Market faces test over liquidity claims

With their occasional references to kwanza, kwacha, dong or perhaps pula alongside the more common dollars and euros, the foreign exchange markets have always had a slightly mysterious, travel-stained glamour.

Add that to a reputation for cross-border, round-the-clock activity and you have a market fully confident in its long-held claim to be the most global and liquid.

But those claims to liquidity are in reality still to be fully substantiated. For many currencies, there are still more “wrong” times of day to trade than right ones – when activity is thin and big deals risk significantly moving the markets.

For investors, this matters. Trade at the “wrong” or illiquid time of day, and the deal will be more expensive, although by how much exactly is hard to quantify, since it depends on many factors, of which liquidity is just one. Market-moving deals also run the risk of becoming more public – something many investors are keen to avoid.

This is particularly true of the smallest currencies, which still offer by far their highest, and sometimes their only, liquidity during their own business day. The kwanza, kwacha, dong and pula (Angola, Zambia, Vietnam and Botswana) are among that group.

But elsewhere, there is a group of rapidly growing currencies from the biggest “emerging markets” that are beginning to offer the sort of accessibility that was once the sole preserve of the biggest currencies. London traders say, for example, they can get nearly the same liquidity and depth of market in Brazil’s real during early UK hours as by waiting for São Paulo to open.

According to the Bank for International Settlements, whose triennial survey of the market is the industry standard, trading involving the real jumped 70 per cent between 2007 and 2010. Deals involving China’s renminbi – the closely controlled “redback” – nearly doubled.

Elsewhere in the region, the currencies of India, Indonesia and South Korea all saw trading growth of more than 30 per cent. But among this turbo-charged emerging markets supergroup, the real standout was the Turkish lira, with a 300 per cent jump in its use.

“The theme of more activity from emerging markets certainly isn’t going to go away,” says Nick Howard, global head of FX and emerging markets distribution at Barclays Capital. “More portfolio managers are crossing borders to invest, with the natural result being an increase in EM-based foreign exchange transactions. FX activity is more than a function of direct trade flows and as the financial leverage in EM increases structurally so will EM FX volumes.”

The growth among emerging market currencies is impressive, but its overall size should be put in proportion; the Korean won, the most-used in that group, is part of just 1.5 per cent of daily trades. The US dollar, on the other hand, is one side of 85 per cent of deals while the euro, in second place, is used in 39 per cent.

When it comes to liquidity, the real focus is still the major currencies. This is where the real liquidity-hunters, the funds which develop computer algorithms to trade multiple times a second, play.

So-called algos have been credited with providing much of the 50 per cent jump in spot trading that the BIS reported last year. Although the survey cannot say for sure, the real surges came in the major currencies and from non-bank financial institutions.

Banks are confident this is the result of algo traders, but not all are happy with it. Some dislike the “fake” liquidity.

“We’re not providing liquidity just for the sake of it,” says one head of FX. “What do these guys bring to the business? Do you gain information from them? I’m not so sure. You need to be damn good to deal with them – and you’re talking low margin business too.”

The lack of a market centre makes general liquidity hard to gauge accurately. The market used to be entirely based around the banks’ interbank market, but the development of electronic platforms over the past decade has changed this. Now banks’ prices are streamed directly to their customers, to other banks via the still giant interbank platforms, and to the clients of other independent platforms.

“We think the market is dramatically fragmenting on liquidity and trading, but becoming more highly integrated, so it’s actually more efficient,” says Harpal Sandhu, founder and chief executive of Integral Development, which operates electronic trading networks.

Even such a fluid market is not without its shocks however.

The latest example came only last month, when in the week after Japan’s earthquake and tsunami, the dollar unexpectedly plunged Y3 in half an hour at the tail-end of the New York day but before Asia traders reached their desks.

Banks generally said they provided prices – albeit at far wider spreads between bids and offers – for their clients throughout, although at least one has faced claims it stopped quoting to some of its clients.