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Survey finds tremendous increase in currency trading.

November 2004, by Carlise Peterson for Currency Trader magazine

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Triennial report shows the FX market is expanding rapidly. What's behind the growth?

A global reserve bank survey confirms what many in the market have suspected: The FX market has grown immensely over the past three years.

The much-anticipated Bank for International Settlements (BIS) Triennial Survey of FX Market Turnover for 2004, released Sept. 30, revealed average daily FX turnover (the value of trading volume) rose from $1.2 trillion in 2001 to $1.88 trillion in April 2004, a 57-per-cent increase at current exchange rates and a 38-percent increase using 2001 exchange rates (see Table 1).

The triennial report by the BIS, based in Basel, Switzerland, said the rise followed a surge in interest from hedge funds and asset managers.

The 2004 survey shows a large increase in activity in traditional foreign exchange markets compared to 2001. Turnover rose across instruments, but particularly in the spot and forward markets, according to the BIS. In addition to valuation effects, factors boosting turnover include individual trader and investor interest in foreign exchange as an asset class alternative to stocks and bonds.

Money managers and individual traders

According to the survey, trading between banks and financial customers (such as hedge fund managers) rose, and its share of total turnover went up from 28 percent to 33 percent (Table 2). The survey said the higher activity between reporting banks and financial customers may reflect a sizeable increase in activity by hedge funds and commodity trading advisers, as well as robust growth of trading by asset managers (money managers).

Between 1998 and 2001, when the last survey was taken, activity in that market segment had been driven mainly by asset managers while the role of hedge funds had declined.

“There are two contributing factors driving the BIS-reported increase in daily turnover in the foreign exchange market,” says Michael Woolfolk, senior currency strategist with Bank of New York. “First, the prior tri-annual figure was reduced by the launch of the euro and subsequent elimination of high volume European cross currencies such as the Deutsche mark/French franc (DEM/FRF) and Deutsche mark/Italian lira (DEM/ITL). Given the growth trend in FX turnover during the preceding decade, this number would have been closer to $1.7 trillion without the launch of the euro.

“Second, the current tri-annual turnover figure reflects an acceleration in the velocity of foreign exchange transactions as hedge funds and other speculative trading interests play a larger role in the market,” he adds.

The survey reveals trading between reporting dealer banks rose between 2001 and 2004, although its share continued to fall, from 59 percent in 2001 to 53 percent in 2004. According to the BIS, restraining factors might include the continuing consolidation in the banking industry, as well as efficiency gains derived from the use of electronic brokers in the interbank spot market. The share of trading between banks and non-financial customers edged up slightly to 14 percent.

“Interdealer shrinkage is actually a testimony to individual customers,” says Glenn Stevens of FX brokerage Gain Capital. “They're bypassing the banks and going to market makers like us. Also the onset of electronic trading has contributed. Price discovery is a lot closer.”

Dollar still rules, derivatives gain ground

Between 2001 and 2004, there were no substantial changes in the composition of the FX market.

The U.S. dollar was on one side of 89 percent of all transactions, followed by the euro (37 percent), the yen (20 percent) and the pound (17 percent). Table 3 shows the U.S. dollar/euro continued to be by far the most traded currency pair in April 2004, with 28 percent of global volume, slightly less than in 2001, followed by U.S. dollar/yen with 17 percent (20 percent in 2001) and U.S. dollar/pound with 14 percent (11 percent). The share of trading in local currencies in emerging markets increased slightly to 5.2 percent.

In the OTC derivatives market, average daily turnover increased by 112 percent between April 2001 and April 2004, to $1.2 trillion at current exchange rates. The OTC market section consists of “non-traditional” foreign exchange derivatives — such as cross-currency swaps and options — and all interest-rate options.

“What surprised me was the large increase in derivatives trading,” says Osman Ghandour of The Forex Edge. “It appears the forex market is attracting a higher level of speculative fever — always a dangerous sign.

“However, what's more, I think participants have become more sophisticated in trading crossrates, which also adds to the turnover,” he continues.

Bank of New York's Woolfolk also sees speculative trading as a significant factor in the forex market.

“Currency is now traded as an asset class more so than at any time in the past, and such speculative interests have undoubtedly boosted FX turnover,” he says.

Business in interest rate contracts grew by 110 percent. The increase was driven especially by trading in dollar-denominated instruments, which were up by 128 percent, according to the survey. Activity was intense for dollar-denominated options, with turnover up a whopping 675 percent. Because of this jump, trading in interest rate options represented 17 percent of total trading in interest rate products — a threefold increase over April 2001.

“If you look at the breakdown of the increase, the largest component is not the spot market, but rather FX swaps, although all three components — spot, outright forwards and swaps — all posted gains year over year,” says Dave Floyd of Aspen Trading, an FX trading and research firm.

Euro also robust

Activity was also strong for euro-denominated contracts, up by 100 percent. Business in euro-denominated interest rate swaps expanded by 66 percent. In terms of market size, contracts denominated in euros remained larger than those in dollars — $461 billion vs. $347 billion.

After decreasing between April 1995 and April 2001, activity in yen-denominated interest rate swaps expanded by 119 percent, to $35 billion. According to the BIS, the growth may reflect the signs of economic recovery and the associated changes in the outlook for interest rates. Activity in pound-denominated interest rate swaps was also up by 157 percent, to $59 billion.

Turnover in foreign exchange derivatives — or currency options — was up by 109 percent, to $140 billion. A currency option provides a trader with protection against adverse movements in foreign exchange rates. The share of this segment of the OTC derivatives market remained around 12 percent. Activity was boosted by contracts involving the U.S. dollar (up by 104 percent, to $110 billion), especially the dollar/euro and the dollar/yen pairs (up by 124 percent and 58 percent, respectively). Turnover also increased for other euro-denominated contracts, by 130 percent, to $23 billion.

Looking at the counterparty breakdown, turnover with other financial institutions rose to 43 percent of global OTC derivatives turnover, up from 29 percent in April 2004. •

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Back in November 2004, the online magazine Currency Trader published, for the first time of its history, a detailed and very informative article on the depth of the Forex market.

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