Trading Dynamics of Emerging FX Markets
by James Watson, Head of EMEA FXAll New business, Thomson Reuters
This article explores the foreign exchange trading dynamics of emerging foreign exchange markets from the perspective of FXall, the leading multi-bank foreign exchange trading platform serving over 1,300 institutional clients across the foreign exchange markets.
Multinational companies are increasingly looking to developing markets as a source of growth and, at the same time, many local corporates regularly look outside their domestic markets to compete internationally. Currency fluctuation coupled with regulatory complexities have driven corporate treasurers to focus on their FX execution frameworks, including risk management, as one way to help protect their companies’ bottom lines.
Certain trends, such as the continued growth of electronic trading and increasing regulation of derivatives trading products, are impacting corporate treasury approaches to FX execution and provide insight into the future direction of the market. Here, I explore some of the drivers of this change.
Subsidiary automation facilitates centralised treasury functions
In order to manage FX risk, it is essential that corporate treasurers thoroughly map out the dynamics of their businesses, identify and quantify their FX exposures, and then implement the relevant remedial measures – such as centralising their treasury function. FX risk management is a time sensitive activity and it is increasingly important that treasurers have the ability to view and measure their risk exposure in real time. The drive towards better risk management in the global financial markets has resulted in a need for corporates to implement more sophisticated systems in the form of subsidiary automation, whereby their treasury systems and trade execution functions are centralised. Traditionally, companies operating across developing markets, and globally, have operated in a silo fashion and therefore were not benefitting from the efficiencies that can be gained through netting their transactions. This decentralised approach to the treasury function involves the management of multiple banking relationships in multiple locations, which can often prove extremely inefficient and costly.
Today more and more corporates with subsidiaries in multiple countries are partnering with providers of electronic FX solutions to help them centralise and streamline their treasury function. In doing so, it is possible for corporates to gain real time access to data, which provides a clear view of cash flowing across the entire organisation. Many large corporates have developed global and regional centres that enable them to centralise and consolidate internal FX flows before netting them to trade. The centralised function, which has a holistic view of cash flow from all subsidiaries, is then able to analyse the information, identify potential FX execution risk and help mitigate it.
e-FX solutions drive thoughtful execution strategies
When treasurers think of FX and risk, they typically think of political risk, economic risk, and payment risk, most of which can be categorised as external risks over which corporates have little influence or control. However, as corporate treasury departments continue to play an even more strategic function within corporates, there are other types of FX-related risks that are beginning to develop and over which the treasury community can exert some control. One of these risks is execution risk. For treasurers, achieving the best price through best execution has a demonstrable and direct impact on the company’s performance – every marginal saving delivers to the bottom line. For this very reason, it is critical that corporate treasurers take measures to mitigate execution risk.
Unlike in more established markets where corporates are beginning to use advanced order execution mechanisms to trade FX similar to active traders, in developing markets, corporate treasurers typically do not trade for alpha. The treasury function of corporates in developing economies typically regard FX trading as a ’cost centre’ and focus primarily on mitigating the risk that arises from currency fluctuation, thereby locking in costs and ensuring efficient cash management.
However, in addition to centralising the treasury function, corporates are becoming increasingly driven towards thoughtful execution strategies and are realising the need for a complete end-to-end solution for FX trading. As a result corporates are connecting their treasury management systems to multi-bank FX platforms, which have done much to improve execution standards in the FX industry worldwide. FX platforms provide corporate treasurers with advanced workflow, robust audit trails, straight through processing (STP), as well as deep liquidity and tighter pricing. This in turn has made hedging accessible at lower costs and reduced processing times, leading to faster execution, and greater transparency and control of FX exposures.
To ensure that treasurers are achieving best execution, a best practice policy should be put in place that details in which scenario a trade should be competed for, and from how many banks prices should be requested. Ideally, a corporate should seek a range of prices to ensure that there is a sense of where the market is trading. Typically, this tends to be between two and four prices. That said, there may be times when, in order to minimise market impact, large trades need to be executed quickly, that corporates may decide that the most effective route is to deal with a single counterparty. In the quest to achieve best execution, multi-bank FX trading platforms have not supplanted the need for corporates to nurture their bank relationships. Indeed, bank relationships are vital for those corporates who wish to execute bespoke trades.
Provisions for these types of occasions should be covered by best practice guidelines which respond to specific best execution goals, put the processes in place to achieve them and enable them to be measured. When a corporate needs to ensure that a trade with a single counterparty has been priced justifiably, online trading platforms can provide corporates with reports that benchmark the price achieved against the indicative market rates.
One of the key safeguards of best execution are execution analysis tools which enable users to analyse trading over time to assess on an ongoing basis the effectiveness of an FX strategy. The FXall solution involves the analysis of data such as currency pairs traded, trade sizes, times of execution and counterparty performance, after which FXall relationship managers can highlight to treasury departments how they can improve FX execution performance. If a treasury department can integrate this type of reporting and analytics with the benefits of an electronic FX trading platform, the improvements to execution performance should be significant.