A new world in FX
The FX market has shown resilience in recent months but has emerged changed from all the turbulence, with new participants and new trading strategies in evidence.
The global foreign exchange market, like all financial markets, has experienced a year of unparalleled turbulence and change. Fortunately, the market was extremely resilient and managed unanticipated settlement challenges to experience its highest volumes ever. However, some of the structures, trading in spot and forwards in particular, underwent changes.
As a consequence of the market’s breakdown, its composition has changed and some hedge funds retreated from market-making, reversing a trend that many thought unstoppable. As volatility came back with a vengeance, it was necessary to adopt new trading strategies and all market participants have been forced to adapt – or scrap – their approach to take account of sharply different market conditions.
Following the market changes in September and October 2008, prices became harder to obtain and for a time liquidity disappeared in some of the largest and most mainstream products, such as euro/dollar forwards. Where prices were available, the cost of trading was substantial. At the same time, intraday volatility ballooned. Euro/dollar is now capable of moving 100 basis points within 15 seconds – a level of volatility not seen in a decade. Both liquidity and volatility have improved somewhat from fourth-quarter 2008 levels, but they are still above historical norms. Liquidity is expected to remain constrained for at least the remainder of this year.
Consequences of volatility
Perhaps the most immediate repercussion of the massive increase in FX volatility in September and October 2008 was that trading strategies based on normal expectations of volatility failed. For many hedge funds that used historical volatility patterns to create trading models, there was an immediate need to re-tool their algorithms to adjust their performance.
There is a degree of consensus that a return to the low volatility seen in markets in the past decade is unlikely in the foreseeable future. Instead, the market may revert to the more longstanding condition of relative instability, which prevailed in decades prior to the last one – even if there is a new cycle of lower volatility in the immediate future.
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