Buy Side Increases FX Use

Terry Flanagan

While buy-side institutions have traditionally been wary of making investments in alternative asset classes, such as derivatives and foreign exchange, there are signs that this tide is slowly turning.

That shift has occurred due to the ongoing electronification of the markets, as well as the sell side offering more tools and services to allow asset managers to more easily trade in the space.

“Over recent years we have witnessed the growth of currency overlay managers,” Sanjay Madgavkar, global head of foreign exchange prime brokerage at Citi, told Markets Media. “These managers dynamically manage the currency exposures of large investors such as pension funds. These strategies are aimed at either hedging risk or actively managing currency transactions with a view to providing a return to the investor.”

Investors have been turning to alternative investments, including FX, fixed income and other derivatives, in order to hedge risk as volatility has been rising in equities and as correlation and a decline in fundamentals have taken hold. This diversification is becoming increasingly important as the aftermath of the financial crisis continues to weigh heavily on the capital markets. Investors have been fleeing equities and heading into currencies and fixed income instruments in droves as the markets continue to stumble. Estimated inflows for the first third of the year for the top 50 largest exchange-traded funds by assets under management saw a net inflow of 11.4% to fixed income ETFs versus a net inflow of 2.5% to equity ETFs, according to Morningstar.

For the buy side, however, trading of foreign exchange instruments has been sporadic, with hedge funds among the most active.

“In our view, institutional investors and pension funds tend not to get into more speculative investments like currencies or any commodity,” said Bob Near, head of foreign exchange sales at BNY Mellon. “The main growth is on the hedge fund space and alternative funds. We do see some hedging activity from the buy side, but it does ebb and flow.”

Traders who are more opportunistic based on the outlook of the markets and have a higher risk appetite with shorter time horizons, and tend to get into and out of the market quickly, are more apt to get into currency trading, according to Near. These include hedge funds, alternative funds and those with more sophisticated algorithmic trading capabilities. Those that trade FX as an asset class need to be robust in their infrastructure and in their controls. “Trading in currencies is not for the faint of heart,” said Near.

There is, though, a lot of potential upside in the foreign exchange market. It is by far the most liquid asset class in the world, reaching $4.7 trillion in global average daily volume at the end of 2011. FX is also inherently a cross-border investment, and allows a quick and easy way for investors to gain exposure to a foreign market. The market also operates 24 hours a day, weekends excluded, making it a market that is constantly moving and changing.

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