Emerging market liquidity faces capital charge crossroads

By Vinay Trivedi,

Emerging markets currently hold both promise and peril for institutional investors and investment bank FX trading desks alike. According to the European Central Bank (ECB), changes in global risk appetite is one of the main forces behind emerging market (EM) currency movements. Despite their potential for lucrative returns, navigating the terrain of EM currencies has traditionally been hindered by excessively high capital charges. This, coupled with the inherent volatility and liquidity challenges, has constrained the activities of hedge funds and regional market makers until now.

Characterised by their susceptibility to global risk appetite and political/economic uncertainties, EM currencies often experience heightened volatility.

To safeguard against potential losses, regulators have typically imposed higher capital requirements. While well-intentioned, these measures inadvertently hinder capital efficiency, particularly for hedge funds and market makers.

Even for the more liquid non-CLS currencies like CNH, firms are compelled to utilise the full capital equivalent to their exposure. This results in underutilisation of capital limits and significant inefficiencies.

The repercussions have been manifold. Higher capital charges translate to increased costs, reducing trading capital and profitability. Consequently, fund managers have typically avoided allocating substantial capital to emerging market currencies, deeming the associated risks and costs prohibitive. This risk aversion not only limits opportunities for hedge funds but also constrains the growth and development of EM. Moreover, higher capital charges influence trading strategies, prompting hedge funds to reallocate capital to assets with lower charges. This shift not only diminishes exposure to EM currencies but also exacerbates liquidity risks, further impeding market efficiency.

This capital charge conundrum holding firms back from accessing better sources of liquidity in EM currencies, is really a consequence of the longstanding conflicting demands placed on market participants across global FX. Historically, FX has mainly operated as an OTC market, where trades are negotiated directly between counterparties without a centralised exchange. This system suits the vast majority of firms as it allows them to customise their trades to suit their own individual needs. 

The issue is that OTC contracts lack the transparency and standardisation that many institutional investors crave, and why we have seen the growth of more and more exchanges introducing listed FX futures contracts offering benefits such as transparency, liquidity, and regulatory oversight.

The irony lies in the fact that, in order to address the excessive capital charge conundrum in emerging market currencies, both listed FX futures and OTC FX marketplaces need to be singing from the same hymn sheet. By tapping into a broader pool of liquidity across both markets, hedge funds can more effectively manage their positions in emerging market currencies. Increased liquidity reduces the risk of market impact and slippage when entering or exiting positions, thereby lowering overall trading costs to offset the higher capital charges. 

In addition, by accessing pricing information from both markets in real-time, traders can make more informed decisions about executing trades in emerging market currencies. Improved price discovery helps to mitigate the risk of executing trades at unfavourable prices, thereby reducing potential losses and capital charges associated with adverse market movements. For hedge funds, lower capital charges translate to greater capital efficiency, empowering them to optimise trading capacity without unduly burdening their balance sheets. 

Additionally, a more equitable pricing mechanism in the OTC market, untethered from excessive capital charges, fosters fairer trading conditions. Hedge fund investors could stand to benefit as well. With the ability to roll positions through futures expiry, investors can leverage existing futures clearing lines to capitalise on cross-margining benefits. This streamlines operations but also enhances risk management, enabling investors to navigate volatile market conditions with greater agility. Market makers also stand to benefit. Lower capital charges enable local market makers to provide higher quality liquidity to the local market by quoting bid and ask prices and facilitating trade execution, resulting in tighter bid-ask spreads and increased market depth.

Many emerging markets have made significant strides in improving their market infrastructure, regulatory frameworks, and governance practices to attract institutional investors in the past few years. Efforts to enhance transparency, market access, investor protection, and regulatory compliance have bolstered confidence among institutional investors, making emerging markets more attractive destinations for liquidity deployment. However, nobody can deny that there is still much work to be done. Institutional investors will only allocate capital to emerging markets in search of attractive risk-adjusted returns and income generation opportunities if they are convinced the underlying market structure is up to scratch.

Lowering capital charges through fostering closer connections between FX futures and the OTC FX marketplace hold the key to unlocking the full potential of emerging markets.

By enhancing liquidity through cross-margining, market participants can navigate the complexities of emerging market currencies with confidence. This not only benefits hedge funds, their clients and market makers, but also contributes to ensuring the overall emerging market infrastructure becomes increasingly more sophisticated. 

Vinay Trivedi is Chief Operating Officer, Sell Side Solutions, SGX FX