Foreign exchange (FX) is the largest financial market in the world by a wide margin. The volumes traded in FX are multiples of global stock or bond markets. Nothing comes close. So how big is this market? According to the Bank for International Settlements (BIS), $6.6 trillion dollars….per day!
Every 3 years, BIS comes out with a survey of volume traded. The latest survey, released on 16 September 2019, reveals the huge headline number of $6.6T traded per day - the highest number ever reported! This figure was a massive $1.5T/day jump from the $5.1T/day reported 3 years ago. 30% growth is incredible - after all, we're not talking about tech company valuations. Nor are we talking about a persistently growing metric such as inflation or GDP. From 2013 to 2016, volume actually declined by 5%.
So Why the Huge Growth? Is It Real?
If we dig a little deeper into the numbers, the spot portion of FX grew by roughly $0.3T/day to just under $2T/day but is still a hair shy of 2013 numbers. The increase in spot volume is “real,” however 2019 is more of a rebound than a growth story when put in context. The majority of all 2019 FX growth came from FX swaps (almost 60% of the growth).
Why so much in FX swaps? Funding and funding distortions. Going deeper still into the numbers, $0.4T of the growth was in FX swaps with tenor of less than 7 days. This is really short-term stuff and includes simply managing foreign currency bank balances (bank Nostro funding). Even the longer dated FX swaps are funding related. And here is where we start to see the distortion.
When I met with several large banks in Japan a few years ago, I saw firsthand the problems caused by massive quantitative easing (QE). Japanese banks struggled to invest in anything with a positive yield unless they searched outside of the country. These banks would invest in long-term US assets and hedge back with FX swaps - sometimes short dated FX swaps. That was the path to positive yields, albeit with risk. The distortion of QE has grown and is now prevalent in many countries, as developed markets experience zero or negative interest rate environments. Banks and investors are searching for yield wherever they can find it; across the credit spectrum, across the yield curve and across the globe. The natural result is a growth in the volume of FX swaps.
QE Distorts the FX Market
Whether QE has caused distortions in global equity valuations, yield curves or even levels of market volatility is beyond the scope of this piece. However, the tremendous growth in FX volume is, in large part, due to a very unusual market condition leading to excessive cross-border funding needs. And since there is no end in sight for low interest rates and QE, the largest market on Earth is only going to get larger.