Are central banks allowing markets to get a bad name?

Asian offshore derivatives trading dispute raises questions about the role of markets

Bank Negara Malaysia’s governor, Muhammad Ibrahim, in May hit out once more at the role of ringgit derivatives trading in Singapore and reaffirmed his commitment to limit the size of the market.

The Malaysian central bank governor acted after he assessed that trading activities and prices in the offshore forwards market late last year bore no resemblance to Malaysia’s economic fundamentals – yet offshore trading was causing spillover price effects in the onshore market. As a result, he tried to stem offshore trading volumes, resulting in volumes falling by more than 90%.

Some market participants are aghast at the move. They maintain that offshore foreign exchange (forex) derivatives trading provide foreign investors in Malaysia with a useful hedging facility. They add that the offshore market provides genuine price discovery, free from the influence of onshore policy officials, whose views potentially could be biased because of nationalistic or political considerations.

This is the traditional response by market intermediaries when there is a whiff of ‘interference’ by public policy officials – and it resonates well. There are plenty of precedents where market prices are borne out to more closely resemble reality than official policy views at the time.

But the Malaysian central bank governor’s concerns appear to be both sincere and genuine. And, in many ways, they reflect the broader view by many central bankers, market regulators and academics that financial markets have been overrun by short-term speculators with little interest in the provision of capital for productive ends. The issue is not whether or not markets are an optimal mechanism, but that those that dominate them increasingly are bending them to suit their own interests – at least in the short term. It’s a case of market function.

Purveyors of ‘fake liquidity’

Increased market activity by speculators can help to narrow bid/offer spreads, particularly in ‘normal times’. But there is widespread concern that high-frequency traders (which represent ever-growing fee income for dealers, brokers and exchanges) are exacerbating volatility in less certain times. Even those institutions that are not engaged in predatory order book manipulation – which needs to be eradicated – often pull liquidity from markets, just as real-economy participants most need it. US conglomerate Berkshire Hathaway’s vice-chairman Charlie Munger in 2014 said high-frequency trading was “the functional equivalent of letting a lot of rats into a granary” and that it did “the rest of civilisation no good at all”.

Rapid, deep and volatile moves in security prices within a very short period of time – so-called flash crashes – now appear to take place on a regular basis, even in the most liquid markets. Recent examples include sterling’s 6% fall against the US dollar in two minutes in 2016, the 35 basis point plunge in 10-year Treasury yields within minutes in 2014 and the 1,000bp fall in the Dow Jones Industrial Average in 2010.

Bigger markets do tend to recover quickly from extreme shocks, which is why such moves are called ‘flash crashes’. But the prevalence of momentum trading, the chase for yield and the increasing use of standardised models, among other factors, including loose central bank monetary policies, mean markets can be out of kilter for some time.

Emerging markets are particularly prone. This was highlighted by the huge outflows that took place during the taper tantrum in 2012 – when comments by former Fed chairman Ben Bernanke alluding to the end of loosening US monetary policy triggered a wave of carry trade unwinding. Malaysian governor Muhammad adds that the risks linked to opportunistic trading also tends to layer up. A period of volatility and subsequent withdrawals gives way to another period of calm where even greater exposures are built up and subsequently removed due to some exogenous trigger.  

Ringgit selling overdone

Malaysia’s latest problems emerged when Donald Trump was elected US president in November 2016. This caused outflows from many emerging market currencies into US dollar assets, amid expectations that a major new infrastructure programme and tax cuts would spur the US economy and cause a rise in the US dollar. Such outflows are now expected, and have resulted in Asian central banks holding high levels of forex reserves.

But Muhammad says the reaction in the offshore market was overdone, with ringgit non-deliverable forwards (NDFs) trading in New York trading hours at a variance as high as 3,000bp versus the onshore market. “This was madness – the market mechanism had failed,” Muhammad told participants attending the Risk Asean dinner in Kuala Lumpur last month. “Such a significant move is obviously driven more by speculative activities and misplaced market sentiment, rather than any significant change in the economic fundamentals of the country.”

The Malaysia governor said that, while it had the façade of a vibrant and liquid market, with daily trading volumes of $9 billion, the ringgit NDF market was dominated by opportunistic traders that had no connection to real economic needs: “To make things worse, even our own market players consistently took their cue from the NDF market.”

Onshore passthrough

It was the impact the NDF market was having on onshore prices that appeared to be the final straw for the central bank. Bank Negara Malaysia responded by forcing dealers with strong businesses links to Malaysia to sign letters of ‘attestation’ stating they were not active in the offshore market.

Many dealers were resistant to the move. Some tried to portray the central bank as being opposed to market forces. Nonetheless, a number of global banks have already signed ‘attestations’, with more expected to do so, according to Muhammad. Given Malaysia’s growing economy, strong reserves, large commodity exports and the active role of foreign banks onshore – for example, Singapore’s UOB and OCBC, and the UK’s HSBC – the central bank’s actions have contributed to restricting NDF volumes to around $500 million per day.  

Others nations might not find themselves in such a strong negotiating position. And it appears they should not expect too much support from their counterparts overseeing offshore financial centres.

BNM governor Muhammad Ibrahim (right) shares a joke with Central Banking’s editor-in-chief, Christopher Jeffery
BNM governor Muhammad Ibrahim (right) shares a joke with Central Banking editor-in-chief Christopher Jeffery
CIMB Group Holdings

“Most unfortunate was the absence of concern by regulators overseeing this market for NDF activities, oblivious to the destabilising and adverse impact on neighbouring parties,” said Muhammad, in an obvious reference to the authorities in Singapore, which is the main NDF trading hub in Asia, with other offshore centres for NDF trading including New York, London and (to a lesser extent) Hong Kong.

Central bank officials in Singapore’s other big neighbour, Indonesia, appear more relaxed – at least for the time being. Bank Indonesia deputy governor Perry Warjiyo says NDFs are not allowed. But as long as the onshore prices influence offshore prices – rather than the other way around – there doesn’t seem to be an immediate problem.

“Since we introduced the Jakarta interbank spot/dollar rate back in 2013, NDF fixing in Singapore, for example, uses the reference of the domestic Jakarta interbank spot/dollar offering,” Perry tells Central Banking in an interview.

“So by focusing on deepening the forex market, consistent with our monetary and exchange rate policy, we are being quite successful in not only stabilising the forex and domestic market, but also making this the reference for the offshore market.”

Giving markets a bad name?

Bank Negara’s Muhammad, however, believes there are destabilising implications arising from offshore activities and that the “short-sightedness, greed and foolishness” of offshore market participants gives “a bad name to the market-based mechanism”: “They corrupt the idea of market openness and the liberalisation process.”

Most unfortunate was the absence of concern by regulators overseeing this market for NDF activities, oblivious to the destabilising and adverse impact on neighbouring parties

Muhammad Ibrahim, Bank Negara Malaysia

This “short-sightedness” may have long-term implications for trust in the market-based system, Muhammad said, and “might even risk the process of further integration of financial markets in this region”. This appears to be a reference that negative connotations from the trading of NDFs in Association of Southeast Asian Nations’ (Asean) currencies potentially could hurt Singapore’s ambition to open up Asean capital markets.

Time will tell if Malaysia will wield much leverage over Singapore. Even if it does, there is the potential for the NDF market to move to another jurisdiction. Indeed, the genesis for many offshore or new markets is due to an effort by market participants to get around rules in the first place. Shadow banking activities, such as the creation of money market mutual funds in the US or wealth management products in China, were the result of controls on bank interest rates. And regulators have often ‘turned a blind eye’ to such activities. Just as a certain amount of jaywalking makes a city function more efficiently – there would be more gridlock without it – the problem emerges when there are too many parties breaking the rules. 

Central banks are victims, too?

Market function remains an issue that few seem ready – or, perhaps, able – to tackle on an international basis, despite central banks and regulators having a vested interest in the smooth functioning and fairness of financial markets.

That may be a mistake – and one that may already be having a negative impact on central banks themselves.

While the forex and market operations of central banks are very large in notional and national terms, the fees they pay big market intermediaries often pale in comparison to those on offer from entities that trade large – often leveraged – volumes on a frequent basis. This means there is no guarantee taxpayer-funded central banks are getting a good deal. This is particularly the case when transactions take place ‘in the dark’ – for example, via dark pools or over-the-counter derivatives. These are useful platforms to transact quietly in large size, but other parties may have access to more privileged information and pricing.

By failing to get to grips with market function, some central banks themselves may not be in a position to understand if they are getting fair prices – and perhaps the community only has itself to blame.

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