A new report from Greenwich Associates finds that a “perfect storm” of market volatility formed to drive up global foreign exchange trading volumes by nearly 25% in 2004, in turn, creating a new class of “professional” FX investors.

“The massive increase in FX trading volumes seen over the past 12 months can be attributed in part to cyclical factors obvious to anyone watching the evening news: the war in Iraq, terrorism, fluctuations in the value of the U.S. dollar, and rapidly rising commodities prices. Also contributing to the volume growth however, were the active trading strategies employed by hedge funds and asset managers looking to capitalize on these high volatility levels,” it said.

“Financial institutions and non-traditional FX users are accounting for a growing proportion of foreign exchange trading volume,” says Greenwich Associates consultant Woody Canaday. “The changes that are occurring in global FX have been so profound that the market has begun to evolve from its origin as a by-product of international trade and international capital markets transactions to an asset class in itself.”

The relatively lacklustre performance of traditional investment markets has encouraged an increasing number of asset managers and retail players to trade foreign exchange as an independent asset class, Greenwich notes, but it says the most prominent members of this new breed of professional FX investors are hedge funds. “When you combine last year’s dollar volatility with the drastic ups and downs in pricing for commodities — which are priced in dollars — you produce nothing short of a currency volatility bonanza for hedge funds,” says Greenwich Associates consultant Frank Feenstra.

Banks also accounted for a large portion of total FX volume growth in 2004. “The migration of smaller banks from the professional interbank market to the customer market was another big driver behind the growth in trading volumes in 2004,” says Greenwich Associates consultant Peter D’Amario.

While trading volumes have increased throughout the foreign exchange markets — including among corporates — Greenwich Associates consultant Tim Sangston says it is too early to tell if the market can maintain this level of activity. “Market conditions have attracted a swarm of active FX traders, but until volatility levels fall, it remains to be seen whether the development of this new class of investor is a temporary reaction to current volatility levels, or if it is a secular change to the composition and behavior of the FX investor base.”

Europe accounts for the majority of global FX volume, or roughly 60% in 2004, and the highest rate of year-to-year growth in average foreign exchange trading volumes was found in the United Kingdom. Average volume in the UK rose from $38.9 billion in 2004 to $55.4 billion in 2005 — an increase of some 42%. Trade volumes in the US followed a similar trajectory, with average volumes rising 39% from $39.2 billion to $54.5 billion.

Volume growth in other regions — while falling short of that of Britain and the U.S. — was nevertheless robust, Greenwich says. In Canada, average trading volume increased 4.6%, from $18.6 billion to $19.5 billion. Average continental European trading volumes rose from $35.4 billion to $41.7, or 18%. In Latin America, volumes grew from $15.1 billion to $16.2 billion, or 7%. And, average trading volumes in Asia ex-Japan rose from $20.9 billion to $21.4 billion, or slightly more than 2%. The only year-to-year decrease occurred in Japan, where average trading volumes declined by more than 6%.

“There is one reason that the biggest increases in average FX trading volumes occurred in the U.K. and the U.S.,” says Greenwich Associates consultant Robert Statius-Muller. “A disproportionate number of hedge funds are domiciled there.”

A stable interest-rate environment, sluggish corporate bond issuance and the adoption of tighter accounting standards in several markets last year pushed down buy-side trading volume in interest-rate derivatives for the third year in a row, Greenwich reports. Interest-rate derivatives trading volume among corporate and government accounts fell by more than 12% from 2003 to 2004, with significant volume decreases reported in nearly every major market except Europe.

“Asia saw the biggest fall, with year-to-year volume dropping almost 29%, while reported volumes in the United States, the United Kingdom and Japan fell approximately 22%,” it says. “Interest-rate derivatives fared slightly better in Europe, where volumes declined by only about 3%.”