Archive for January 2015

Client confidentiality – 1990’s style…

When I was trading FX for Morgan Stanley about 20 years ago, we were doing business with a number of the larger Hedge Funds. At that time it was felt to be important that the trader knew who he was quoting when the Salesperson shouted for a price, but we were also conscious of client confidentiality. A bright spark on the Sales desk said, at the weekly meeting, that they should shout the clients name backwards. So Tiger would be “Regit” and Moore would be “Eroom” or “Nocab”. That’s a great idea, I said (with a hint of sarcasm in my voice), but what will you shout when Soros is on the phone asking for a price ? !

EUR/CHF positions – the problem with VaR…..

There are many talented, mathematical minds in the Risk function of banks and other financial institutions, and they are experts in devising models to manage risk by predicting possible market behaviour. It appears that a PhD in Astrophysics is much more useful in a Risk department than experience of how markets actually behave in the real world. The problem has always been that the models fail regularly, with spectacular consequences. No model can allow for the huge vacuum that existed after the SNB pulled their bid at 1.2000.

The most widely used risk measure is Value at Risk (VaR) and the amount of “value” (read potential loss) allocated to EUR/CHF positions (for example), when combined with some measure of historical volatility of that currency pair, will determine the maximum allowable position size that the trader can hold.

The problem with this approach is that as historical volatility falls (as it did all through 2014 in EUR/CHF) position sizes can be increased whilst still staying within the allocated VaR limit. In layman’s terms, the trader says to himself “this currency pair is not moving much, so I can take a bigger and bigger position and STILL stay within my VaR limits”.

Let’s hope that this mythical trader was long of Swiss francs last week……

Dual Currency Deposits – a layman’s guide

The Dual Currency Deposit (DCD) is a popular cash-management tool for companies that have multi currency cash flows. Let’s take a simple example of a UK-based company who are importing goods from the USA. They have an occasional need for Dollars, but they have spare cash balances in Sterling.

UK rates are low, and they are earning very little interest on their Sterling deposits. The DCD can offer a higher-than-market Sterling interest rate as long as the company accepts that their Sterling deposit may be repaid to them in US Dollars. They are effectively selling a Call option on their Sterling to the receiver of their deposit, and it is the premium generated from the sale of this option that provides the above-market deposit rate. The company must decide at which GBP/USD rate they are happy for the conversion to take place (the strike price of the option) and when this could happen (the maturity of the option)

For example, the current deposit rate for GBP for 3 months is only 0.50%. The current GBP/USD rate is 1.5200. A customer who places a DCD in Sterling with a maturity of 3 months and a “conversion” rate of 1.5500 will earn an annualised rate of approx 3.00% on their Sterling, which is significantly higher than 0.50%. After 3 months, if the GBP/USD rate is above 1.5500, the company will be repaid their deposit in Dollars.

FX Derivatives do not have to be complicated – they just need to be explained in plain and simple terms.

FX investigations – where next ?

News that FX traders may have shared information about order flow with large customers is not really news. However, there is a significant difference between sharing information about order flow BEFORE the deal takes place, and reporting it in generic non-specific terms, AFTER it has occurred.

The focus of the investigations is going to shift in 2015, as compliance teams and the various authorities realise that the actions of the FX traders with regard to fixing deals, are just the tip of the massive iceberg that is the foreign exchange market. There are still a number of unanswered questions :

Why do Fund Managers continue to allow their FX business to be done at “benchmark” prices that they KNOW are sub-optimal? When will pension fund holders start to question whether the Fund Managers have fulfilled their fiduciary duties concerning “best execution” ? How do major bank Salespeople differentiate themselves from their competitors in order to “win” business ?

Although we have seen a welcome pick-up in market volatility over the last few months, this might be a year of fears over what will be revealed by the next phase of investigations, and this may continue to cast a shadow over the FX market in 2015.

EUR/USD – Will it be different this time ?

The all-time low of EUR/USD was seen in Q4 2000 at 0.8230 and the all-time high was 1.6038 in Q3 2008. Since then, there have been 4 assaults on the 50% retracement level of 1.2134. The first time this happened, the move was rejected (approximately 8 years after the low), but the next three times (Q2 2010, Q3 2012 and most recently, this month) have seen 1.2134 breached, but we have never followed through towards the 61.8% retracement level of 1.1213.

Will it be any different this time ? IMF data would suggest that here does not appear to be much of an appetite to buy Euros at these lower levels, and with the prospect of Draghi introducing QE very soon, and Greece’s membership of the EU under threat, it would appear that short EUR positions will be held for the time being. Having said that, it pays to be careful, when it all looks too easy !