Liquidity Dearth May Be Permanent

William Rugg and Peter Luxton see signs of a permanent drying up of liquidity in FX markets.

The trading desert in which currency market liquidity shrivels every summer seems to be turning into a more permanent feature of FX trading, with spot markets being particularly badly hit.

The signs show longer-term structural changes may be leading to a more lasting dearth of liquidity - the ability to buy and sell large volumes of currencies quickly without causing substantial price movements. Such a dearth would result in even greater volatility - or rate variation - in key currency pairs, such as the euro/US dollar, sterling/US dollar and Swiss franc/US dollar. All have shown increasing volatility since the mid-1990s.

A straw poll of FX dealers taken recently by S&P MMS highlights the split between dealers at the handful of banks that dominate FX trading, who are less inclined to see a shrinkage in liquidity, and those at smaller banks, who believe liquidity is declining.

Smaller banks are seeing less overall FX business with the demise of interbank trade and the dominance of structural currency flows, typically arising from cross-border mergers and acquisitions. Here, the big banks take the lion's share.

Whether the pie is shrinking or not, the dominant banks seem to be taking an ever-growing portion. This feeds the trend toward order-driven markets and a decline in interbank trade.

The Bank for International Settlements’ tri-annual FX survey, published in April this year, shows daily average volumes in currency markets peaking at $1.5 trillion in 1998, up from $1.2 trillion in the previous survey.

Anecdotal evidence, however, suggests daily turnover has since fallen back to the 1995 average of $1.25 trillion.

Spot FX trading has taken a particular hammering, dropping to 40% of total daily trading from 44% in 1995 and from almost 50% in 1992.

When total FX daily turnover was growing, the absolute amount of spot trading also rose (albeit at a decreasing rate) and averaged $600 billion daily in 1998. But with the overall market shrinking, the absolute size of the spot market may also be falling.

Several factors are involved in the shrinkage in traded volumes. With the onset of the European monetary union, for example -- and 11 currencies being replaced by one -- banks have consolidated. This has cut the number of individual banks trading currencies.

The 1998 Asian and Russian financial crises -- and the associated collapse of the Long-Term Capital Management hedge fund -- also contributed. In curbing investor appetite for foreign investment, they affected the demand for currencies.

The spread of electronic currency trading is another factor. By helping make price discovery more efficient, it has cut the number of trades needed to get an idea of best prices.

It is unclear from looking at currency volatility -- which measures the variability of FX rates -- whether these and other structural changes have led to a generalised dearth of liquidity and more choppy FX rates. But it appears to be the case for some currency pairs.

Implied one-month volatility for the euro/US dollar, sterling/dollar and Swiss franc/US dollar -- effectively the market’s estimate of future volatility in those pairs -- rose above their four-year historic volatility averages in the first half of this year. (euro/dollar volatility history is synthesised from the histories of the legacy currencies which were merged into the euro.)

Similarly, euro/US dollar one-month implied volatility rose steadily from the first half of 1999 to just under 13% in the first half of 2000 -- while the four-year average is just 9.30%.

In contrast, implied volatility for the yen/US dollar pair has declined, dropping to 12.36% in first-half 2000 from a peak of 18.46% in the second half of 1998. This compares with a four-year average of 12.73%.

The standard deviation (SD) around the mean implied volatility -- the most important measure of the risk attached to trading a particular currency -- has more than doubled for euro/US dollar since early 1999 to reach 1.3 SDs in the first half of this year. But the riskiness of yen/US dollar trading has declined over the same period to 1.1 SDs in first-half 2000 compared with 3.2 in early 1999.

What about the two key traditional speculative currencies? Average implied volatility for sterling/US dollar has held remarkably steady between 8.0% and 8.5% since 1998, other than a dip to 7.5% in the first half of 1999. But there was a sharp pick up in the standard deviation measure in first-half 2000 to 1.2 SDs from 0.7 in first-half 1999, showing that the amplitude of intra-day fluctuations has increased.

In contrast, average Swiss franc/US dollar implied volatility has climbed steadily since early 1999 (9.9%) to 12.6% in first-half 2000, its highest level for five years. Standard deviation for this pair rose to 1.2 from 0.9 over the same period, but is still well under the peak of 2.5 recorded in second-half 1998.

Thus there are tentative signs that the frequency of sharp intra-day changes has increased, but no firm evidence of a significant generalised shift in the pattern of FX volatility.