Why it is crucial to nurture SA’s onshore market

10 OCTOBER 2022

This article first appeared in Business Day on 10 October 2022

Volatile rand highlights shrinking onshore forex trading

By John Cairns and Anthony Grant

The rand’s extreme volatility of recent weeks has served as a reminder of the importance of large and liquid foreign exchange (forex) markets that ensure efficient pricing and enable importers and exporters to settle their transactions easily.

The market in the rand has grown over the past two decades. But in recent years onshore trading has declined at the expense of the offshore trade. Historically SA was unusual among emerging markets in that it had a sizeable domestically based forex market where much of the trading in its currency took place, with trading in other third-party currencies. This was originally mainly a legacy of SA’s exchange control regime.

However, the market grew rapidly after the 1994 democratic transition opened SA up to the world. Its development was supported by a robust system of authorised dealers, with traders, corporate treasurers and financial institutions who are active in the market.

This onshore market is a vibrant and healthy one, offering excellent liquidity and service to customers, who are well served by SA’s local banking groups and a few global players. However, in recent years there has been a decline in onshore trading in the rand. The market has shifted offshore, particularly to London, which remains by far the world’s largest forex market.

The shift away from SA is reflected in turnover in the domestic foreign exchange market falling, and participation by foreigners decreasing — despite the rand trade globally being more liquid than before and the currency still tending to be a proxy for other emerging market currencies.

The latest Reserve Bank data shows turnover in the SA (onshore) foreign exchange market increased in the second quarter after declining for much of the past two years, with net average daily turnover up 2.4% to $14.6bn, and non-resident participation in the market increasing for the first time since early 2021. But the Bank’s data shows onshore trade in the rand is still well below the level of five years ago.

Global norm

Updated numbers on the global rand trade, including both onshore and offshore, will be available only in December, when the Bank for International Settlements publishes the results of the survey of foreign exchange trading it conducts every three years. But while global trade in the rand multiplied from just $2bn a day in 1992 to $72bn in 2019, its ranking dropped from being the world’s 10th most traded currency in the late 1990s to 18th a decade later, because trade in other emerging market currencies grew even faster than SA’s.

In an important sense SA has simply moved closer to the global norm, where most of the rapidly growing trade in emerging market currencies takes place offshore, in global centres such as London and New York, rather than onshore in their home markets.

A 2019 study for the Bank for International Settlements concluded that forex markets for the currencies of emerging market economies rose from 19% to almost 25% of global forex turnover from 2016 and 2019, and attracted a wider range of participants. One trend the study found was an increase in the share of trading generated by hedge funds, proprietary trading firms and other financial customers.

Another trend was the surge in offshore trading as global investors’ appetite for emerging market assets grew. “Offshore markets tended to drive onshore markets during times of global market stress.”

The offshoring trend is not necessarily a negative one for clients: the rand remains one of the most traded emerging market currencies, often serving as a proxy for other currencies because it is so liquid. And to the extent there is wide global interest and wide pools of liquidity, it means clients can trade in sizeable quantities most of the time.

Economic activity

Even so, it is crucial to nurture SA’s onshore market, which remains a significant asset for clients and the economy. Relative to other emerging markets SA still has a surprisingly high share of trade in the home market. It is a well-regulated and sophisticated market, anchored by a system of authorised dealers with a range of hedging instruments. It offers excellent liquidity and service for customers, with SA’s banks accessing that global pool of liquidity on their clients’ behalf.

Much of the rand trade out of London is for investment purposes. By contrast, the onshore trade is dominated by transactions that are linked to underlying economic activity, especially to cross-border flows of goods and services and to foreign direct investment. Transactions that are conducted in the local market result in the inflow and outflow of currency, which is important for the country's balance of payments. The Reserve Bank has implemented a reporting system that records these inflows and outflows to get a sense of how the mix of imports and exports of the country is doing.

It’s certainly been a wild ride lately. The market has benefited from healthy volumes thanks to the commodities and resources boom that boosted export receipts and onshore flows, and earlier this year contributed to the rand being one of the best-performing emerging market currencies. The US Federal Reserve’s hawkishness and SA’s own domestic load-shedding challenges have seen the currency track back.

The volatility makes life interesting, albeit challenging, for clients and their bankers, underlining the importance of managing those forex risks. If anything, it highlights how important it is to have a well-functioning onshore market that supports excellent service for onshore (and offshore) clients.

Cairns is RMB Client Strategist and Grant CEO: Foreign Exchange Product House.