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Jamal Mecklai
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March 8, 2010
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Background
In the absence of national boundaries, there would be no currency market. There would, of course, continue to be equity markets and interest rate markets (which would intermediate between savers and borrowers) and commodity markets (that would intermediate the supply and demand of different commodities).
Once the realities of national boundaries are brought in, we see that currency markets act upon all of the other markets enabling cross-border efficient allocation of capital and price discovery (in the case of commodities). Thus, currency markets do not have an independent constituency like equity markets (which match holders of risk capital with people that require risk capital) or interest rate markets (which match savers with borrowers) or commodity markets (which match producers with consumers). Rather the constituents of all of these markets become the underlying for currency markets.
This may go some way to explaining why currency markets are the deepest and most liquid in the world – the underlying they service is theoretically the sum of the underlying of all other markets.
Further, given that all countries have capital controls of some form or other, this is not surprising, and it points out that as globalization continues, which I believe it will despite the current hiatus, FX market volumes will continue to grow like topsy.
Volumes and Speculative Liquidity
Interestingly, although the OTC FX market is the largest in the world, trading over USD 3 trillion a day, it is not – from the point of view of speculative liquidity – the largest. In 2007, the total volume of trade in the world was about 40 trillion a year (comprising about 32 trillion of merchandise and 8 trillion of services). Capital flows, while highly volatile, total not much more than 4-5 trillion a year, which brings the total underlying for the FX market to about 45 trillion a year.
Dividing the daily volume by this number gives a ratio of about 16.5, which means that the speculative element is 16 times the real flow.
The US Treasuries market, which traded just 5-600 billion a day on average in 2007, has an underlying of just 4.5 trillion, providing a ratio of 33, indicating that the speculative volume in US Treasuries is about twice that in the FX market.
Currencies as an Asset Class
As already mentioned, different degrees of capital controls in different countries doubtless reduce the total volume of trading in currencies – i.e., a smaller portion of the underlying is actually hedged, which could explain the smaller speculative liquidity relative to interest rates. Again, currency volatility is, often, much higher than bond price volatility, suggesting that currency markets are riskier than interest rate markets, which could also explain the lower speculative liquidity.
Finally, currency moves are – certainly relative to moves in equities – somewhat muted. The dollar can move 40% against the Euro over, say, 3 to 5 years, but moves of this nature can be seen in commodities or in individual stocks in a year.
Thus, given the relatively high risk (higher volatility than bonds) and lower returns than equities or commodities, and the fact, as mentioned earlier, that currency markets do not have an independent underlying, it is perhaps not surprising that currencies as an asset class have never really made it big.
Having said that, there is a significant volume of currency trading for profit – not just big banks and investment houses, but hundreds of thousands of small traders using bucket shops globally and, more recently, the currency futures market domestically. While, as in all markets, 90% of small traders lose money, it is certainly possible to make money trading currency markets, provided that you can be DISCIPLINED.
Our currency futures trading desk has been able to generate excellent returns (over 4% a month), albeit over a short span on 6 months. However, it takes rigor and, as I said before, discipline to make it happen.
In sum
Currency markets are both different and not different from other markets, like equities, interest rates and commodities.
They are different in that they do not have their own underlying – or, more correctly, an underlying exposure in the currency market is also largely an underlying exposure in one of the other national markets. [Direct cross-border investment in unlisted equity or debt is an exception.]
They are similar in that they offer traders an opportunity to take positions for profit.