The Paz Activity Curve

What causes differences in FX activity levels by geography?

Over the course of studying FX activity level by geographies, Forex Datasource probed potential links between a nation's FX trading volume and other factors - such as foreign trade, foreign direct investment, remittance activity, and other macroeconomic factors. The relationship between national FX volume and these variables held best when converting them to GDP ratios. 

 The Paz Activity Curve (PAC) is a regression line useful to compare a nation's foreign exchange (FX) trading activity relative to similar-sized economies. For easy of mention and following the precedent of luminaries like John Taylor (Taylor Rule) who's work is well above ours, Forex Datasource employs my last name (Javier Paz) to reference this particular indicator. The PAC relies on two key ratios: 

  • External Openness. Foreign trade as a share of GDP (x-axis)
  • FX Trading Activity. FX Trading volume divided by GDP (y-axis)

A nation's FX trading activity is equivalent to the single-counted notional FX volume for a year, based on a country's "net gross" FX turnover found in Bank for International Settlements triennial FX surveys and normalized central bank FX surveys, whenever the latter are available. 

As part of this nonacademic exercise, we segmented economies into six groups, primarily by 2017 GDP:

  • Very large economies: GDPs of US$2 trillion or more
  • Large economies: GDPs of US$1 trillion to US$2 trillion
  • Midsized economies: GDPs of US$400 billion to US$1 trillion
  • Small economies: GDPs of US$10 billion to US$400 billion
  • Micro economies: GDPs smaller than US$10 billion
  • Financial centers: Jurisdictions with higher-than-average FX turnover relative to GDP - we set that minimum threshold at 25 (e.g., FX trading volume is 25+ times GDP size)

Using the "Very large economies" chart above as an initial example, each country listed in this category has four observations (1990, 2000, 2010, and 2017) and a particular color/number to help us track that nation's individual journey in terms of external openness and FX activity levels. 

Takeaway 1. It is understood that a nation's external trade openness goes up/down over time as trade policies and the private sector seek greater global insertion, but changes in foreign trade openness do not necessarily generate a linear correlation in FX trading activity. This is a critical point where silent opportunities exist for more FX activity to occur, if policy makers or sell-side firms act upon this kind of information. The Germany and the Eurozone data points show how external openness increases over time but it's FX activity levels decrease. 

Since the advent of the euro in physical form in 1999, FX activity levels in the eurozone have been generally regressive and particularly since 2010. Potential causes: 

  • Eurozone nations trade with each other more and the use of foreign currency is lessened
  • The prospect that European banks are not yet suitably capitalized since the 2010 European crisis drags on, leading to greater risk concentration among fewer mega names
  • The apparent lack of priority for EZ policymakers to establish solid OTC FX operations in continental Europe prior to Brexit 
  • Since 2010, the European Central Bank ensures that euro volatility remains low, which reduces a significant amount of trading in EURUSD and other European pairs that track EURUSD movements (EURCHF, EURDKK,..)  

Germany's lower FX activity ratio compared to France caused us to dig deeper into trade data. A hypothesis we considered and discarded was that Germany was exporting more to Eurozone nations and therefore would require less non-Euro FX transactions. The 2017 export/import destination data we evaluated revealed that Germany had traded with EZ peers something like 36% of its US$2.4 trillion foreign trade total, whereas nearly 47% of France's US$1.1 trillion foreign trade went to the EZ. Since Germany has more trading with nations outside the Eurozone than France, we conclude that German banks may have a lesser focus in FX trading than those in France, making it possible for non-German banks to pick up business in Europe's largest economy.   

Takeaway 2. Countries with a high stake in foreign trade don't necessarily prioritize having a healthy OTC FX market within their borders as a strategic asset. China's FX turnover without including Hong Kong's FX activity is very low for an economy its size. The Bank of China's major upgrade of China Foreign Exchange Trade System (CFETS) with help from NEX Group in late 2017 and the Eurozone's arm wrestling with London to move some/all EUR clearing to the continent suggests that trade-dependent nations are waking up to the fact that they should have more control and sophistication accessing foreign markets via the proper FX infrastructure and oversight.  

In coming days/weeks, we will share additional PAC charts we have analyzed. If this is a topic of particular interest for work, feel free to contact us at the link on the top right. 

Most Relevant Audience

All FX market practitioners, and in particular capital markets regulators, sell side bank executives, and academics conducting macroeconomic/financial markets research. 

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