When financial market intermediaries warehouse net risk positions of other market participants the marginal value of their capital should affect the expected and actual returns of such positions. This is of particular importance in the FX market, where excess positions typically end up on the balance sheets of a small group of international banks. Empirical evidence confirms that currency returns have been related to the dynamics of capital ratios of the largest dealers. Excess returns on FX carry trades can, to some extent, be interpreted as compensation for the balance sheet risk. Currencies that trade at a high forward discount have paid off poorly when intermediary capital ratios decreased.

Reitz, Stefan and Dennis Umlandt (2019), “Foreign exchange dealer asset pricing”, Deutsche Bundesbank Discussion Paper, No 39/2019

The below are excerpts from the paper. Headings and text in italics and brackets have been added.
The post ties in with with this site’s summary on endogenous market risk, particularly the section on ‘exit risk’.

The importance of intermediaries in the FX market

“The foreign exchange (FX) market with a turnover of 5,067 billion US dollar in 2016 can be considered as the biggest over-the-counter (OTC) market in the world, where a set of specialized dealers provide FX liquidity for a large variety of customers and trade heavily among each other…Large foreign exchange dealers…are at the core of the FX dealing process, face low transaction costs, and make use of complex investment strategies as well as extensive data resources.”

“Financial intermediaries’ balance sheets are playing an increasingly important role in describing asset price dynamics, because of their ability to reflect current funding conditions of key players in the market… Intermediaries’ balance sheet factors matter most for those asset markets, which are highly intermediated…Given that the foreign exchange market is by far the largest venue for intermediated over-the-counter transactions, FX dealers’ balance sheets [are] a promising candidate to understand currency excess returns.”

Excess returns of carry trades [can] be interpreted as compensation for balance sheet risks of major foreign exchange dealers. This reasoning is supported by the specific structure of foreign exchange trading, which consists of a customer-to-dealer segment and a dealer-to-dealer segment. .. The first tier consists of a dealer-to-customer trading segment, where dealers trade foreign exchange with their clients such as importers, exporters, and international investors. The second tier refers to a dealer-to-dealer trading segment confined to FX dealers operating among themselves…In the customer-to-dealer segment the average dealer provides foreign currency liquidity and hands over the excess of all buy and sell orders to major dealers in the dealer-to-dealer segment…Large dealers typically dominate the dealer-to-dealer trading thereby also attracting a major share of other dealers’ order flow…Core dealers tend to take risks on their balance sheets…As a result, excess positions from foreign exchange trading show up only in the balance sheets of major dealers.”

“Thus, it is the marginal value of wealth of large FX dealers which may propagate a stochastic discount factor instead of the marginal value of wealth of the representative household [as in traditional asset pricing models]… Capital ratios of core dealers should contain most of the information relevant for FX pricing…Regarding the intermediaries’ specific metric for asset pricing information…recent empirical contributions stress the importance of balance sheet variables for explaining…excess returns in a number of asset classes.”

Empirical evidence for the importance of capital ratios of top FX dealers

“Our empirical results confirm that FX dealers’ capital ratios perform remarkably well… as a priced risk factor in a variety of currency portfolios…particularly when it comes to explaining excess return to the carry trade.”

“In particular, our intermediary asset pricing models show a remarkably good fit for carry trade portfolios. This points towards a risk-based explanation of carry trade returns related to balance-sheet conditions of main FX dealers. Currencies trading at a high forward discount tend to pay off poorly when the capital ratio decreases and balance sheet constraints are tightening.”

“The core market makers’ balance sheets are expected to be most informative… The top three FX dealers are assumed to be closest to the core dealers in FX markets acting as ultimate liquidity providers for customers and average dealers. Moreover, as suggested [in other research] only the top-tier dealers are expected to also warehouse FX inventory risks on their balance sheets…In fact, balance sheet information of the reported biggest three FX dealers by market share is sufficient to describe the cross-sectional variation of currency portfolio returns.”

“To capture the market share of FX dealers we rely on data reported in the Euromoney FX survey…As shown [in the table below], a total of 39 financial institutions entered the top ten at least once in the period between 1984 and 2017…The biggest three intermediaries maintained a combined share of below 20% in the 1980s [and] reached a peak of over 40% market share in 2008. In general…foreign exchange trading became much more concentrated over time.”

“To get the market equity we multiply the share price of the stock market where the holding is located with the number of common shares outstanding. The reason for using the market value of equity is that it better reflects whether the intermediary is in financial distress. Due to a lack of availability, book values of debt are used to proxy the corresponding market value. Book debt is computed as total assets minus total common equity of the considered institution… The empirical analysis is based on monthly frequency…We compute the average capital ratio of the core FX dealers in each month by computing a weighted mean of capital ratios of the three FX dealers’ with the biggest market share in foreign exchange trading.”

“Our empirical results [show] that excess returns in currency markets are well explained by the financial wealth of the three most active FX dealers who are the relevant marginal dealers, while the additional explanatory power from including more peripheral dealers’ capital ratios is negligible.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.