How Regulation Has Distorted FX Market Liquidity

The FX markets are the largest financial markets in the world with an average daily trading volume of over $6 trillion. The trading volume in FX swaps, which is the most liquid FX derivative instrument, has exceeded that of spot for many years – by 2019, it accounted for almost half of all trading in global FX markets (Chart 1). But despite this, prior research on the liquidity in FX markets has focused disproportionately on the spot markets, rather than FX swaps. BIS economists Vladyslav Sushko and Ingomar Krohn address this by analysing FX swap markets. They find compelling evidence that the liquidity conditions in FX swap markets impact spot markets and vice versa.

Chart 1: Trading in FX Swaps Exceeds FX Spot

Source: BIS Triennial Central Bank Survey

What are FX Swaps?

FX swaps are contracts where one party borrows in one currency and simultaneously lends in another. Importantly, there is no FX risk, as the FX swap is made up of a spot FX transaction (to exchange the initial currency amounts) and an FX forward (to reverse that exchange). The forward contract therefore removes the FX uncertainty as the future exchange rate is agreed at the outset in the forward contract. In an FX swap contract, there is no exchange of interest. It’s simply one party using an FX swap hedging itself from exchange rate risk. Another popular derivative instrument is cross-currency swap, which aids two firms in removing exchange rate and interest rate risk. Research here is focused on short term FX swaps.

Measuring Swap Liquidity

The spread between forward and spot rates reflects the cost of the term funding of one currency against another. In their research, Sushko and Krohn use this forward spread as their main measure of FX funding liquidity. More specifically, they state:

• If the reported FX swap points are negative, this indicates that USD is trading at a forward discount compared to the quoted currency. Hence 1-month FX swaps reflect the cost of obtaining USDs today at the spot rate against JPY and reversing this transaction in one months’ time at the pre-agreed forward exchange rate. So with this measure of FX funding liquidity, the forward spread is equal to the forward rate minus the spot rate all divided by the spot rate.

• Their alternative measure of funding liquidity is linked to covered interest parity (CIP). According to theory, CIP links the FX forward rate to interest rates in the cash markets of countries of the featured currency. Therefore, the implied appreciation or deprecation of the forwards relative to spot must equate to the interest rate differentials in the cash (OIS) markets. However, if the implied change in forwards does not match the interest differential, then there is a deviation from CIP, which reflects liquidity pressures.

FX Swap and Spot Liquidity are Connected

The authors focus their study on the two most liquid crosses JPY/USD and EUR/USD. These pairs are termed as funding currencies by market participants. Global financial institutions and corporates often fund their balance sheets (issue bonds) in low interest rate currencies like the JPY and EUR and translate into operational business currency via FX swaps.

They find that the bid-ask spreads in spot and FX swaps are very highly correlated. In the sample period from 2010 to 2016, they find a correlation of 0.97 for JPY/USD and 0.98 for EUR/USD between spot and swap markets. This indicates that the market liquidity of the two markets are interlinked.

Additionally, they find that FX funding liquidity, whether measured by the forward discount or the deviation from CIP, associated with the widening of bid-ask spreads is not only in swap markets but also in spot markets.

Since mid-2014, the link between FX markets and FX funding liquidity conditions has strengthened significantly. And while quarter-end liquidity crunches have always been present, since 2014 these have become several times larger. This suggests market liquidity has declined.

Why Has Liquidity Worsened?

(1) Policy divergence

One of the main reasons appears to be policy divergence between the ECB, BOJ and the Fed. In recent years, the BOJ and ECB cut rates into negative territory, while the Fed raised rates (Chart 2). This led to a flurry of activity in cross-currency and FX swaps to take advantage of lower interest rates to fund balance sheets and earn carry into higher yielding currencies. This was specially the case for investing in the dollar, which had the extra benefit of being the dominant reserve and trade invoice currency. It was during the period of policy divergence, July 2014 and May 2017, that USD funding liquidity crunches in FX swaps markets became larger.

Chart 2: Central Banks Policy Divergence

Source: Macro Hive, Refinitiv Datastream

(2) Regulation

Another major reason was due to changes in the regulation for Global Systemically Important Banks (G-SIBs). FX swaps fall in the category of ‘off-balance sheet’ instruments. While under leverage ratio rules, only 1% of shorter-dated FX derivatives count towards calculations; under G-SIB scores and its complexity component, the entire notional amount of FX swaps is counted.

Therefore, G-SIB institutions have an incentive to manage their exposures to stay in lower G-SIB buckets. They significantly cut back their quoting activity in FX swap markets during quarter and year-ends to avoid entering into higher surcharge buckets (see Chart 3). This reduces the regulatory capital cost on derivative instruments around reporting activity dates. This window-dressing can result in financial instability.

Chart 3: G-SIB Surcharge and Bucket Cut-off Points (2016-2017)

Source: BIS

The Role of Small Dealers

Even though small dealers do step-up their quoting activity when G-SIB dealers pull back, smaller dealers are low volume players. They also charge wider bid-as spreads and steeper forward discounts in order to remain profitable. Consequently, their presence does not improve liquidity.

Another reason for the negative relationship between FX market liquidity and small dealer competition in the swap market relates to the relative informational disadvantage of small dealers compared with large dealers. Past research has found that the order flow of large dealer banks is more informative than that of small banks in terms of return predictability. Large dealers intermediate the lion’s share of customer flows inside their internal liquidity pools. Large dealers possess more precise information about the ‘true’ market forward exchange rate at any point in time because they intermediate FX swap buying and selling over a large and diverse client base.

The authors find that wider spreads in FX swap markets are charged by small dealers when they take over from large dealers. This in turn translates to wider spreads in spot markets, despite the fact that large dealers remain the dominant liquidity provider in spot.

As for the market shares of differently sized players, they find the following:

• Tier-1 dealers (G-SIBs) have seen their share of quoting activity in FX swaps drop by 5 percentage points (pp) in JPYUSD, though for EURUSD there has been a small increase of 2pp.

• Tier-2 dealers (non-G-SIB large dealers) have seen their share of quotes in FX swaps increase by 3pp in JPYUSD and 8pp in EURUSD

• Tier-3 (small dealers) have seen their share of quotes in FX swaps increase by 15pp in both JPYUSD and EURUSD.

The general trend, then, is for G-SIB dealers to reduce their swap quotes, while other dealers have increased theirs. However, the same trend is not seen in FX spot, where regulations would not affect the behaviour of G-SIB banks (see Charts 4 & 5). The authors find this is particularly the case around quarter-end.

Chart 4: Quotes by Dealer Size JPYUSD

Source: Macro Hive, BIS, Reuters

Chart 5: Quotes by Dealer Size EURUSD

Source: Macro Hive, BIS, Reuters

Bottom Line

FX spot and swap market liquidity are intimately linked. So the worsening swap liquidity of recent years has contributed to worsening liquidity in spot markets. This especially so around quarter-ends. One implication for market players, then, is to execute FX swap and spot outside of quarter-end (i.e. intra-quarter) to obtain better liquidity conditions. Another is to track forward spreads and cross-currency basis to monitor liquidity conditions in swap markets, which could in turn impact spot liquidity.

Importantly, regulation appears to have contributed to this worsening in liquidity. Smaller dealers who are less affected by regulations fail to step in and improve liquidity conditions. Overall, this adds to liquidity risks in financial markets that have been building for many years now.

Manan is a macro researcher with 8 years of experience on the sell-side including Nomura & J.P Morgan. At Nomura, he specialised in scenario analysis for G10 and major EM economies.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)