University of St Gallen analysis reveals new insights into FX market microstructure

A paper has been published by researchers at the University of St Gallen analysing an FX dataset from CLS, a financial market infrastructure delivering settlement, processing and data solutions, to identify information asymmetry in the FX market and estimate its impact on FX price movement.

Angelo Ranaldo, Professor of Finance and Systemic Risk, and Fabricius Somogyi, a third-year PhD candidate, reported that they used CLS FX Spot Flow data to demonstrate that a trading strategy based on asymmetric information risk can potentially offer strong diversification for FX trading strategies. Compared to traditional trading strategies such as FX carry, value and momentum, the strategy based on asymmetric information risk generated consistent outperformance when applied against the past six years of historical data.

Based on the premise that some groups of market participants are systematically better informed and continue to serve as dealers’ “smart money” in the FX market, the paper outlines strategies designed to convert “smart money” into “smart beta” by systematically investing in currencies with higher levels of asymmetric information risk and thereby gaining higher expected returns. The research finds that this dollar-neutral self-financing strategy remains profitable (as applied against the historical data) even after applying transaction cost estimates, generating an after t-cost Sharpe of 0.65 and excess returns of 3.16 per cent per annum. In addition, the strategy is negatively correlated to traditional trading strategies such as FX carry, value and momentum. The research findings may be attractive for market participants who seek consistent returns in various scenarios, as backtesting results indicate that the trading strategy was also effective during periods of unconventional monetary policy and is unaffected by specific regulatory issues or institutional events such as when the Swiss National Bank announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro in January 2015.
The fragmented and OTC nature of the FX market creates significant challenges sourcing comprehensive data, but the research findings were made possible due to the detail and comprehensiveness of CLS’s FX Spot Flow data. With over 50% of global FX traded volumes, CLS offers the largest single source of FX executed trade data available to the market, providing the researchers with access to valuable insights into FX market dynamics, in particular, the interactions between different categories of market participants such as banks, corporates, funds, and non-bank financial firms.
Professor Angelo Ranaldo, University of St Gallen, says: “This project began as a seminar paper, but we realised the depth of the dataset from CLS made it possible for us to study the FX market at a more comprehensive level, resulting in exciting new insights into a traditionally opaque market. We believe our research will be particularly beneficial to risk managers, currency hedge fund managers, and the regulatory community.”
Masami Johnstone, Head of Information Services at CLS, says: “CLS’s unique position at the center of the FX market means we have a key role to play in increasing transparency in the market. The research from the University of St.Gallen is another example of how CLSMarketData provides insights for a clearer view and more meaningful analysis of the FX market, enabling portfolio managers and traders to calibrate and refine their investment and trading strategies.”