The world's foreign exchange market

The Bank of International Settlements (BIS) carries out an authoritative survey every three years of Foreign Exchange (FX) market volumes. The next BIS survey will be conducted in April and the results will be released in the second half of this year.

In the three years since the last BIS survey, the Bank of England and the New York Federal Reserve have released regional FX volume surveys. These are less authoritative than the BIS survey since they cover only a region rather than being a global survey.

However, these regional surveys are released every six months rather than every three years. The surveys refer to the combined volume of spot, forwards and swap trades as 'traditional' FX volume. A striking feature is how the combined traditional volume passing through London and New York has increased by nearly 50% since the last published BIS survey in April 2004.

This survey estimates that the US and the UK account for 50% of the global FX volume. If market shares have not changed markedly since 2004, there is a global FX volume as high as US $2.9 trillion per day.

The forthcoming BIS survey will give a more accurate measurement. However, it is doubtful that it will be far from this estimate. The BIS survey is awaited with interest since, if the estimate proves to be accurate, this will allow more confidence in future regional surveys.

The UK volumes have increased rapidly for both types of trade. Spot and forward trade volumes have increased by 49% over this period and swap trade volumes have increased by 41%. However, US swap volumes have hardly increased at all since April 2005 - increasing by only 5%.

In contrast, the US spot and forward volumes have increased 32% over this period. However, the volume measured in April 2006 was larger than for October 2006. This shows that London has increased its FX volume at the expense of New York, and this is particularly true for the swap market.

There are many reasons why one might see a large increase in swap volume. This could be because of a large increase in speculative trading. Since one does not know the maturity of a speculative trade in advance, the position is generally rolled on a relatively high frequency through swap trades.

Thus an increase in speculative FX volumes would tend to be associated with a larger increase in swap volumes. In addition, if more large corporates are hedging their FX exposure and/or hedging at greater frequency, this would also lead to a large increase in swap volume.

Since US swap volumes have not grown in the same way as UK volumes, it is possible that the reason for the increase is something specific to London rather than a change in trading practices. For example, the London increase in swap volume may be a result of increased merger and acquisition (M&A) activity in Europe.

There has been speculation in the media recently about the carry trade (that is the borrowing in a lower interest rate currency for investment in a higher interest yield currency) being overextended. The Financial Times reported that the danger signals are apparent in the Commitment of Traders positions, published each week by the Commodity Futures Trading Commission (CFTC).

However, the volume of trades in the FX market has increased significantly in recent times, so it is only natural that the CFTC positions have increased as well. The real question to ask is: are the position sizes for the carry trade at record levels with respect to the new size of the market?

The reasons for the increase in swap market volume are ambiguous. Hence, the increase in spot and forward trade volumes are only being taken into consideration to answer this question. The spot and forward volumes in 1998 (when the most recent major carry squeeze occurred) were estimated at $696 billion per day, whereas now these volumes are estimated as $1,172 billion per day. Thus, speculative positions, which were dangerous in those days, would not be so dangerous now.

While it is undeniable that the carry trade has increased in popularity in recent times and position sizes have grown, the belief is that it is overly pessimistic to assume that the positions are so extreme as to signal the onset of another carry squeeze.

Therefore, it is probable that carry trades will run the course for some time before the next great unwind.

This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.