Institutional FX Positioning: Don’t Fight The Flow

By James Harte

Informational Imbalances

The development of trends in FX markets relies on the aggregation of institutional order flow to drive a currency or currency pair in a particular direction. Many new traders often find themselves on the wrong side of these moves and typically spend a lot of time in a trap known as “fighting the flow.”

The Forex market has a highly decentralised structure meaning that unlike stock exchanges, there is no physical location for the recording of order flow. Consequently, information on these flows is restricted to bank and larger institutional players. To put this in a simpler context: Bank and institutions are able to track portions of order flow in the market but the individual retail trader cannot.

To understand the importance of this imbalance we can refer to a report produced by the Bank of International which sought to establish the value of studying client flows in FX.  The report, which was published in 2013 but revised in 2016, looked at a number of different aspects including what it is that characterises different FX customer groups (e.g., are they contrarian investors, do they take on risk or hedge against it, do they speculate on trends?) and whether large dealers possess an advantage from their ability to view a large percentage of customer trades?

In terms of establishing the predictive value of the various segments of client flow, the report concluded that:

• Asset Manager flows are aligned with sustained shifts in future FX prices indicating a superior processing of fundamental information in their order flow
• Hedge Funds are associated with temporary currency movement suggesting shorter term positioning and the liquidity effects of large trades.
• Corporate flows appear to be largely uninformed regarding currency direction
• Private client flows reflect contrarian positioning

To quantify the value of these different client flow, the study used a simple portfolio approach which found that currencies with highest net buying pressure outperformed currencies with the highest net selling pressure by 10% pa.

A zero-cost long-short portfolio showed:

• Asset Managers yielding average excess returns of 10%
• Hedge funds yielding average excess returns of 10% pa
• Corporate clients yielding average excess returns of 0%
• Private clients yielding average excess returns of -14%