Eric Busay, senior investment officer at Mountain Pacific Group, talks to Profit & Loss about the growing barriers to entry in the FX market and why asset managers are so focused on reducing tracking error.
Profit & Loss: As someone who has been in the FX industry for some time now, what’s your perspective on the current state of the market?
Eric Busay: One interesting development is that the FX market is becoming more non-linear, especially with respect to liquidity. What I mean by this is that liquidity in the market is great, until it’s not.
The problem for market participants is that it has become harder to predict when liquidity will deteriorate. Before, people understood that if there was a crisis – like in 2008 – that liquidity conditions would go downhill quickly. But now there’s unexpected reasons why liquidity air pockets are occurring.
Part of the reason for this could be internal to the banks or the fact that some of the fairly dependable liquidity sources, like dark pools, can suddenly disappear en masse. But I think that this trend will continue to dominate the currency markets and you’re going to continue to end up seeing increased bursts of volatility as a result.
P&L: Is this a new trend, or is it a return to the liquidity conditions that we saw a decade or more ago?
EB: I wouldn’t necessarily say that it’s new, but there are more unexpected sources now for why these liquidity gaps can occur. There used to be a rule of thumb that if you did ‘x’ amount of a currency it could move the market by a certain amount of basis points, and now that rule of thumb has gone out of the window.
Now you’re finding that you can hit surprising pools of liquidity when you thought that things might be relatively thin and conversely you can hit these air pockets as well at various times. But it’s not as clear as it used to be when either of these scenarios will occur, and I think that’s what has changed.
Also, once things becomes stressed or appear to be headed in the direction of becoming stressed in the market then I think you can see a simultaneous pull back from some of the liquidity providers during that time and this is contributing to the air pockets.
Now there are usually trends to counterbalance this, there are always people looking for new advantages in the market and the pullback of liquidity providers could provide them with this. But at the same time, regulation has made it more onerous and more expensive to deal. So while there is less efficiency in dealing, you’re not going to get as many participants jumping in to do so.
P&L: So do you think that the barriers to entry for the FX market have gone up?
EB: Well, when I first started trading FX, the implicit cost to write a ticket was twenty-five to thirty US dollars, regardless of the size of the transaction. This was because you had to do wire transfers, there was the back office work, people had to process the transaction, etc.
Then, because of the advent of electronic trading, the cost of writing a ticket went down to a few cents and it became almost as efficient to take a position of a few thousand US dollars as it was to take a multi-million dollar position, in terms of the cost per unit associated with it. The cost of writing a ticket became trivial, but I don’t think that it is trivial anymore.
Also, just in terms of the onboarding experience, it’s very clear that there are much greater barriers to entry than there used to be in order to get dealing relationships set up. Now there are a lot more regulatory requirements, such as the Know Your Customer and Anti Money Laundering declarations, which are not a bad thing, but they do add another cost and therefore another barrier to entry.
There are also other regulations that increase the amount of time that it takes for a firm to come into the FX market. I think what that means is that the dynamism of how quickly the market can react to any kind of anomaly that takes place is probably longer than it was.
P&L: But conversely, is the increased use of algorithms increasing the response time to market events?
EB: It used to be that people could do relatively large amounts with relatively limited capitalisation, if they had strong algos. But I’m not sure that counterparties are that willing to take on the credit risk of those organisations the way that they used to. That ends up becoming an issue with respect to liquidity.
In some ways though, the increasing use of algos hasn’t changed things that much. They all have circuit breakers in them now that either refuse to make a price or widen the price substantially in stressed market conditions. But the equivalent to that back in the old days with telephones was simply that the dealers would either not pick up the phone, or wouldn’t pick up the phone in a timely fashion. So although the algos have made it a bit more sophisticated in this regard, it’s still the equivalent to not picking up the phone.
P&L: So how do firms effectively trade FX in this unpredictable liquidity environment that you’re describing?
EB: It really starts with risk control and that’s one of the main focuses I have when I talk to our clients; I want them to think about risk holistically, but relative to their portfolio.
For example, there are natural risk offsets that can take place in a portfolio and we try to help clients identify these. When we sit down and talk to these clients, it is similar to the questions that you have to ask as an indexer, such as how much deviation from the benchmark are you willing to tolerate?
Because in some cases the client is focused on returns, but they need the expected returns and the actualised returns to be relatively close. So we try to help people think about currency in that vein.
We want them to think of currency as another lever in their portfolio that can either enhance their risk and return and it’s actually possible that structuring a portfolio correctly can result in lower risk and higher returns.
P&L: Speaking of benchmarks, why are some asset managers so tied to trading FX at the WMR Fix? Why is there such an obsession with tracking error?
EB: Effectively, what is the WM? It’s a fictional number, but in truth it is a statistical methodology for trying to determine a snapshot in time that took place a couple of minutes around the London close at 4pm.
Is that real? It’s not entirely false, but at the same time it’s simply a representation of what happened during that period of time and people are dealing on it, and that’s what makes it real and it does have real implications.
Even if no one dealt on the WM, these firms are still being rated at the end of the month based on where the exchange rates were and if there’s a wild swing it can make a significant difference in terms of the results for that month for that asset manager.
So the obsession is there because the accounting makes a representative number real, because it is real for people who get mark to market at the end of the month. Everyone is making adjustments at month end to match what is going on with the WM, but it affects not just the adjustments, it affects the entire portfolio.
P&L: But what about positive tracking error?
EB: I never viewed positive tracking error as a bad thing, I would refer to that as alpha potentiality.
Ultimately, negative tracking error is unambiguously bad, but positive tracking error by itself isn’t bad unless there’s too much of it. If you’re an index fund and you’re running things at one hundred basis points over the index, then that’s way too much – you’re taking big risks in that portfolio in order to be able to get those kinds of results. Outperformance can be an indication of a deviation from guidelines and procedures. But if you’re up a couple of basis points, then that’s reasonable.