Vol 2 No. 29 October 3, 2011

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    IntroductionThe tensions in the financial markets, which became apparent in earlyAugust 2011, have intensified sharply in September 2011 on account ofconcerns over the downgrade of the US by Standard and Poors, euro zonefinancial crisis, currency intervention from Japan and Switzerland, etc.These factors have contributed to the volatility in global financial markets.However, currency markets have acted as the pressure valve for the globalfinancial system with trading volumes surging to fresh highs worldwide.

    Record Trading VolumesICAP, the worlds premier interdealer broker by trading volumes, reportedthat the total average daily spot FX volumes on the EBS platform were $186.9billion in September 2011, an increase of 46 percent year on year. Similarly,NYSE: FXCM, a global online provider of foreign exchange trading, saw theretail customer trading volume touching $363 billion in August 2011, 17percent higher than July 2011 and 36 percent higher than August 2010, andinstitutional customer trading volume reaching $120 billion in August 2011,

    100 percent higher than July and 96 percent higher than August 2010.Trading volumes surged for exchange-traded foreign currency futures also,with the CME Group reporting that on an average 991,000 foreign exchangecontracts changed hands during August 2011, up 11 percent from July and21 percent higher than the same period last year.

    Drivers of VolatilityThe strains in the debt markets of the US and Europe have emerged asimportant drivers of volatility. With sluggish growth and very low interestrates in the core major economies, currencies such as the dollar, euro,pound-sterling and yen remain unattractive. Moreover, low interest ratesin the US have compressed the yield differential between the dollar andlow- yielding currencies such as the Japanese yen. Debt deleveraging inthe major economies suggests many emerging currencies will continue to

    enjoy a growth and yield advantage, which should translate into gains forcurrencies in emerging economies.

    Declining Carry TradeCarry trades (i.e., borrowing funds in a currency with low interest rates andinvesting the proceeds in currencies that offer higher returns to collect thecarry between the two rates) have been dealt a blow by the sharp volatility inthe currency rates. Popular funding currenciesthe borrowing and sellingleg of the trade have usually been the Japanese yen, Swiss franc, and theUS dollar. Though the exact size of the market is unknown, the estimatesput its size in outstanding deals at more than US$ 1,000 billion. Carry tradeis popular with hedge funds and other large institutional investors. Carrytrade has now become unattractive in view of sharp volatility in the currencymarket. However, carry trades are bound to return when the market calmsdown.

    Top 10 Currency Traders (% of Overall Volume, May 2011)

    Rank Name Market Share (in %)

    1 Deutsche Bank 15.64

    2 Barclays Capital10.75

    3 UBS AG 10.59

    4 Citi 8.88

    5 JPMorgan 6.43

    6 HSBC 6.26

    7 Royal Bank of Scotland 6.20

    8 Credit Suisse 4.80

    9 Goldman Sachs 4.13

    10 Morgan Stanley 3.64Source: Euromoney FX survey 2011

    High-Frequency TradingHigh-frequency trading (HFT) has increased its presence in the foreign

    exchange (FX) market in recent months. This development is one aspect ofa broader trend facilitated by the wider use of electronic trading in foreignexchange, both in the broker-dealer market and at the customer level.HFT in FX operates on high volume but small order size, low margin, lowlatency (with trade execution times measured in milliseconds), and shortrisk-holding period (typically well under five seconds). As such, it occursmainly in the most liquid currencies. HFT participants in FX tend to beconcentrated in three cities: Chicago, New York, and London. Outside thesethree centres, there are currently very few HFT firms. HFT firms conduct theirFX activities mainly on inter-dealer electronic broking platforms such as EBSand Thomson Reuters (London-based companies) and multi-bank electroniccommunication networks such as Currenex, Hotspot FX, and FXall (US-basedcompanies). They are also active on the Chicago Mercantile Exchange (CME)

    for trades involving FX futures.Contributed by M Ravindran & Pinky Jain

    When economic integration progresses, interdependence among countries becomes stronger, which, in turn,implies more potential for spillovers.

    Viviane Reding, Vice President, European Commission

    Global Currency Trading Soars Amidst Crisisd e v e l o p m e n t s t h a t m a t t e r i n f i n a n c i a l m a r k e t s

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    Mumbai, IndiaINTERNATIONAL PROGRAMMEON EXCHANGE OPERATIONS &ADMINISTRATION

    ol 2 No. 29 October 3, 2011

    Market Volatility5852

    17

    2165

    Major currency

    volatility, left s cale

    VIX equity volatility,

    right scale

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    Source: www.wellsfargo.com