Point of View

The global foreign exchange market has exploded in recent years and at the heart of all the activity is London, the long-time center of the foreign exchange universe.

The average daily global turnover in foreign exchange transactions hit a record US$3.2 trillion in April 2007. That’s up from $2.9 trillion a year earlier and about $1.3 trillion in April 2001, according to International Financial Services, London, a private-sector organization to promote the U.K.-based financial services industry throughout the world.

“Within the international investment community there is much more awareness of foreign exchange and its risks and more appetite for hedging currency positions,” says Peter Gloyne, director of global foreign exchange at Northern Trust in London. “Previously many global investment flows tended to be unhedged. Today, a pension fund deciding to diversify into global mandates typically has a much better appreciation of its overseas exposures. There’s a greater understanding of foreign exchange risks, and that results in more hedging activity.”

In addition, there is a greater acceptance of foreign exchange as a separate asset class, he says. “Foreign exchange was a consequence of a global investment decision, but now more and more institutional investors are looking at foreign exchange opportunities to add alpha to their global performance,” Gloyne says.

As more investors view foreign exchange as an alpha generator, they shift their hedging strategies from passive to active. “Passive hedging takes away currency risk; active hedging looks to benefit from currency movements to add return,” Gloyne says. “As investors become more interested in foreign exchange they have moved through passive and are looking actively at foreign exchange as an asset class in and of itself.”

London’s Many Advantages

London reigns supreme in executing foreign exchange transactions for myriad reasons, including geography, reputation and culture. The “Triennial Central Bank Survey 2007,” conducted by the Bank for International Settlements (BIS), shows U.K. trading desks, mostly located in London, conducted 39% of all foreign exchange contracts worldwide. This domination is even more pronounced considering that most of these transactions did not involve the pound sterling. Only 21% of all trades in foreign exchange derivatives had one leg in pound sterling, compared with 51% in the euro and 85% in U.S. dollars.

As in real estate, location is everything and London’s position halfway between the United States and Asia gives it an enviable time zone advantage. “When we come in in the morning the Far East is still open,” Gloyne says. He adds that the U.S. markets open long before London’s day is done, providing a vital time overlap. “London is there for the critical time period each day.”

In addition, London plays host to a large number of foreign banks. “Numerous European banks have located their trading operations in London to take advantage of the strength of our infrastructure and our sophisticated dealing facilities,” Gloyne says.

London’s strong legal and regulatory environments also make the city attractive to foreign financial institutions. “Our regulatory authorities have created an environment which is conducive for business,” he says.

Furthermore, the diversity and multi-cultural nature of London’s citizenry provides financial institutions with a rich labor pool. “London is an incredibly cosmopolitan city. You have people from so many different nationalities working here, so global financial institutions are able to find regional experts already working within the city,” Gloyne notes.

Pound Sterling Remains Strong

Gloyne also says the U.K.’s decision to opt out of converting to the euro has helped solidify London’s position as a world financial market. While conventional wisdom held not converting would harm London’s stature as the pound sterling decreased in importance relative to the euro, in fact the opposite occurred. The pound continues to be heavily traded. Conversely, other countries converting to the euro saw their currencies disappear.

“The pound still attracts investment flows and volume,” Gloyne says. “There was a feeling that London would suffer because European centers would develop their financial markets and challenge London, but once it became apparent that the European cities weren’t going to be taking over, banks started moving to London.”

In the end, London’s advantages — its strategic geographic location, large multicultural professional workforce and the presence of many foreign financial institutions — solidify the city’s dominance as the center of institutional investors’ foreign exchange activity.

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