“Winter is coming” and volatile markets come with it

By Jay Moore, CEO & Co-Founder and James Davison, Head of Growth

As the days shorten and the temperature starts to drop, there’s no doubt that fall is behind us and the coldest months lie ahead. But what does the end of the year mean for FX swaps markets??

Winter is coming. For Game of Thrones fans, this phrase will be very familiar. It’s the motto of House Stark that not only means exactly what it says, but it is also used to convey a sense of foreboding and to be vigilant in anticipation of turbulent and uncertain times ahead. While the Game of Thrones world is fantasy, winter is coming should perhaps be the new mantra of professionals in FX swaps markets. Here’s why.

Over the past several years, there has been heightened market volatility at year-end. This is caused by:

1. Participants rushing to hold USD on their balance sheet over the holiday period – leading to a spike in implied interest rates in FX basis for major currencies against the dollar?
2. FX market makers closely managing the size of their risk-weighted assets to stay within their GSIB tiers

As a result, liquidity becomes constrained and FX forward spreads widen, generating increased volatility in pricing. When this happens, traders are thrown into the unknown. Spreads may widen or tighten sporadically, adding unnecessary costs to the overall portfolio they are managing.

Unsurprisingly, FX swaps are poised once again for volatility as we head towards the end of the year. This year, however, could be much, much worse.

The external factors of LIBOR cessation and escalating inflation prints bring further uncertainty and potentially more volatile markets. For example, if the market anticipates the Fed will change its interest rate policy, demand for USD will shift causing a sudden spike in volatility.?

Consequently, foreign investors will face increased hedging costs, not only due to changes in FX basis but the increased spread investors need to pay banks to provide liquidity to the market. These increases in hedging costs can affect underlying investors (like you and me), as the increased costs will feed down to the underlying funds –?whether it’s a public pension plan to a retiree’s pension account.?

Additionally, asset managers will also need to trade earlier than required to access liquidity and fulfil their obligation to their investors of maintaining FX hedges against their foreign investments.? This can cause a significant increase in tracking error to the portfolio versus the benchmarks they are required to hit.?

Turning a lose-lose-lose into a win-win-win?

The truth is that year-on-year traders know this heightened, year-end volatility is coming. But as passive volumes continue to grow and more regulations come into play, it is becoming increasingly challenging to mitigate the potential year-end risks on portfolio performance without looking to peer-to-peer networks.

We can see this from taking a look at how investment managers will chop up large trade orders bit by bit to source liquidity and minimize the market impact of scheduling massive jumbo trades. However, in these instances there can be 10-15 days of uncertainty as to whether or not these trades will be met and rolled when investment managers try to hit their benchmarks. Investment managers haven’t been able to avoid the added cost of their FX swaps over year-end in the past – but they didn’t have FX HedgePool.?

We’ve created a solution to this problem that allows investors in opposing jurisdictions to match each other at mid, while working with a panel of banks to warehouse the credit risk. With the growth of passive hedging, we’re helping to alleviate the build-up of pressure and volatility as more flow comes to FX HedgePool. By using the platform, managers can roll their FX hedges at a fixed, predetermined cost, removing the uncertainty that comes with trading in the market, especially during year-end volatility,? while eliminating market impact entirely.

The way asset managers flows are matched on the platform allows for trades to be matched at their required benchmarks – mitigating tracking error. This, together with our ability to guarantee the cost of FX hedging, enables? asset managers to fulfil their fiduciary responsibility to their investors and manage their portfolios with confidence and certainty.

This year – like every year –?we know that “winter is coming”. Don’t be caught off guard and let periods of volatility affect your FX hedging practices again. Contact us at [email protected] to find out how you can access a new source of secure, anonymous, and consistent liquidity that eliminates pre-hedging risk for all.