The drop in market volatility we saw in the first half of 2014 – referred to ironically by FT Alphaville as “the Great Moderation 2.0” – now seems an age away. Certainly volatility levels have fallen back for now from the dramatic October spike, but we as head into 2015, the consensus mood is that volatility has found a higher baseline taking it back in the direction of historical norms.
As we know, a range of factors contributed to that rise in volatility, from the end of the Federal Reserve’s quantitative easing program, to the sharp depreciation of the yen, to the fall in crude oil prices. Yet, when one thinks of some of the more difficult risks to manage, geopolitical events come to the fore. The latest Bank of England Financial Stability Report in the summer polled London market respondents on what risks they found most challenging for their firm to manage. The answers are quite striking:
• Geopolitical risk (36 percent of respondents).
• Sovereign risk (33 percent)
• Risk of an economic downturn (27 percent)
• Risks around regulation/taxes (26 percent)
• Risks surrounding the low interest rate environment (23 percent)
• Operational risk (17 percent)
• Risk of financial market disruption (14 percent)
In Europe, geography has often meant that market participants have been particularly conscious of geopolitical risk, especially when it comes on top of fundamental divergences in economic policies. We have the U.S. economy looking quite robust and the Fed debating when to raise short-term rates, while the European Central Bank (ECB) and Bank of Japan, seem more committed than ever to “do whatever it takes” to avoid deflation. Geopolitical uncertainties coupled with major relative differences in economic performance are a prescription for volatility.
What we tend to see is that higher volatility leads to greater activity in the most liquid markets – those that both transmit risk and provide participants with liquid hedging and risk transforming opportunities. Naturally pre-eminent are firstly the FX market – London sees around $2.5 trillion in FX traded every day (Bank of England data), more than in Tokyo and New York combined – and secondly the short term dollar interest rate market.
The FX Joint Standing Committee data for the first half of 2014 showed an upward trend: average daily UK FX turnover was 7 percent higher than six months previously, with FX swap turnover up 8 percent to a survey high. Crucially however, the task of managing higher volatility sits against the backdrop of radically new conditions in Europe’s banking and financial markets landscape, as the impact of Basel 3/CRDIV on capital and bank liquidity gathers pace. We’ve all seen a wide range of data underscoring the hugely changed market liquidity picture – for example the recent IMF Financial Stability Report showed a 34 percent decrease in bank trading books from 2011 to 2014. Direct and knock-on impacts from regulation are changing the way risk gets managed in Europe. For example, while European asset managers have tended to use more OTC than futures in FX, this is now changing quickly.
At the same time we’ve witnessed heightened regulatory focus around the FX market and its benchmarks. Given the indispensable role of the FX market, especially in higher volatility conditions, the launch in September of the new Foreign Exchange Professional Association – of which my colleague Derek Sammann is vice chair – is a welcome development. Its work in education, research and advocacy to advance a liquid, transparent and competitive global FX market will resonate strongly with market users.
FX Growth in Europe and Asia
For CME Group, it is not surprising that in these new conditions, European market participants have been turning to us – both accessing the global depth and range of the company’s leading contracts, as well as utilizing the growing range of contracts on our new European exchange. The third quarter saw our average daily volume (ADV) by European clients up 22 percent compared to the prior year, and some record volumes in October in interest rate and Eurodollar futures. Our FX volume in October was up 53 percent from October 2013, and on Dec. 3 reached record open interest of 2.7 million contracts.
Our new FX futures contracts have seen average daily volumes in Europe grow from a few hundred to around 4,000 contracts by the autumn. Encouragingly, we are not only seeing liquidity from market makers, but also other participants starting to get involved.
In addition, Asian participants – for whom the oil price and geopolitics are always center-stage – often see Europe as a natural market for managing risk, given liquidity and time zones. CME Europe is already benefitting from this, with its FX product range well suited for Asian and emerging market interest.
For European participants, the coming year will all be about managing the “return of vol”, week in, week out. Recent moves in energy prices have thrown up dilemmas for many of our clients, with consequences that are continuing to play out not only in energy prices, but also in the interest rate and foreign exchange markets. Of course, the flip side of unexpected risk is unexpected opportunity.
2014 certainly threw up much of both for market players. With Europe’s banking stress tests over, one upside risk is undoubtedly a better functioning credit system that will positively underpin market conditions. Certainly the substantial increase in geopolitical risks in 2014 was absorbed confidently by markets. But whatever events throw up next year, market participants will be looking – in this new constrained-liquidity financial system – to rely on the full array of risk-management tools to navigate across the major asset classes.