Emerging market liquidity faces capital charge crossroads

May 13, 2024
Posted in News
May 13, 2024 MaxxTrader

Emerging market liquidity faces capital charge crossroads

Hedge funds and market-makers need a more capital-efficient way to trade Emerging Market currencies.

Emerging market (EM) currencies hold both promise and peril for hedge funds and market-makers alike. Despite their potential for lucrative returns, they are susceptible to changes in global risk appetite, as well as political and economic uncertainty, which leads to heightened volatility.

To safeguard against extreme losses, local governments have implemented various regulatory regimes designed to ensure financial stability while protecting their over-the-counter spot currencies from massive capital outflows in the event of economic shocks.

For example, the Central Bank of Brazil has previously implemented reserve requirements on foreign exchange positions held by financial institutions and interventions in the FX market through spot and derivatives transactions. Meanwhile India’s central bank has put several measures in place to regulate the FX market and prevent excessive volatility in the rupee.

Even in the case of the more-liquid non-CLS currencies, such as offshore renminbi, firms are compelled to hold capital against their full exposure. The result is underutilisation of capital limits and significant inefficiencies.

Coupled with the inherent volatility and liquidity challenges associated with EMs, these factors have, until recently, constrained the activities of hedge funds and regional market-makers. Although well-intentioned, these measures inadvertently hinder capital efficiency, particularly for market participants that have become more constrained from a capital perspective.

The repercussions are manifold – higher capital charges translate into increased costs and therefore lower trading capital and profitability. Consequently, fund managers have typically avoided allocating substantial capital to EM currencies, deeming the associated risks and costs prohibitive.

Such risk aversion not only limits the opportunities available to hedge funds; it also constrains the growth and development of emerging markets themselves. Moreover, higher capital charges influence trading strategies, prompting the funds to reallocate capital to assets with lower charges. By reducing exposure to EM currencies, this shift also exacerbates liquidity risks, which further impedes market efficiency.

This situation is essentially a consequence of the long-standing, conflicting demands placed on market participants across global foreign exchange. Historically, FX has operated mainly as an OTC market, in which trades are negotiated directly between counterparties without a centralised exchange. It’s a system that suits the vast majority of firms as it allows them to customise trades to suit their individual needs.

The issue is that OTC contracts lack the transparency and standardisation that many institutional investors crave – hence why we have seen an increasing number of exchanges introduce listed FX futures contracts that offer benefits such as transparency, liquidity and greater regulatory oversight.

But the irony lies in the fact that if they are to address the conundrum of excessive capital charges in EM currencies, both listed FX futures and OTC FX marketplaces need to be singing from the same hymn sheet by creating more efficient pools of liquidity.

Why is this so? Emerging markets have become increasingly interconnected, therefore connectivity between FX futures and the OTC FX marketplaces can break down barriers to entry and enable cross-market trading strategies. By tapping into a broader pool of liquidity across both markets, fund managers can more effectively manage their positions in EM currencies. Using futures contracts, for example, delivers cost savings in terms of capital requirements due to the clearing benefits offered by centralised clearing houses.

Also, when a hedge fund trades futures, it typically needs to put up only a fraction of the total contract value as margin, rather than paying the full amount upfront, as you would with many other financial instruments.

The wider pool of liquidity also lessens the risk of market impact and slippage when entering or exiting positions, thereby lowering overall trading costs to offset the higher capital charges. With greater liquidity, large trades can be executed with less impact on prices.

In other words, the bid/ask spread tends to be narrower when liquidity is more plentiful, so traders can buy or sell larger quantities of the EM currency without significantly affecting the market price. Furthermore, by accessing pricing information from both markets in real time, traders can make more-informed decisions. Improved price discovery helps to mitigate the risk of executing trades at unfavourable prices, thereby reducing the potential losses and capital charges associated with adverse market movements.

For hedge funds, lower capital charges empower them to optimise trading capacity without unduly burdening their balance sheets. Additionally, a more equitable pricing mechanism in the OTC market, untethered from excessive capital charges, helps foster fairer trading conditions.

Hedge fund investors also stand to benefit. With the ability to roll positions through futures expiry, investors can leverage existing clearing lines to capitalise on cross-margining benefits. This not only streamlines operations but also enhances risk management, enabling investors to navigate volatile market conditions with greater agility.

Meanwhile, lower capital charges enable market-makers to quote better bid/ask prices locally and facilitate trade execution, resulting in tighter spreads and increased market depth.

Many emerging markets have made significant strides in improving their market infrastructure, regulatory frameworks, and governance practices to attract institutional investors over the past few years. Efforts to enhance transparency, market access, investor protection, and regulatory compliance have bolstered confidence among these investors, making EMs more attractive destinations for liquidity deployment.

But no-one can deny that much work remains to be done. Institutional investors will only allocate capital to emerging markets in the search for attractive risk-adjusted returns and income generation if they are convinced the underlying market structure – including both futures and OTC FX – is up to scratch.



This article was published on FX Markets on 2 May 2024.
Authoured by Vinay Trivedi is Chief Operating Officer, Sell Side Solutions, SGX FX.

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