I have been covering the US Commodity Future Trading Commission’s (CFTC) efforts to revamp the regulatory structure that governs forex, since it was unveiled earlier this year. On August 30, the CFTC formally published the “final regulations concerning off-exchange retail foreign currency transactions. The rules implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Food, Conservation, and Energy Act of 2008, which, together, provide the CFTC with broad authority to register and regulate entities wishing to serve as counterparties to, or to intermediate, retail foreign exchange (forex) transactions.”
Not only has the CFTC clearly established its authority to be the primary regulator of retail forex, but it has also laid out specific regulations. Chief among them is limiting leverage to 50:1 for major currency pairs, and 20:1 for “other retail forex transactions.” [It's not presently clear which specific currency pairs will be classified as major]. Remember that the original proposal (which, along with my endorsement, generated vehement protest) called for a decline in leverage to 10:1. Due to negative feedback from traders and brokerages, which ascribed malicious political motives to the changes and argued that it would move the entire industry offshore, the CFTC backed down and implemented only a modest decline in leverage. However, it’s important to note that the National Futures Association (NFA) as well as individual brokers will have discretionary power in setting leverage limits lower than 50:1. There will undoubtedly still be some opposition from traders, but I think we can all agree that the new rule represents a fair compromise.
As for the claim that traders would/will move their accounts offshore, this will become largely moot, since all brokerages, regardless of nationality, will be required to register with the CFTC and subject to its rules/oversight. Of course, those traders that are so inclined will still find a way to circumvent the rules by shifting funds “illegally” to unregistered brokers, but they do so at their own risk and will have no recourse in the event of fraud. As Forbes noted, “It seems these new rules will put a stop to Americans trading retail forex offshore to evade CFTC rules. That trend picked up the pace in recent years and it may need to be reversed quickly.”
Brokerages must register as either futures commission merchants (FCMs) or retail foreign exchange dealers (RFEDs). These institutions will be required to “maintain net capital of $20 million plus 5 percent of the amount, if any, by which liabilities to retail forex customers exceed $10 million.” While this rule will raise the barriers to entry for potential forex start-up brokerages, it will protect consumers against broker bankruptcy. In addition, “Persons who solicit orders, exercise discretionary trading authority or operate pools with respect to retail forex also will be required to register, either as introducing brokers, commodity trading advisors, commodity pool operators (as appropriate) or as associated persons of such entities.”
One final rule change worth noting is quite interesting: brokerages must “disclose on a quarterly basis the percentage of non-discretionary accounts that realized a profit and to keep and make available records of that calculation.” This calculation will be useful both in and of itself, and also in identifying any significant discrepancies between competing brokers. For the first time, we will be able to see whether forex trading is currently profitable (i.e. whether those that profit are in the majority or minority) and whether/how this profitability metric changes over time, in response to particular market conditions.
The new rules go into effect on October 18.
If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.
Since the S&P 500 is a pretty good proxy for risk it can be said that the Australian Dollar is a manifestation of investor risk appetite. When risk aversion was high, the S&P and the Aussie were low. When risk tolerance picked up, they rose. It’s funny how this came to be. It is probably best seen as a vestige from the credit crisis, whereby investors evenly divided assets into two classes: risky and safe. When you look at the performance of the Australian Dollar, it is pretty clear as to which side of the dividing line it was placed.
This is probably fair, since the Australian Dollar is a growth currency. According to the just-released Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the Australian Dollar is now the world’s fifth most traded currency (behind only the G4: Dollar, Euro, Yen, & Pound), having usurped that position from the Swiss Franc. In 2010, it accounted for 7.6% (out of a total of 200%) of all trading volume, primarily as a result of trading in the USD/AUD currency pair, which was the fourth most popular in forex.
Investors have come to see the Australian Dollar in somewhat contradictory terms. It is both stable and liquid, but its economy is unpredictable and inflation is usually above average. The current economic situation was strong, with GDP growth projected to exceed 3% in 2010. Its benchmark interest rate (4.5%) is the highest in the industrialized world, and may touch 5% before the year is over. On the other hand, its political situation is currently uncertain, thanks to an election that produced a hung Parliament and the recent resignation of its Prime Minster. In addition, while its trade balance is currently in surplus, it fell in July thanks to decreased demand from China. Analysts wonder whether it isn’t entirely dependent on China (directly via exports and indirectly via high commodity prices) to generate positive GDP growth.
Ultimately, investors don’t care about any of this. They care only whether the global economy is stable and whether another financial/credit/economic crisis is likely to occur. Even though any such crisis will probably spare Australia, the Aussie is punished by even the whiff of crisis because Australia is perceived as being riskier to invest than the US, for example. “The Australian dollar is going to stay heavy. Markets don’t like uncertainty,” summarized JP Morgan.
Sadly, it’s currently not worth parsing the nuances of trade statistics and monetary policy, because it has no bearing on the Aussie, though at least this makes my job easier. For the time being, the Australian Dollar will tick up if it looks like the global economy (principally the US) will avoid a double-dip recession. Otherwise, it is in for the same rough stretch as the S&P.
The long wait is over! The Bank of International Settlements (BIS) has just released the results from its Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, conducted in April 2010. The report contains a veritable treasure trove of data, perhaps enough to keep analysts busy until the next report is released in 2013. [Chart below courtesy of WSJ].
First, the data confirmed earlier reports that average daily forex volume had surged to a record level in 2010: “Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. The increase in turnover of other foreign exchange instruments [consisting mainly of swaps and accounting for the majority of forex trading activity] was more modest at 7%.” In addition, for the first time, investors and financial institutions accounted for a larger share of turnover than banks, whose trading activity has remained roughly unchanged since 2004.
The composition of the turnover actually didn’t change from 2007, interrupting a shift which had been taking place over the previous 10 years. Specifically, the share of overall turnover accounted for by the so-called major currencies actually increased in 2010, from 172% to 175%. [Since there are two currencies in every transaction, total volume sums to 200%]. Growth in the G4 currencies (Dollar, Euro, Pound, Yen) was more modest, however, increasing from 154% to 155%. This reversal is probably attributable to the credit crisis, which drove (and in fact, continues to drive) investors out of emerging market currencies and back into safe haven currencies, namely the Dollar, Yen, and Pound. However, this theory is belied by the significant increase in Euro trading activity, which certainly hasn’t benefited from the recent trend towards risk aversion.
While emerging currencies as a group accounted for a smaller share of overall activity, certain individual currencies managed to increase their respective shares. The Singapore Dollar, Korean Won, New Turkish Lira, and Brazilian Real all fit into this category. Still other currencies, such as the Indonesian Rupiah and Malaysian Ringgit, also managed impressive gains but account for such a small share of volume as to be insignificant when looking at the overall the picture. Those who were expecting even bigger growth should remember that it’s ultimately a numbers game: the amount of Ringgit it outstanding is dwarfed by the number of Dollars, so any gains that the Ringgit can eke out are impressive. In addition, when you consider that the overall forex pie is also increasing, the nominal increase in volume for these small currencies was actually quite large.
The ongoing search for yield in all corners of the financial markets is likely to bring some of the more obscure currencies into the fold. “In June, I began getting questions about Uruguay, Vietnam and others,” said Win Thin, senior currency strategist at Brown Brothers Harriman in New York…investors often asked Mr. Thin questions about less-familiar currencies such as the Ukrainian hryvnia and Romanian leu.” In the same article, however, Mr. Thin cautioned that interest in such currencies is still probably lower than in 2007-2008, for a good reason. “It’s not like the Group of 10, or even the more liquid emerging market currencies where, if you decide you’ve made a mistake, you can get out.”
Due to the lack of liquidity and higher spreads, these obscure currencies aren’t really suitable for trading. Of course there will be a handful of institutional and even retail investors that want to make long-term bets on these currencies. They tend to be more aware of the risk and less sensitive to the higher cost and lower convenience. The overwhelming majority of traders, however, churn their portfolios daily, if not hundreds of times per day. A 10pip spread on the USD/MXN (Dollar/Mexican Peso) would be considered too high, let alone a 50 pip spread on any transaction involving the Ukrainian hryvnia.
In short, the majors will account for the majority of trading volume for the foreseeable future, regardless of what happens to the Euro. At the same time, that won’t prevent a handful of selected emerging currencies, such as the Chinese Yuan, Indian Rupee, Brazilian Real, and Russian Ruble from increasing their share. As liquidity rises and spreads decline, volume will increase, and their rising importance will become self-fulfilling.
The frequency of my reports on the Chinese Yuan is admittedly much higher than it used to be. Why? Call it disbelief. More than two months have passed since China revalued its currency, and after a rapid 1% appreciation, the RMB has actually fallen back. Today, it stands only .5% higher against the Dollar compared to June 18. On a trade-weighted basis, it is actually 2.3% lower. What is going on?!
It can foremost be attributed to a disconnect between Chinese words and Chinese action. While The People’s Bank of China (PBOC) purportedly supports a stronger, flexible Yuan (”Adopting a more flexible exchange-rate regime serves China’s long-term interests as the benefits…far exceed the cost in reorganising industries and removing outdated capacities.”), in practice, it has prevented the currency from budging. On numerous occasions since supposedly allowing the RMB to appreciate, it has intervened in the forex markets through various shadow dealers to prevent this very outcome.
In fact, China has increased its purchases of South Korean and Japanese sovereign debt, ostensibly as part of its diversification strategy, but more likely to put upward pressure on those currencies. “Data from Japan’s Ministry of Finance show that China bought a net 1.73 trillion yen ($20.3 billion) of Japanese government bonds in the first half of this year, compared with a net sale of 5.9 billion yen ($69 million) a year earlier. That strong demand has been a key factor strengthening the yen in recent weeks.” This could have broad implications, since in the last quarter, China accumulated $81 Billion in new forex reserves, and seems intent on further diversifying out of US Dollar-denominated assets.
China’s general obstinacy towards in dealing with the Yuan is baffling to market observers, especially given the trade surplus of nearly $30 Billion in June, its largest since January of 2009. In fact, China can be seen moving backwards. It recently inaugurated a pilot program that will allow exporters to hold offshore accounts of foreign currency, which might be expected to relieve some of the upward pressure on both the Yuan and on China’s foreign exchange reserves: “If you don’t force firms to surrender their foreign-exchange proceeds, then they won’t be exchanged for renminbi, which is a source of appreciation pressure.” In this way, China can both limit speculative capital inflows (even by domestic investors) and inflation.
Foreign governments, led by the US, are still threatening action. Senators and Congressmen continue to harp on the issue (it is election season, after all), and are still threatening to slap a tariff on all Chinese imports. However, their efforts are being undermined by both the Department of Treasury (which refuses to label China a “currency manipulator”) and the Department of Commerce, which recently determined that the application of a broad-based tariff on all Chinese imports would violate its mandate.
I have always been cynical about China’s forex policy, on the basis that it is self-interested and disingenuous, and I think the fact that it remains pegged to the USD confirms that sentiment. In the end, China won’t bow to international pressure. It will only allow the Yuan to appreciate after it has determined that its economy won’t be negatively impacted, and even then, the pace will be glacial.
The recovery that emerging markets (their economies and financial markets) have staged since the lows of 2008 is impressive. In most corners of the financial markets, all of the losses have been erased, and securities/currencies are trading only slightly below there pre-credit crisis levels. Even compared to twelve months ago, in 2009, the performance of emerging market currencies holds up well. In the year-to-date, however, most of these currencies have appreciated only slightly, thanks to a particularly weak month of August.
The MSCI emerging market stock index is currently down 2.5% since the start of the year. You can see from the chart above that most emerging market currencies tend to track this index pretty closely, rising and falling on the same days as the index. Interestingly, emerging market stocks appear to be much more volatile than emerging market currencies. You can also see that while the Malaysian RInggit has started to separate itself from the pack, the others have moved in lockstep with each other and are all about even for the year.
On the other hand, emerging market debt – as proxied by the JP Morgan Emerging Market Bond Index (EMBI+) has been unbelievably strong. Prior to the slight correction in the last couple weeks, the index has risen a whopping 20% over the last twelve months. On the surface, this disconnect between stocks and bonds would seem to be an anomaly, or even a contradiction. After all, if investors are only lukewarm about emerging market currencies and stocks, what reason would there be for them to get so excited about bonds.
If you drill a little deeper, however, it all starts to make sense. Due to a weak appetite for risk, 2010 has been a favorable year for bonds, at the expense of stocks. I would have assumed that poor risk appetite would also have helped G7 financial markets, at the expense of the emerging markets, but you can see from the chart below (which shows the MSCI emerging markets stock index closely tracking the S&P 500) that this simply isn’t the case. On the contrary, this same dynamic is playing out simultaneously in emerging markets. “Today, we are favoring emerging-market debt over emerging-market equities because the debt provides us with a better risk-adjusted return,” summarized one portfolio manager.
When it comes to debt, emerging markets have actually outperformed G7 debt, in spite of the current risk-averse climate. “Funds investing in emerging-market local-currency debt have attracted $16.9 billion of net inflows so far, more than triple the record annual intake of $5 billion recorded in 2007.” The logical basis for this shift is surprisingly straightforward: “When we look at government debt, we’re always comparing and contrasting the yields versus the fundamentals. I just don’t know why you would want those low yields from a Treasury bond in the developed world when you can get much higher yields — and in our estimation, an improving economic story — in Indonesia, Malaysia or Brazil.”
In other words, why would you want to earn 2.65% from a country (US) whose national debt is close to 100% of GDP, when you could earn double or triple that rate from investing in the sovereign debt of countries whose Debt-to-GDP ratios are sustainable?! In addition, when it comes to investing in debt, the lack of volatility in emerging market currencies can bee seen as a plus, since it prevents the interest rates from becoming diluted. To be fair, fundamentals don’t represent the whole story: “After 2008, you really have to take liquidity into consideration. Emerging markets are going to be some of the first to freeze up in a crisis.”
In fact, some analysts are already starting to question whether the markets haven’t gotten ahead of themselves in this regard, and that perhaps we are due for a big correction: “Come September, when trading resumes in earnest, we’ll find out if the cozy emerging markets world we have experienced over the past few months was summer laziness or strong conviction.” With vacations ending and traders set to return to their desks, we won’t have to wait long to find out.
