currency index has dropped from over 100 to under 50 in recent years. That aside, however, it shows there is value is having some risk on the books in FX, which begs the question, why, when the returns are clearly there, have so many banks sharply reduced their risk levels? It can’t be due to a lack of available traders, they clearly exist, and has regulation cut opportunities that much?

It could be argued, and I will, of course, that rather than dedicate so many capital resources to helping customers trade by providing prime brokerage services to one-and-all, banks may well have been better off giving that capital to their own desks. The returns from the CTI are good, but I can only imagine they would have been enhanced in a bank, where the risk could often be used to bolster liquidity to counterparty clients?

I was pondering this out loud to a friend last week, who observed, quite astutely in my view, that it is partly a result of the chat room scandal from a decade ago – yes, it is that long ago! – which promoted banks to minimise prop trading and using customer trades to enter/exit positions. If that is the case, surely it is time for a re-think? There are so few sell side institutions without strong oversight and surveillance functions, that I think it would be very hard for anyone to abuse their position in the market – at least from a trading point of view.

I engage with youngsters entering the FX industry a lot through the ACI Australia Dealing Simulation Course and one characteristic they nearly all have is an honesty and a willingness to accept responsibility if and when things go wrong – in other words, they are not tempted to go down the wrong route just because of a loss. A lot of this is down to the training they have already received at their institution, thus, surely, the conduct issue is less threatening than it once was?

If nothing else, a prop desk could help pay the increased brokerage bills banks are facing from the platforms!

It feels to an extent like some banks continue to use these episodes – and don’t get me wrong, a multi-billion fine for a business that makes $600 million will leave scars – as an excuse not to build a prop trading function into their FX businesses, which means they are missing an opportunity.

I also understand that “prop trading” is not a word banks like, but as is the case with so many other phrases, “risk-taking” has been bastardised by some firms to mean the risk they take on for the 25 milliseconds before turning a position they have just been given. I feel, therefore, the need to make a delineation!

This is not a plea for a return to the old days, I should make that clear, merely it is to suggest that the performance of a sector intimately involved in our business would indicate that a change is worth considering. The FX business at many firms is a constantly evolving beast, my suggestion here is, for the next evolution, rather than spend a fortune on changing an already-successful client facing part of the business, perhaps it could be allocated to a small group of traders, systematic and discretionary, who can just trade the markets (without access to the client order book) as they see fit?

The performance of currency CTAs suggests such a desk would be profitable, so if nothing else, it could help cover the increased brokerage costs banks are facing from the platform world!

colin@thefullfx.com