By Patrick Graham
LONDON (Reuters) - Hedge funds and speculative investors have pulled back from the $5 trillion a day global currency market and less risk-taking by banks as well as reduced trading on multi-player platforms is a risk to future financial stability, the Bank of International Settlements said on Sunday.
In analysis expanding on September's triennial report on the world's single biggest financial market, economists from the bank and Warwick Business School Professor Michael Moore pointed to changes the Basel-based central banks' central bank said should be of "first order" concern to regulators globally.
Activity in the $5 trillion a day market, they said, had in reality been falling steadily since peaking in late 2014, driven by changes in banks' business models, regulation and the impact of the shattering moves in the Swiss franc in January 2015.
"What happens in financial markets does not always stay in financial markets," BIS Head of Research Hyun Song Shin said. "Financial disruptions can have a real economic impact."
"How the evolving FX market affects risk-sharing is still uncertain, but this is a matter of first-order importance. Any major changes to liquidity conditions might have consequences for market risk and the effectiveness of the hedging strategies of corporates, asset managers and other foreign exchange end users."
The report in September showed global currency trading fell to a daily average of $5.1 trillion last April, a 5.5 percent from the $5.4 trillion average three years ago and the first broad contraction of the market since 2001.
BIS said the main driver of this had been a fall off in trading by hedge funds and other speculative investors, which they said had been pushed lower by the closure of some bank prime-broking businesses and trimming of others.
Prime-broking refers to the arrangements by which banks provide trading lines and the credit that speculators use to make big leveraged bets on currencies.
BIS also warned about risks from the market's major banks, as well as a new breed of non-bank electronic traders, raising the amount of flow that is "internalized" - i.e. matched off to other orders internally rather than traded with another party.
It said that also came with a weakened role for anonymous trading platforms like those run by Reuters News parent company Thomson Reuters <TRI.TO> and ICAP-owned EBS Brokertec <IAP.L> in favor of direct relationship based trade.
That, and the role for non-bank players who may not absorb as much risk when markets are volatile, may be contributing to flash crashes like those seen on sterling and other markets in the past couple of years.
"While relationship-driven ... trading... delivers lower spreads in stable market conditions, its resilience to stress may be tested going forward," BIS said. "There are also indications of rising instances of volatility outburst and flash events."