Foreign Exchange: The Complete Deal. James McDowell. Sharpe
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from 2007 to 2010 with daily turnover of USD 1.8trn. This reflects the critical role of swaps in the hedging process, which I shall be covering later.
Market share by currency
The currency distribution of global foreign exchange turnover shown in Table 3.3 comes as no surprise. As befits its reserve currency status, the dollar remains the most traded currency, accounting for 85% of all transactions. The euro and the yen account for 39% and 19% respectively.
Table 3.3 – Most traded currencies by market share
Emerging market (EM) currencies are still traded in relatively small size, accounting between them for less than 20% of total transaction volume. Notable within this group are India, Korea, Taiwan and China. EM is an area of expected growth for the future, especially if China adopts a flexible exchange rate system for the renminbi (CNY). In the 2010 figures USD/CNY accounted for only 0.8% of daily turnover.
Market share by currency pair
If one looks at currency pairs by market share (Table 3.4), EUR/USD dominates, accounting for 28% of market share, which is USD 1.1trn per day, up from USD 372bn in 2001. Market share has been around this level for the past ten years. The share of USD/JPY is 14%, but this appears to be on a declining trend having accounted for 19% in 1998. GBP/USD comes in at 9%, a level which has been remarkably steady over the past decade and leaves sterling as the fourth most traded currency, followed by AUD, CHF and CAD.
Table 3.4 – Most traded currency pairs by market share
Who trades foreign exchange?
The following is a list of the groups that trade foreign exchange and their main purposes in doing so.
Corporates, commodity trading accounts (CTAs)
Transactions are driven by:
payables
receivables
inter-company loans
dividends
royalties
acquisitions
divestitures.
Companies will need to record for accounting purposes the value of assets, liabilities and equity and reported income relating to overseas subsidiaries/investments. This is commonly referred to as ‘translation’ exposure. This exposure will be recorded in the financial statements as an exchange rate gain (or loss).
Portfolio fund managers
Transactions are driven by:
sale and purchase of fixed income, equities and real estate of foreign denominated assets held within portfolio
overall currency exposure which can be managed by outside currency manager.
Hedge funds
Trade foreign exchange as a separate asset class
Speculate using computer models
Buy and sell foreign-denominated assets within the fund.
Central banks:
maintain foreign currency reserves and will adjust weightings of currencies
are responsible for inter-government and institutional settlements
may intervene in the market to affect the value of the domestic currency.
Sovereign wealth funds (SWFs)
Sovereign wealth funds (SWFs) are state-owned investment funds. SWFs are focused on longer-term returns and can generally hold a wide range of currencies and assets, which translates to more diversification versus central bank reserve managers. About 66% of SWFs are largely funded by oil and gas exports while non-commodity SWFs are typically funded by transfer of assets from official foreign exchange reserves and government budget surpluses. Examples of major funds are Abu Dhabi (ADIA), Kuwait (KIA), Government Fund of Norway and the Chinese SAFE Investment Company.
Commercial banks
Spot trading
interbank market making
servicing client orders
speculation.
Forward trading
interbank market making
speculation
works with money market desk to manage bank’s balance sheet funding.
Option trading
interbank market making
speculation.
Private individuals
speculation
sale and purchase of overseas assets – usually property
hedging currency exposures.
Banks’ share of global foreign exchange
Over the past 25 years a combination of large bank mergers and aggressive trading practices has effectively muscled the small banks out of the foreign exchange market, although traditionally they had supported it. It is now estimated that the top ten banks account for over 75% of foreign exchange transactions by volume and the top five somewhere from 50% to 60%.
Trading is increasingly being done over electronic platforms (e-trading) and this means that concentration becomes even more pronounced, with the top three platforms (Deutsche, Barclays, UBS) estimated to account for around 60% of the business. Indeed, the banks’ focus is on enhancing electronic trading platforms to attract the customer. It has taken a long time and considerable expense from the big players to build up this infrastructure. This creates huge entry barriers or at best a serious challenge for aspiring new entrants.
These multi-dealer trading venues are commonly referred to as electronic communication networks (ECNs) and formed the second phase of the electronic revolution led by Reuters and EBS with electronic inter-dealer brokers in the mid-1990s. EBS and Reuters Match are still the primary funnel for foreign exchange business.
The major banks’ emphasis is in fact not so much trading in a proprietary manner but to attract transactional and trading flows, i.e., volume. Foreign exchange is considered a core product for the major banks. There is very little capital required to support the business, which is essentially an off balance sheet product.
Furthermore, the product is for the most part short-dated, extremely liquid and client-driven, which adds to its attractions. This in turn generates an impressive return on capital. It is generally recognised that for banks to offer a full service, scale is required; first, to provide liquidity and, second, value- added services, such as technical research, that differentiate them from the pack.
It should be emphasised that the key issue is not so much about price, as, for the vast majority of