Friday, June 20, 2008

FX a haven to investors wounded by credit crunch

http://www.reuters.com/article/reutersEdge/idUSL1664014920080523

FX a haven to investors wounded by credit crunch

By Simon Falush - Analysis

LONDON (Reuters) - Financial markets may be going through their toughest time in decades but foreign exchange markets are booming as investors, wary of ailing credit markets, look to the asset class as a way of driving returns.

Investors stung by heavy losses in credit markets are diverting resources into FX trading, pushing trading volumes ever higher toward a daily average of $4 trillion that could be reached by the end of the year.

Merrill Lynch (MER.N: Quote, Profile, Research, Stock Buzz) and Citigroup (C.N: Quote, Profile, Research, Stock Buzz) have suffered a combined loss of $42.5 billion in writedowns as a result of exposure to poor quality credit assets, but growing FX revenues have taken some of the sting out of these losses.

Both Citi and Merrill Lynch posted record currency revenues in the first quarter with Merrill Lynch doubling its income compared to the same period last year.

LEVERAGE AVAILABLE

And while banks may be wary about lending money to investors looking to trade credit-related instruments there are no such qualms about involvement in foreign exchange, helping maintain hedge fund activity in the area strong.

"Banks may not be willing to lend to hedge funds margined against credit instruments but customers are not finding themselves credit constrained (when looking to borrow to funds for) FX trading," said Justyn Trenner, principal of research and advisory analytics group ClientKnowledge.

"There is evidence that customers are picking and choosing who they'll trade their foreign exchange through. The boot has moved onto the other foot. But the underlying interest in the asset class has not diminished in any way," Trenner added.

Investors have moved out of the carry trade where they borrow low yielding currencies like the yen to fund purchases of higher yielding assets, as volatility increased.

One-week implied volatility on dollar/yen currency options was trading around 5.0 percent in June, when the carry trade was at full tilt, and increased to as high as 18.40 percent in March, though it has subsequently retreated to 11.75 percent.

Low volatility is good for the carry trade as investors are more comfortable in the relatively risky position when markets are calm than when there are sharp, unpredictable moves.

However, investors are still selectively buying into high yielding currencies that they think will deliver strong growth.

The Australian dollar this week surged to 24-year highs against the U.S. dollar, and with volatility rising, flows in and out of these strategies is more rapid, again increasing volumes.

The Bank for International Settlements said FX trading volumes average $3.2 trillion a day. Trenner at ClientKnowledge says this figure will likely soar to $4 trillion per day by the end of the year.

COVERING POSITIONS

Sharp moves in the currency market that have seen the dollar retreat by nearly 8 percent versus the euro this year have forced companies and funds to think about their exposure to these fluctuations.

Lisa Scott Smith, managing director of global currency at Millenium Global Investments, said the sharp moves in currencies had highlighted the large potential risks that companies and funds with exposure to different currencies face, bolstering the amount of hedging that companies engage in.

"We are seeing increasing demand from institutional players, pension funds, corporations who are realizing given these dislocations in markets that there are currency issues," she said.

A benefit of foreign exchange that these investors are looking to exploit, is that it can generate positive returns when other assets are suffering.

When markets turn south investors can buy into low-yielding currencies like the yen and Swiss franc which tend to rise at times of heightened risk aversion.

"It has a low correlation with other asset classes and investors have seen strategies drive solid returns in difficult conditions," said Thanos Papasavas, head of currency management at Investec Asset Management.

To meet the demand that these potential returns are generating, banks are reallocating staff from areas which have seen demand ebb, like structured credit, into foreign exchange.

Societe Generale reorganized its credit and FX operations in April to bolster its currency capabilities ID:nL0336801.

TECHNOLOGY KEY

However while the investment environment is important, improvements in trading technology is also key as it enables a wider range of investors to trade faster and more frequently.

Michael Spencer, chief executive of ICAP (IAP.L: Quote, Profile, Research, Stock Buzz), the world's largest interdealer broker, which saw strong growth in forex revenues help drive its pretax profits rise to 330.2 million pounds ($645.9 million) this week, said the growth of electronic trading and advances in technology have been key in driving growth.

"The average transaction time on EBS platform was 150 milliseconds per transaction 18 months ago, its mow 6 milliseconds. The mere speeding up of the platform itself allows the algorithmic trading platforms to speed up by themselves and has contributed to volume growth."

He added that increased globalization and the growth of emerging markets has also boosted the volumes.

"We trade currencies on EBS which a dozen years ago which we wouldn't have thought possible a dozen years ago....Currencies like rouble, renmibi, Korean won...these are non-trivial currencies, they will tend to drive volume growth."