Has the volatility in the FX market started to recover?

Regulatory uncertainty, technological change and traders behaving badly have collided in a perfect storm for banks’ foreign exchange operations. There are signs, however, that the worst has passed, and the return of more-normal times could be just around the corner. More volatile trading conditions, if sustained, could help to keep the business profitable.

The FX market has gone through some major changes since the 2008 market crisis. The new regulation, though well-intentioned, has created uncertainty, as the rules are still being written or implemented. Similar to the evolution of the equity market, foreign exchange has been moving quickly into an electronic marketplace, and the negative news has helped make the transition quicker and more pronounced.

On the positive side, electronic pricing has created better price discovery, more transparency, more competition, tighter spreads and better economies of scale, On a negative note, the evolution of electronic trading has made it more challenging for liquidity providers to analyze the flow and has forced them to evaluate relationships based on management information systems reporting, and less through direct conversation with customers. Expect the next few years to be both exciting and challenging, as the market finds its balance.

Zero-interest-rate policies in place at many developed-market central banks, reflecting low inflation and low growth, have yielded an unprecedented period of low volatility in foreign exchange and interest rates. This environment has taken a toll on transaction business at major banks globally. In addition, technological innovations have altered the landscape, with systemic or model-driven trading, often away from banks, taking a large slice of the daily volume in FX.

A confluence of these two developments has undermined the profitability of FX trading at the banks. However, with the ending of the Federal Reserve’s quantitative easing, and the Fed and the Bank of England both considering when to raise rates, while the European Central Bank moves closer to full-blown QE and the Bank of Japan engages in more QE, the volumes and volatility in the FX market have started to recover.

Moreover, the volume of FX trading run through computer models appears to be declining, which may in part reflect greater regulatory scrutiny of high-frequency trading. “FX business largely associated with major banks is recovering rapidly from a depressed state.

I am optimistic that as some central banks seek to normalize policies as their economies improve, while others seek to engage in even more unconventional strategies to spur growth, the return of volatility and volumes are probable and would be a healthy development for this sector.

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