3:06 pm - Tuesday September 26, 0744

Fundamentals and basic instincts drive FX Markets

Bank for International Settlements, Basel, Switzerland conducts triennial central bank survey on foreign exchange and derivatives market activity. The last such survey was conducted in April 2010. As per the findings of this survey, Global Foreign Exchange Market Turnover was 20% higher in April 2010 than in April 2007 with average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37/% of the foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007

Features of FX Markets

Market Structure – Decentralized, OTC, No formal market making requirements
Trading Hours – Essentially 24 hours a day, five and half days a week
Fee, Commission – Built in the Bid-Ask Spread
Regulation – Self Regulated
Latency – More variable across venues
Short Selling – No restriction for freely traded currencies
What is traded? – Cash for Cash
Trading Rationale – Investment and Transaction purpose

Best practices

The best practices in FX markets can be summarized in the following areas

Pre trade preparation and documentation – Know your customer, Determine documentation requirements, Agree upon trading and operational practices

Trade capture – Capture or enter trades in a timely manner, Use straight through processing, Use real time credit monitoring, Use standing settlement instructions, Review amendments, Closely monitor off market transactions

Confirmation – Confirm and affirm trades in a timely manner, Be diligent when confirming by non secure means, Be diligent when confirming structured or non standard trades, Be diligent when confirming by telephone, Verify expected settlement instructions, Confirm all netted transactions, Confirm all internal transactions, Confirm all block trades and split allocations, Automate confirmation matching process, Establish exception processing and escalation procedures

Netting – Use online settlement netting systems, Confirm bilateral net amounts, Employ timely cutoffs for netting

Settlement – Use real time nostro balance projections, Use electronic messages for expected receipts, Use automated cancellation and amendment facilities, Implement timely payment cutoffs, Report payment failures to concerned, Understand settlement process and settlement exposure

Nostro reconciliation – Perform timely nostro account reconciliation, Automate nostro reconciliations, Identify non receipt of payments, Establish operational standards for nostro account users

Accounting and financial control – Conduct daily general ledger reconciliation, Conduct daily position and P&L reconciliation, Conduct daily position valuation, Review trade prices for off market rates, Use straight through processing of rates and prices

General best practices – Ensure segregation of duties, Ensure that staff understands business and operational roles, Monitor dealing staff activities and they compulsorily avail annual leaves, Understand operational risk, Institute controls for trades transacted through electronic trading platforms, Identify procedures for introducing new products, new customer types or new trading strategies, Ensure proper model sign off and implementation, Control system access, Establish strong independent audit / risk control groups, Use internal and external operational performance measures, Ensure that service outsourcing conforms to industry standards and best practices, Implement globally consistent processing standards, Maintain records of deal execution and confirmation, Maintain procedures for retaining transaction records, Develop and test contingency plans, Prepare for crisis situations outside the organization

Some latest trends in markets

High Frequency Trading

HFT in FX markets is a rapidly evolving phenomenon. It is brought about by advances in information technology and the spread of electronic trading. It is having a notable effect on the structure and functioning of the FX market, and is prompting behavioral changes in other market participants. HFT in FX operates on high volume but small order sizes, low margins, low latency (with trade execution times measured in milliseconds) and short risk holding periods (typically well under five seconds).

Analytics

Analytics that facilitate FX market and its participants are also growing along with, mainly in the following areas namely (a) SoCs – Systems on Chips – Traditional offline analytics to in-line embedded analytics and (b) Simulate real time from multiple sources and systems to predict the future. Analytics is also getting into the cloud to enhance and facilitate high performance and grid computing.

Relationship

With the volatility and liquidity stresses seen during the recent financial crisis, greater client interaction with sales desks at banks is occurring as clients are seeking advice on executing trades in the new liquidity environment. Banks would like to monitor such transactions on real time basis on one on one basis.

Data from the foreign exchange markets provide an opportunity to look at the importance of electronic execution methods across economies for different foreign exchange transactions and counterparties. They confirm that the prevalence of electronic execution methods declines as the complexity of the instrument increases. More than half of foreign exchange spot turnover worldwide is executed electronically, whereas less than one tenth of foreign exchange options are. When the electronic executions decrease, relationships take over; periodic customer interactions predominantly rule the market place.

With the ever-increasing volume of business handled in the market place and with every player trying to position aggressively to have a major share, there is a coordinated effort to win over the hearts of the customers. More and more players are willing to invest in efforts to ascertain the requirements of the market place rather than focusing on what they have already to offer. This sincere effort in checking up with the customers on their needs and expectations is building up relationship.

Fundamentals and Basic instincts

Fundamentals drive the business. When they are supported by best practices, we see orderly performance by the participants in the market place. Even when the fundamentals are strong and best practices are followed, sometimes the participants may not post profits. These participants can comfort themselves that at least they may not be booking huge losses and facing life threatening reputation issues for themselves and for their organizations.

Basic instincts drive behavioral finance. This theory dictates that markets might fail to reflect fundamentals under three conditions – irrational behavior, systemic patterns of behavior and regulatory limits.

Greediness and lax supervision have affected banks very badly in recent times – Nick Leeson of Baring Bank, Jerome Kerviel of SocGen and Kweku Adoboli of UBS to name few top rogue traders in the recorded and published history. It has nothing to do with the discipline of business but more with the attitudes, approaches and short-termisms of the people involved. The 6th May flash crash also suggests that systemic risk is perhaps more likely to be triggered by this ‘rogue’ approach.

However, if the basic instincts are played within the boundaries of the fundamentals and respecting best practices and relationship, there is every possibility, the participants might be performing well in the market place.

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