The latest survey carried out by the Bank of England’s (BoE) foreign exchange joint standing committee appears to confirm the view that trading in sterling does badly in conditions of widespread stress.
Data gathered from 27 financial institutions in the UK for the April 2020 survey shows that while there was a decline in average daily turnover for all the major currency pairs compared with the findings of the previous survey in October 2019, sterling trading fell particularly sharply, with USD/GBP and EUR/GBP down by 32% and 31% respectively.
The previous survey reported that USD/GBP was the second most-traded currency pair after USD/EUR, with a gap of almost $5 billion a day to USD/JPY. However, according to the new data, daily USD/JPY trading exceeded that of USD/GBP by almost $27 billion in April.
The pound is among the least defensive currencies in the G10 and investors typically avoid it during periods of stress and high volatility
– Kenneth Broux, Societe Generale
The appeal of the yen as a safe-haven currency explains why trading volumes overtook those of sterling at a time when markets were reeling from the effects of coronavirus lockdowns.
“The pound is among the least defensive currencies in the G10 and investors typically avoid it during periods of stress and high volatility,” explains Kenneth Broux, head of corporate research FX and rates at Societe Generale.
“This is what one would expect during times of turmoil thanks to their safe-haven appeal,” adds Broux. “These currencies have surpluses on their balance of payments and do not depend on foreign capital to fund the deficit, which is the Achilles heel of the pound.”
Rajesh Venkataramani, a partner at Goldman Sachs, says at least some of the fall in sterling trading compared with previous periods can also be attributed to volumes having been elevated when markets reacted to UK prime minister Boris Johnson’s election as leader of the governing Conservative Party last year, raising the likelihood of the UK leaving the European Union without striking an exit deal.
“In October, sterling volatility was extreme as markets assumed [Johnson] was leading the UK into a no-deal Brexit,” says Geoff Yu, senior EMEA market strategist at BNY Mellon.
Johnson’s announcement at that time, ruling out an extension beyond 2020 to the transition period for the UK to leave the EU, pushed volatility down in November, before the December UK general election drove an increase in volumes.
In terms of instruments, FX swaps and currency swaps were hardest hit, with the former down by a fifth between October and April, and average currency swap volumes falling 37%.
Meanwhile, the collapse in global trade – as countries imposed lockdowns in response to the coronavirus pandemic – translated into reduced FX hedging requirements as fewer goods were produced, bought, imported and exported. Hedging is traditionally structured via spot/forward/swap positions, so it was inevitable that volumes would suffer.
Another factor was financial stress.
“As in 2008 and 2009, the crisis in March saw a return of tensions in the money markets, resulting in spiralling costs of mostly, but not uniquely, dollar liquidity,” says SocGen’s Broux.
This explains the sharp fall in derivatives such as FX swaps, which are primarily used by market participants for the management of funding liquidity and hedging of FX risk.
Some market participants have previously suggested there is a trend towards the use of options rather than swaps. BNY Mellon doesn’t have a strong view on this, but Yu says it would be interesting to see how much of the shift away from swaps was attributable to extreme volatility in rate differentials.
“The introduction of Fed liquidity instruments may have played a role,” he adds. “In such an environment, using options rather than rate-related derivatives to hedge currency risk does seem more appropriate.
“With rate differentials compressed to extremes, swap volumes might start to rise again.”
The other notable finding from the survey was that average daily reported UK FX turnover in April was 16% lower than in October. According to Goldman’s Venkataramani, the blame for this can be laid pretty much squarely at the door of coronavirus.
“Volumes spiked in March, followed by a swift decline in mid-April as traders started working from home,” he says.
“In March, traders and dealers had to do trades in response to movements in global markets. Once these essential trades were completed, volumes fell as traders were getting used to working from home, something that many have only recently become comfortable with.”
Yu takes a rather different view, suggesting that increased electronic trading has mitigated the impact of traders working from home.
“Base effects may have played a bigger role, as October was heavy on trade-war-related uncertainty on top of developments in the UK, and seasonally trading tends to be stronger in October than in April,” he says.