The last triennial survey of FX trading volumes and trends published by the Bank of International Settlements (BIS) in December 2019, showed that FX markets for emerging market (EM) currencies grew more rapidly than those for major currencies. In fact, between 2016 and 2019, EM currency trading rose by 60%, almost double the global average (33%), and by the end of 2019 accounted for almost 25% of global turnover.
The BIS ascribes this growth to several factors such as the growing appetite among global investors for EM assets in their search for yield. It should also be noted that banks enjoy greater profitability by offering more exotic products. Between 2016 and 2019, there was also an increase in the share of trading generated by hedge funds and proprietary trading firms. The presence of more non-bank financial institutions was hugely driven by the electronification of FX trading, states the BIS. This enabled smaller players to access markets that had been traditionally dominated by inter-dealer trading among banks.
There was also a noticeable growth in forwards, particularly NDFs, and offshore trading, a trend that was driven by the inclusion of these instruments on the main electronic broking platforms such as EBS and Reuters/Refinitiv which launched NDF trading platforms in 2020.
The BIS concludes that the rapid growth of EM currency trading and its electronification can create both challenges and opportunities. On the plus side, it allows for round-the-clock trading and the greater liquidity can boost foreign investment in those emerging economies.
However, the increase in offshore trading can influence the price discovery process for exchange rates in markets that are more difficult to monitor. There are also similar risks for FX traders in these more exotic currencies. The higher profit margins on offer have to be weighed against the lack of automation and higher operational risks. And just as central banks have sought to expand their monitoring capabilities, the many vendors and developers of FX trading platforms and services have looked to develop more products and tools geared towards EMs in order to reduce those operational risks.
“The EM world is differentiated from other currencies by often reduced liquidity, more complex workflows and additional trading restrictions,” says John Stead, global head of pre-sales at smartTrade Technologies. “Some processes and currencies can be fully electronified so benefit from the existing advanced trading functionality already used with non-EM instruments. But at the extreme ends of the EMs, some currencies and the liquidity providers do not have any electronic rates distributed via application programming interfaces (APIs).”
Instead, the rates are quoted via a daily rate card sent via email or fax each day. “We have the ability to capture these rates from non eFx sources in order to keep manual processes to a minimum,” says Stead. “Once captured banks may use these rates within the existing eFx flows. Some can be provided via API for interbank trading but the sell side only wants to show clients a rate fixed at a certain time each day. Here the process required is one of moving from a variable rate to a distributed rate card can be automated reducing risk and again keeping any manual work to a minimum.”
The use of APIs has become vital in allowing maximum integration of flows and reducing the manual intervention, says Ludovic Blanquet, chief product and strategic planning officer at smartTrade Technologies. “Semantic and self-describing APIs, also known as RestAPIs, allow for a much richer integration between human interventions and automatic processing. As the banks reduce the size of their operations, they need to raise their productivity. Intelligent automation allows them to do both while protecting their margins. Any process that is automated creates an audit trail and key checkpoints triggering a commensurate decrease of operational risks levels.”
The role of technology and automation becomes even more important in EMs where liquidity is harder to come by, as is the relationship between trading platforms and liquidity providers, says Stead. “The partnership between banks and their liquidity providers is especially important when liquidity is scarce as can be the case when quoting and managing risk for pairs outside of their traditional trading hours.
“In addition to the liquidity challenges we see clients have to manage some very complex operational and regulatory challenges in terms of providing onshore and offshore rates, single side pricing and ensuring clients only trade at certain times on the day and ensuring that only certain entities can trade with specific clients,” says Stead.
Consequently some of smartTrade’s more recent developments have centred on creating the logic to allow the automation of pricing and risk management where local conventions differ from international conventions – for example, the settlement period is different for certain currency pairs for local markets and for the interbank market, such as USD/TRY.
Other developments have focused on workarounds for the manual processes that still exist – for example, smartTrade has added the ability to manually make markets in currencies with the ability to check ‘made’ rates versus benchmark rates.
However, the hope is that the complexity that comes with manual processes will be gradually reduced due to some macro-economic trends. The first of these is Covid 19, which Blanquet says has reduced everyone’s tolerance for anything manual. Secondly, there is a particularly bright macro-economic outlook for EM currencies as an asset class which can only help to encourage more digital innovation. “China is pushing hard to decouple from America by trying to establish the RMB as a currency for funding import and export activity. Meanwhile emerging economies, especially in Southeast Asia, are increasing their exchanges and calling for more modern financing options. Instruments like NDFs are well suited to support these trends. And currencies like the Brazilian real, the Korean won, the South African rand and the Taiwan dollar will also require more automation as the trading volumes increase.”
For example, the greater take-up of NDF instruments over the last few years is a reflection of an increased sophistication in clients’ hedging requirements and the ability of banks to source liquidity during the day, says Stead. And as more firms turn to algorithmic trading of NDFs, the electronification of the associated workflows and data trails will be essential.
As Blanquet says: “Across all asset classes, we have observed that as soon as an instrument starts to be offered electronically, volumes increase as a result of higher trading velocity and better price transparency. Once both are established, humans are confronted with their limitation to follow the market and algo slowly take over, turning sales traders into algo consultants. So the liquidity does not adapt to the algo, the algos and the liquidity mutually reinforce themselves.”
According to Deutsche Bank’s head of Client Access & Flow Execution, Gordon Alexander, banks’ investment in digital solutions for trading platforms has extended from G10 currency pairs to EM currencies, especially in Asia. This has been driven by the fact the securities denominated in those currencies have been increasingly weighted in EM indices and ETFs.
In terms of e-trading, the critical component in EMs is workflow, says Alexander. “A few years ago we saw clients transition toward aggregator platforms, attracted by pricing. But we are starting to see a swing back to proprietary platforms like Deutsche Bank’s Autobahn because workflow solutions and artificial intelligence (AI) augmented with better market colour features are significant drawcards above and beyond spot and forward pricing execution. Ongoing advances in algorithms and AI technology are sharpening the tools available on e-platforms for traders and corporate clients alike. The key differentiator in EM markets is the need for workflow to augment the platform’s capabilities in addition to providing pricing in local markets,” says Alexander. “For corporate treasurers the diversification of supply chains in EM countries and thus the need to manage hedging and investment flows alongside day to day payment activity in EM trade corridors has led to growing demand for electronic capability.”
There is also much greater use of application programming interfaces (APIs) to develop direct client connectivity and more use of automation and robotics to reduce manual intervention and improve the lifecycle timing of a trade, says Alexander. He references the introduction of an API-enabled FX product jointly developed by Deutsche Bank and BNY Mellon with the aim of improving confirmation rates for restricted EM currency trades. The product was initially applied to custody FX transactions in Korean won and is being progressively being introduced for other local currencies, such as the Indonesian rupiah.
Another driver of digital innovation in EM currency trading is the growth of NDF trading and the use of e-trading platforms, which has evolved in a number of ways, says Alexander. “Volume growth in electronically traded NDFs has been steady. Brokers such as EBS have increased the currency offering and institutions are increasingly offering more NDF pairs and NDF algorithms to allow clients multiple electronic execution methods and increased transparency. Algorithms are focusing on improving execution around broken dates and market events by using other tools to augment liquidity such as FX futures to improve electronic price creation.”
While the growth in trading volume helps to boost liquidity in EMs, there is still a greater operational risk given the tendency for thinner liquidity, greater volatility and less use of automation. In addition to ensuring investment in processing technology, the priority for Alexander is to address the workflow issues. “The strength and evolution of onshore trading platforms require continued investment across multiple markets,” he says. “At Deutsche Bank we have focused on building digital workflows to enable onshore access for clients within often complex local regulatory frameworks, even in markets which experience liquidity gaps.
“The ability to handle the transfer of risk for our clients is a key differentiator. Tracking and managing client orders transparently across time zones and being able to perform fixed income and FX execution electronically removes the uncertainty which can result from voice-executed trading,” says Alexander. “If clients are looking to execute transactions in markets which are inherently volatile and across time zones and products, electronic workflow creates confidence that a bank will consistently facilitate client business and be able to provide ease of execution and efficient workflows.”
The ability of banks to navigate onshore regulation, coupled with automated workflow, AI and algorithms to track liquidity and the capability to facilitate bookings and utilise digital data will be the key innovation areas in EM, says Alexander. “We will continue to invest in integrated workflows across asset classes in fixed income and FX that will create inter-operability with third party and in house solutions to create ever most sophisticated trading platforms for the market in EM currencies.”
As Michael Siwek, founding partner and head of eFX at FX trading platform DMALINK, highlights, the Covid-19 pandemic has accelerated the adoption of technology globally, including FX trading in EM currencies. “More financial and non-financial institutions are turning to electronic execution, with voice-desks likely losing out. Couple this changing landscape with generally low FX market volatility, apart from occasional spikes and rising EM volumes, electronic FX platforms are actively expanding EM coverage to win more business. For example, we have seen more participants entering the NDF market to cater for more EM currencies,” says Siwek.
However, EMs remain prone to thin liquidity and new macro-economic drivers are appearing, says Siwek. “In 2020 we saw the reversal of a decade long trend for Gold accumulation by EM sovereigns. In August we saw net selling by EM sovereigns, not because they no longer considered gold to be a reserve asset, but simply because they needed the cash to pay for the chaos government intervention has created in wake of Covid. Sovereign debt issuance has also started to turn parabolic, which has interesting implications for the US dollar, as the issuance of US dollar denominated debt is a synthetic short on the US dollar. We don’t see this ending any time before 2025.”
At the same time, more buy-side clients appreciate and understand the value of FX platforms in helping create deeper access to custom and regional pools of liquidity and offering the ability to transact when other pools of liquidity dry up. Technology is also helping to bridge some of the operational risks on the post-trade side, says Siwek. “I don’t think we are that far away from the removal of settlement and counterparty risk,” he says also referencing the BNY Mellon and Deutsche Bank collaboration around APIs as well as DMALINK’s own work on client execution and regulatory reporting.
The FX derivatives and futures markets are also becoming more complex and fragmented thanks to the introduction of NDFs on and off swap execution facilities and across several trading venues, notes Siwek. “Disparities across participants’ access to liquidity are inducing further opportunities. Participants are increasingly turning to algorithms to identify, benefit, and maximize returns from these trading opportunities”
Further, NDF liquidity has been most liquid in the one month bucket, says Siwek. However, buy-side client demand is more consistent in the three months bucket and client demand is pushing more liquidity providers to stream pricing out to three months and beyond. The increasing availability of streaming NDF pricing is also creating more opportunities for algo trading and Siwek says that DMALINK is looking into offering off-SEF streaming of NDFs which are centrally cleared by tier 1 banks to its participants by 2021.
The answer to the volatility, fragmentation and complexity of trading FX in EM currencies lies in greater use of electronic platforms that can offer automation for all processes, from price aggregation to pre-trade risk management to trade reporting, says Siwek. “Traders can confidently focus on their market execution strategies and remain confident that they will execute against the best possible price available on the platform. This minimises risk of executing against stale or off-market prices.”
“Further risk systems, including several notification engines, notify the banks of potential issues as soon as they arise, enabling the trader to take prompt action. Automatic trade reporting also removes the risk of error. Finally, in order to ensure that you are not adversely affected by geographical fragmentation in EM liquidity, which we believe is a much bigger issue than volume, you need to ensure that you have access to unique ecosystems of regional liquidity for specific EM pairs, including full amount feeds to minimise information leakage,” says Siwek.
In terms of future digital developments, DMALINK is investing more in algorithmic technologies, including the introduction of machine learning and other artificial intelligence and digital technologies to assist with best execution and regulatory reporting. “We expect the market to follow along the same broad lines,” says Siwek.
Another aspect which Siwek says is in dire need of innovation is the legal aspect of credit documentation between counterparties. “We are exploring options to submit, digitally sign and safely store credit documents between counterparties on the blockchain rather than using paper documents distributed via email. We already see such digital innovation when it comes to Designation Notices distributed over post-trade network Traiana. We believe that four-way agreements can follow a similar evolution.”