Banks are retreating from market-making, managers warn

Forex investment has became more challenging, as market-making banks facing new regulation have become less willing to take risk, say buy-side firms

Investing in currencies has become significantly more challenging as banks have reduced their market-making activities in preparation for new requirements for bank capital, as well as the proposed ban on proprietary trading under the Volcker rule, according to buy-side speakers at the FX Invest Europe conference in Zurich earlier this week.

"Banks that were accustomed to being market-makers in the forex business were also accustomed to being lenders of last resort - or warehousers of risk - and operated as a valuable and timely shock absorber to moves in the foreign exchange market. Regulatory changes and the potential introduction of the Volcker rule have diminished the opportunity for banks to run proprietary risk, and this has without question had a substantive effect on market characteristics," said Paul Chappell, founder and chief investment officer at UK currency management firm C-View.

Chappell added that the growing activity of algorithmic trading has also had a negative effect on the stability and liquidity in foreign exchange markets, particularly in major currencies.

"Irrespective of one's opinion of short-term algorithmic trading, there's no question that the people involved in that endeavour are fair-weather friends. They are not going to be the sorts of people who will stand up and be counted in terms of warehousing risk if things stop working in the way they are anticipating on an intraday basis. They will turn their machines off and that liquidity, albeit to some extent relatively ephemeral, will dissipate," he said.

The net effect of the withdrawal of banks from risk warehousing and the activity of high-frequency traders, Chappell argued, is that a change in liquidity, particularly in G-7 currencies, has caused a significant spike in short-term volatility over the past year.

"You get a lot of mindless moves now on a short-term basis, and they're not to be sneezed at in terms of size. Simply put, if someone now comes to the euro/dollar market with a large enough transaction or a big enough requirement on an intraday basis, and that risk warehousing facility has diminished, you find unexpected moves. We have had frequent instances where euro/dollar has moved 1.5% in one direction one day, and then retraced exactly the same move the next day - this makes managing and implementing strategies different to what it was when those shock absorbers were there," said Chappell.

During a separate panel discussion at the conference, other currency managers shared Chappell's concerns about the impact of changes to bank capital on their ability to provide risk to the foreign exchange market.

"For a certain set of pre-conceived duration trades, the lack of market-making risk from the main banks did damage some systematic strategies, because the intraday moves being delivered were higher than average. There has probably been a higher frequency of weird moves overnight or intraday - that might have been because less market-making banks were taking risk than they were years ago," said Giovanni Pozzi, founding partner and chief investment officer at JW Partners in Milan.

Patrik Safvenblad, investment partner at Harmonic Capital Partners in London, agreed that a decline in the amount of risk capital available in the market has been a challenge - but not necessarily one investors cannot take advantage of.

"From a trading perspective, this is both an opportunity, in the sense you get large and sometimes co-ordinated moves that you can capitalise on, and a risk because these moves can overextend and that's something you have to plan for in discretionary and systematic strategies. That's a much bigger risk now than it was previously," said Safvenblad.

Visit FX Week for more foreign exchange stories.