The Last Look…

Why should we be worried about the potential for crowded trades in one market segment but not another? More pertinently, why would we discourage crowded trades in one segment and not in another?

To clarify the slightly cryptic nature of that opener, let me explain I am talking about hedge funds and corporate and asset manager hedgers and how the potential for crowded trades, or ‘herding’ seems to not only be growing, but in one case, should be encouraged.

First the hedge funds. Over the past week, Bloomberg News has run two separate stories about hedge funds, in this case Citadel and Point 72, launching new programmes that will pay other hedge funds for trading ideas. The idea is they will then use these ideas to populate their own quant strategies.

This has been done before in the investment management industry, by Marshall Wace most notably in late 2023, and of course, multi-manager programmes have something of this about them. My first thought though, came from the retail industry and was “mirror trading”.

Of course, these will not be ‘copy and paste’ operations, but it does beg the question, at a time when money is concentrating in fewer hands, is this a step closer to herding in the hedge fund world? And is that dangerous? Equally, in spite of the vast amount of data available in the world (and the protestations from some that it is all different), quant programmes typically latch onto similar, if not identical signals, is this a good thing?

As far as FX is concerned, I don’t think this is an issue, these programmes are focused elsewhere, but in principle this idea does seem to point to even more herding in financial markets. There have been various warnings, some of them very credible, about this issue, most notably from the Federal Reserve which has made observations on, among other things, the Treasury basis trade and liquidity mismatches multiple times in recent years.

FX will simply be an onlooker to the occasional train wreck in other markets – much as it has been for decades

I am not sure how investors approach this idea of firms taking others’ ideas, and perhaps the release valve here will actually be investors deciding they have enough money tied up with certain funds and deciding not to invest in these new programmes. The success of the hedge fund industry generally in attracting money, and how the biggest just get bigger, suggests not, however.

This is not the first time I have written about herding in markets as we go ever more quant-driven – indeed it is one of the reasons why I have, (believe it or not correctly), predicted discretionary managers outperforming systematic for the past few years. The former can make steady money, the latter will be subject to the odd spectacular blow-up as a crowded trade comes unhinged.

Generally then, I see this type of move as making the environment riskier for investors, and putting the spotlight on those funds who can get out quickly enough. For FX, well, it will simply be an onlooker to the occasional train wreck in other markets – much as it has been for decades.

That said, FX does, I believe, have a place for a crowded trade.

A couple of weeks ago, I wrote a small commentary piece on FX hedging alongside another story, specifically how the industry needed to maintain the noise around its benefits. I have had some interesting responses, several of whom agreed with the points, but some who looked to explain why they don’t hedge. I will share a general view of the latter feedback here, as that is probably most pertinent.

Several firms, it seems, are still to understand that exchanges rates are moving more. Volatility may not be as high as it was a year or two ago, but in terms of actual rate movement (as opposed to the velocity of that move), it’s higher – and of course, many firms decided to stop hedging during the low vol era, and simply have yet to decide to resume doing so again.

There were also operational issues given as excuses, the timing of cash flows for example, and a couple of people pointed out their firm did not have adequate oversight of FX hedging activity to allow it – in other words, as one correspondent put it, “I’m the only one who understands how it works”.

Someone shared a story of a hedge that went badly wrong and scarred the company for life it seems, while some others pointed the finger at banks trying to push too sophisticated products (even options were seen as too difficult to explain internally), or currency overlay, with the associated fees.

Large hedge funds crowding into trades in less liquid markets is a notable risk, whereas a bunch of corporates, who make up less than 5% of the flows in the world’s biggest (and potentially most liquid) market, do not

So here’s an idea. These businesses know, or can easily discover, their vulnerabilities in the FX market, perhaps they should invest in buying a few signals? I have no doubt that someone can explain it to me, but I have never really got why there are occasionally hefty fees attached to currency overlay? It’s often a one-way hedge that reduces or increases with exchange rate movements. Why pay the fees for someone to do that for you? Why not buy the signals on your desired currency pair(s), connect into a venue, single or multi-dealer, and auto-hedge according to these signals?

Of course, the signals won’t always be right, that’s a tricky conversation to have internally I am sure, but they should be right more often than wrong, and generally, in the big picture and over a longer time horizon, they are good.

I am not sure in the age of vibe coding that connecting signals to an execution mechanism is that difficult, and as far as the FX market is concerned, it seems to be handling all these global events and uncertainty pretty calmly, so liquidity shouldn’t be an issue.

Of course, this could lead to crowded trades, but do these firms care? They shouldn’t.

I can already hear some of you observing (shouting probably) that this is too simplistic and I would agree, but it is these less-sophisticated hedgers, that are hemorrhaging valuable money thanks to exchange rate movements, that we should be targeting. More sophisticated hedgers, like asset managers, with multi-currency needs, should either already have a professional team managing this risk, or have outsourced it to an overlay business.

To answer the question at the top of this column is simple. Size matters. In the big scheme of things, large hedge funds crowding into trades in less liquid markets is a notable risk, whereas a bunch of corporates, who make up less than 5% of the flows in the world’s biggest (and potentially most liquid) market, do not.

In summary, (and here I would note that friends of mine have been known to observe that I could start an argument with myself, but I don’t know what they mean), my message here is clear. If you’re a hedge fund manager, go find your own ideas, don’t nick someone else’s. And if you’re a corporate hedger, unashamedly nick someone else’s trading ideas!

colin@thefullfx.com