As investors clamour for liquidity, structured products that use foreign exchange as an underlying asset are gaining in popularity. In all the other main asset classes – whether equity, credit, fund-linked or commodities – investors are facing wide spreads and extreme illiquidity for short-dated products, but not in foreign exchange.
Indeed, in the volatile period since the collapse of Lehman Brothers, foreign exchange traders have been busier than ever – so much so, in fact, that several dealers had to close down their automated order-taking systems because they couldn't keep up with the volume of orders. With prices moving so quickly, a big backlog of orders can be costly for banks that still rely on human traders for execution. The big rewards in the post-Lehman world are coming to those foreign exchange dealers that have invested most in trading platforms that use algorithms to execute orders.
Even in normal conditions the foreign exchange market offers a deep pool of short-term liquidity. More money changes hands in currency markets each day than in the US equity and fixed-income markets combined and today the difference is even more stark.
For this reason, foreign exchange has become a very useful place to invest for investors who are wary of locking their money up for long periods of time. The shorter the horizon, the better. Products with a life of one to three months, six months at the most, have grown in popularity as the crisis has deepened – simple products for the most part, such as range accruals and no-touch or double no-touch options that pay an enhanced yield if the forex view comes off and nothing if it does not.
Some structured products providers are selling even shorter-dated products as money market alternatives, such as structured forex deposits for as little as two weeks. "There's no other asset class in the world that has liquidity in that space," says Lutfey Siddiqi, Asia-Pacific head of FX distribution and corporate FX at Barclays Capital in Singapore.
However, there has been a slowdown in demand for products with longer maturities as retail-investor losses on Lehman Minibonds and other Lehman-related products have made regulators in Hong Kong and Singapore wary of new structured products issuance. Most distributors are now focusing on the new year for a return of new issuance, at least in the retail space. That could be a good time to re-enter the market anyway.
"We have seen an increasing interest from clients to take advantage of the opportunities that have been created by the recent large moves witnessed in the currencies market," says Giovanni Amanti, Asia head of FX structuring at BarCap. "Clearly, a euro buyer will, for example, find buying euro at 1.25 a much more attractive deal than buying it at 1.55 against the dollar. We think this may be a sign that people are starting to think about getting back into the markets."
Clients in the private bank space are already starting to trade some of the new ideas. Amanti says that BarCap is marketing ideas that take advantage of the increased volatility, which is at unusually high levels. Typically, currencies don't move much, but today the volatility on many currency pairs is similar to the vol levels on equities a year ago. Even at those levels, it is still possible to take advantage by using, for example, products that offer a very large range around a spot level or that take a view that the spot will not move as much as the volatility implies.
"Also, given the current high volatility environment, the idea of selling volatility, either within capital protected structures or taking some principal risk, can be very attractive and these ideas are gaining more and more traction," says Amanti.
Structurers are also starting to work on ways to recycle the currencies that investors ended up holding because of trades that went wrong earlier in the year. One of the most popular forex structures was a block currency investment or deposit where the investor basically sold a call on their primary currency, with the risk that they could be converted into another currency and the reward of a higher interest rate. The Aussie dollar was a popular option for providing the yield pick-up, which means that many of those dual-currency investments have now been exercised, leaving a bunch of investors locked into Aussie dollars and hungry for bright ideas.
Inefficient markets
There are some neat opportunities in the market right now that would normally be traded away by hedge funds, if they had any money. As it is, many of them are now strapped for cash thanks to the double whammy of investors and lenders asking for their money back. That can be frustrating.
"The strangeness of the environment means there are a lot of fairly obvious relative value opportunities to pounce upon and make money from if you have the capacity to do so," says Siddiqi. "If you're a hedge fund, you're dealing with redemptions on the one hand and margin calls on the other, so you can see the opportunities, but you just can't go and close them. This time last year, anomalies didn't last for very long because of the efficiencies of the market. Today, we see them persisting longer."
One such unusual movement in the market has been the divergence of Swiss francs and yen. In the past, these two funding currencies typically had more than 50% correlation but are today moving in opposite directions. Again, simple over-the-counter products like best-of or worst-of options can capture the benefit of this peculiar divergence. "Risk aversion used to mean buy yen, buy Swiss," says Siddiqi. "Now, it's buy yen, sell Swiss."
Interestingly, the negative sentiment towards Switzerland stems from its heavy dependence on the financial sector and, in particular, the Swiss government's $54 billion bailout of UBS, which is costing the equivalent of more than two months' salary for every working person in Switzerland. That's not a buy signal for the Swiss franc.
However, as the UBS bailout demonstrates, there is plenty of liquidity being injected back into the financial system by central banks all around the world – it is just that the transmission mechanism that passes that liquidity into the market is still broken. But, if that mechanism was to open up again, there would be a lot of liquidity in the market with negative real yields. At that point, people will start putting money into risky assets again.
At first, says Siddiqi, investors will be tiptoeing back, which will create a market for structures that limit the amount principal investors can lose while still taking advantage of the currently inflated market price for volatility.
Between now and then, the cash element of foreign exchange will stay as vibrant as it is right now, but structures will remain rare.
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