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Playing Asian Dominos

Who pushes markets around—hedge funds or traders at bank proprietary trading desks?

By J.C. Louis

By now it's a familiar pattern. An emerging market goes through a currency crisis and blames the problem on hedge funds. What follows is an acrimonious debate about just who is responsible for the crisis, with central banks and hedge funds blaming each other.

Sorting out responsibility, however, is far more complicated. Hedge funds, commercial banks and central banks are all connected by a variety of subtle business relationships that last fall affected the trading in fragile emerging markets.

Although it may be difficult or impossible for speculative players to break a market on their own, most speculators will readily admit they can catalyze or materially add to a process already occurring. "No speculator can bust a currency,” says Michael Balboa, chief trader at VZB Partners, an emerging market hedge fund. "You bust a currency by creating fear in a local market.” "The infamous ‘foreign speculator' can prompt the problem,” adds Jim O'Neill, chief currency partner at Goldman Sachs, "but for it to go, the local market participants have to be hedging exposure while the policy makers are not prepared to undertake the medicine for currency policy change.”

But where did the fear originate? Some news accounts trace it to an early summer scare that Japanese interest rates would spike, squeezing the yen as a heavily borrowed medium of foreign exchange used to finance Asian-denominated investments. Whatever the source, a crisis of confidence ensued as continuous streams of domestic corporate investors exposed to the local currency looked to hedge.

"Indonesia and Thai companies in the banking and corporate sectors had borrowed money in U.S. dollars and lent money on local currency. As long as they trusted the currency regime, this seemed like easy money, but once cracks appeared, they became worried and began to hedge,” says Michael Pettis, managing director in the Debt Capital Markets Group at Bear Stearns, who notes that trading itself tends to add to market volatility. "The idea that free markets bring benefits to all players is not true. Too many traders and speculators can actually increase volatility, and not reduce it. It is no coincidence that generalized financial crises only occur when the same group of investors are actively invovled in a wide range of markets. If we are all traders, we are all following the trend, and in times of anxiety that can put pressure on currency and increase volatility. It is by acting together that we unwittingly undermine the mar-ket's price-clearing mechanism and cause huge, irrational price moves.”

Indeed, asserts Ezra Zask, president of Barrington Capital Advisors, "contagion is not a matter of macroeconomic forces, but of sophisticated players applying knowledge from one country to another.” Enough of these crises have occurred since the early 1980s to allow global investors to model the common characteristics of emerging market financial crises and then scan for economies that match the list's characteristics. Countries with fixed currency regimes, such as Brazil, Argentina and Russia, are prime targets. "Of these, which countries experience massive capital inflows, causing current account deficits?” he asks. "Of these, whose deficits approach 8 percent of GDP? Of these, which financed these deficits with short-term borrowing?” Currencies that manifest such a mix, says Zask, are targets for speculation.

Who's responsible?

The macro hedge funds invariably top any list of suspects. Soros' Quantum fund, the Tiger funds and London-based Sloane-Robinson are all alleged to have scored immense profits from stock and currency trades in Southeast Asia. But what's often lost is the way other market participants mimic the hedge fund trades. "Repo desks key off the hedge funds,” admits a former currency trader with Bear Stearns in New York. "The whole trading room keyed off the sales desks once we knew they were talking to a major fund.”

In September, a number of Asian central bankers became angry over reports that foreign commercial banks were executing trades and extending credit lines to the hedge funds. The Asians, however, appeared slow to realize that the motive was as much for market intelligence as for commission revenues—and that the bank proprietary desks were emulating the funds' trades. Some central banks even claimed to be monitoring which banks worked with which funds. To avoid detection, many commercial banks were said to reroute currency trades through a chain of banks in New York, London or Tokyo.

"No speculator can bust a currency. You bust a currency by creating fear in a local market.”
Michael Balboa
chief trader,
VZB Partners

In their preoccupation with George Soros and company, however, the central banks ignored the opposite scenario: that the bank proprietary desks took early positions against the local currencies. Seeing the crisis as a rare opportunity to earn huge sums, some apparently passed on that intelligence to the hedge funds whose leverage would enhance the profitability of the banks' positions. Bank traders, for example, were credited with shorting the Hang Seng stock index in Hong Kong in July and early August just before they began selling Hong Kong dollars, thus benefiting from the inevitable fall in the equity market when the Hong Kong dollar got crushed.

"The banks' proprietary trading desks operate as the largest hedge funds in the business,” observes Nikola Meadon, chief executive of TASS Management. "Just look at how many proprietary traders start their own hedge funds.” Proprietary trading desks enjoy a number of advantages, says Philip Moffitt, executive vice president of trading at Tokia Asia. "Hedge funds are more removed from the action, they have less liquidity and trade at wider spreads. It is harder to move positions and to cross markets. The bank can use customer flows and the information they bring more cheaply.”

Some even argue that commercial banks such as Citibank, Chase, Bankers Trust or Union Bank of Switzerland, and investment banks such as JP Morgan, have a greater speculative reach than hedge funds because of their role as market-makers in the currency interbank market. "Places like Merrill and Solomon see the flow, both locally and externally,” says Balboa, a one-time Solomon trader. "Central banks and all of the biggest local companies are invariably the banks' clients. If banks see that these locals are nervous, they can borrow the local currency and convert it to dollars, thereby creating a currency short. They can repay the loan later.” Do the banks front-run these clients? "Massively,” Balboa responds, echoing numerous other sources. "There is no regulator saying you can't. In Mexico, companies and banks made a killing while mutual funds and hedge funds lost money.”

From their preferred market position, Balboa adds, "banks can use the hedge funds by alerting them about the flows and vunerability of a currency. When the hedge funds start selling, this exacerbates foreign exchange devaluations and certainly this was the case in Thailand. Banks can also improve positions by pressing speculators into a trade and then arbitraging those positions in the swap market. Hedge funds typically have no idea about forward rate agreements and swaps.” For these reasons, concludes Balboa, most hedge funds have a higher risk-reward niche trading interest rates in low-interest-rate countries and the equity markets in high-interest-rate environments. But the edge in currencies belongs almost completely to the banks.

The complex relationships between hedge funds and commercial banks are mirrored by the equally baroque relationships between commercial banks and central banks. Throughout the crisis, Asian finance ministers pointed to the IMF "prudential regulations” on banks as a model for the regulation of hedge funds. Yet commercial banks' relationships to central banks are sensitive, subtle and shaded in morally gray areas.

Why? Commercial banks act as a depository, facilitator and counterparty to vast quantities of central bank currency transactions. Unwritten covenants, "Chinese walls” and the banks' own interests in maintaining close ties with the central bank are the principle guardians of a trust that was tested and retested during the crisis.

How could a commercial bank exploit its edge? Most central banks deposit foreign currency reserves used for currency interventions with foreign commercial banks. By monitoring central bank transactions, commercial banks can probe the central bank liquidity by gauging the bank's response to heavy borrowing. A central bank defending its weakening currency might raise commercial bank reserve requirements or issue domestic bonds to offset the expansionary impact of its defensive foreign exchange purchases—a technique known as "sterilization.” Either way, the commercial bank's speculative probe could yield information valuable in proprietary trading.

A senior spokesman for a major New York commercial bank with extensive operations in Asia acknowledged that his organization did investment management of foreign reserves and worked with central banks on risk management. "Chase and Bankers Trust pitch them with presentations like any other client for foreign exchange brokerage, managing of fixed-income portfolios, and consulting on risk management, technology and software. This is a very competitive market. The value of such business outweighs any gains we could make from proprietary trading.” Moreover, he added, the appropriate Chinese walls would be respected if the bank is advising or executing trades for a client who has a view opposing that of the central bank.

"When the hedge funds start selling, this exacerbates foreign exchange devaluations, and certainly this was the case in Thailand.”
Michael Balboa
chief trader,
VZB Partners

Yet the Bank of Thailand and the Hong Kong Monetary Authority (HKNA) reportedly asked domestic banks not to provide currency to speculators or engage in proprietary trading of their own accounts. Several foreign banks in Hong Kong were reportedly threatened with the loss of their mandates for managing HKMA reserves because they were suspected of trading on behalf of speculators.

The central banks have numerous other reprisals, from threatening to withdraw a banking license to failure to renew financing. But banishing a money-center bank is counterproductive in the global economy, as whole regions vie to become investment and financial centers. The weapons of effective currency counterattack are the ones of the marketplace—a contractionary monetary policy.

Some U.S. and European banks were reportedly hurt on their short positions on the Thai baht and other currencies when Asian central banks pushed overnight rates through the roof. "The central banks will try to catch the maximum number of banks off side and inflict the most damage,” says Howard McLean, program director at the Currency Option Resource Centre in Hamilton, Ontario. "When the central banks of two countries decide to intervene in concert, they can make the rest of the street think about picking on someone else. Central banks want to keep the fear of God in the market—God being the central bank.”

In the end, the markets have a critical edge over the central banks. To influence exchange rates, a country must hold reserves in adequate amounts relative to volume of domestic funds that can flee to another currency. At some $960 billion (excluding gold), the total net reserves of the world's central banks is dwarfed by the resources that the private capital market can muster—estimated in 1994 at $15 trillion, and certainly much higher today. The volume of money in the foreign exchange markets alone far outweighs the reserves of any combination of emerging central banks. At $1 trillion a day, concludes one Asian banker, "only 3 percent to 4 percent of the daily foreign exchange turnover worldwide is underlying. These people [the central bankers] have no idea what they are up against.”

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