The Last Look…

There are many out there who believe that FX is, inevitably, following equities in market structure terms, but yet again, in the current economic climate, we are getting evidence of why it should not, and must not, do so.

To say we exist in a random volatility market regime is putting it lightly, policy flip-flops, grandiose statements – some of which will be followed through on, some of which won’t – and the indecision this is promoting at several central banks, is creating a volatile environment in all markets, but particularly equities. This is seeing some investors hurt, long-term players are probably less worried as they are still in at good levels, and a daily ritual of which way is the market going to move 2%?

In equities, as I have argued before, we are dealing with wealth generation and investment and markets, as the disclosures like to say, can go down as well as up. In FX, as I have also argued before, we are dealing with a different beast.

Yes, there is a huge amount of speculative flow, but equally, there is a large proportion of the market that is using FX as a “service” rather than “asset” class – they want to hedge out of large risk and are not interested in making a profit. Rather, they want to avoid large losses.

The risk absorption function in FX is therefore, critical – unlike in equities where frankly it doesn’t exist. A customer sells a few thousand stocks, which are churned and burned by a dozen algos and “market makers”, which merely serves to accelerate any move, hence the multi-percent swings on a daily basis.

The fact is, in FX, those true “real economy” end clients want risk transfer – they may execute it slightly different, using an algo, or breaking it up into smaller parcels, but the bottom line is they want to exit the risk in as quiet a fashion as possible, which is where risk warehousing really offers value.

If we transition the FX market structure into an equities-like structure, these 100, 500 or 900 million trades (and above of course) will be forced into a “transparent” environment, which means every high frequency market maker will be able to jump in front of the order. As I noted the other week, even selling 100 million in one million units will create market impact – ask the pricing algos.

Regulators have done a reasonable job of making the financial system a safer place after the mayhem of 2008-10, but we have to be careful they don’t go too far. Risk is a natural service for any bank to offer, largely because of the strength of their balance sheets – regulators, like some managers, have to learn that making a loss is not necessarily the worst thing. Who would we rather be left with a couple of million loss – a bank making $10 billion a year, or a corporate who may have to let go real workers on the production line because that is where this ends up?

FX is still used to hedge against the basics of economic – cross-border business. That makes it different from equities, and many other asset classes. The market provides services for firms that do the basics – make things or invest pensions – it not just about someone making money from a moving market.

Times are good in FX at the moment (if they’re not, they should be), but they are not so great in equities. To me, this means we need to look at the relative market structures and understand the good that FX markets provide, and at the same time the risky, over-reactive environment that equities provide.

We talk so much about how one size does not fit all, so why are we trying, in some circles, to create a one-size market structure? It doesn’t make sense, By all means have an equities-style environment for those that want to punt the markets, but equally we must remain alert to signs that risk-absorption is declining. The latter would be dangerous for the global economy – far more dangerous, I would argue, than investors giving up the gains from the last six months.

colin@thefullfx.com