Trading dollar denominated markets from the Gulf

The question the pegs answer in advance 

Choosing an account currency is ordinarily a real decision with a real trade off. An account denominated in the currency a holder lives in removes the conversion step between a result and the money it becomes, while an account denominated in the currency most instruments are quoted in removes the conversion step inside the arithmetic. Almost everywhere in the world those two currencies are different, and something has to give.

In the Gulf they are effectively the same. Five of the six Gulf Cooperation Council currencies are held at a fixed published rate against the United States dollar, and the sixth is managed against a basket in which the dollar is the dominant component. A dollar denominated balance therefore converts into the local currency through a constant rather than through a moving rate, so the trade off that makes the account currency question difficult elsewhere does not arise here. That, rather than convention or imitation, is why dollar denomination is the regional norm.

What an account currency actually does 

An account currency is the unit in which the balance is expressed, the unit in which margin is measured, and the unit every result is finally reduced to. It has no effect whatever on which instruments can be dealt or on what they are quoted in. What it determines is how many conversion steps sit between a price move and the number that appears on a statement.

The rule for locating those steps is short. A result is first computed in the currency the instrument is quoted in, because that is the currency the price is denominated in. If that currency is the account currency, the arithmetic ends there. If it is not, the result is converted into the account currency at a prevailing rate, and that conversion is a second, separate arithmetic step whose outcome depends on a rate the position itself never expressed a view on.

Where the conversion step disappears 

A large share of the internationally quoted universe is priced in dollars, which is a fact about global market convention rather than about any particular firm's list. Gold and silver are quoted against the dollar as the international convention. Crude oil benchmarks are invoiced and quoted in dollars. United States listed shares are priced in dollars, the principal United States index contracts are denominated in dollars, and the great majority of internationally listed exchange traded funds tracking broad markets are dollar denominated as well. In each of those cases a dollar denominated account has no conversion step at all: the currency of the price and the currency of the balance are one currency.

Currency pairs are the case most often misread. In a pair the second currency named is the quote currency, so a result on a pair quoted against the dollar arrives in dollars regardless of what the first currency is. The distinction that matters is not whether the dollar is in the pair, but whether it is the second one named.

Where the conversion step remains 

• Index contracts on non United States markets. A German or French index contract is denominated in euro, a British one in sterling, a Japanese one in yen, so a result on any of them arrives in that currency and is converted afterwards.
• Currency pairs whose second named currency is not the dollar. A euro against sterling result arrives in sterling; a pair quoted against the yen delivers a result in yen.
• Metals quoted against a currency other than the dollar, where the same rule applies to the second currency named.
• Shares and funds listed outside the United States, which are priced in the currency of their listing venue.

The consequence is that the value of one price increment is not a constant across instruments. It is the increment multiplied by the contract size, expressed in the quote currency, and then converted into the account currency at whatever rate applies. Two positions of identical size in two instruments whose quoted price moves by the same number of increments can therefore produce different amounts in an account, and the difference is entirely the conversion.

A position in a third currency carries two exposures 

When the quote currency is not the account currency, the account is exposed to two things at once: the instrument, and the rate at which the result is converted. The second exposure is real, it is never displayed as a position, and it can run either way.

What the peg does not remove 

The fixed rate holds between the local currency and the dollar and nowhere else. Against every other currency in the world the local currency inherits the dollar's movements in full, decided by another country's policy process, so a Gulf based holder of a dollar denominated account is not free of currency exposure. The exposure has been consolidated into one currency and made invisible at the point where it would ordinarily be noticed.

For a portfolio this is a correlation fact rather than a conversion fact. Positions across different instruments, different asset classes and different regions look diversified when they are listed, and if every one of them is denominated in the same currency then the currency component of each is the same component repeated. Diversification across instruments does not diversify a currency exposure. It multiplies the number of places one exposure is held.

Two practical asymmetries 

The first is temporal. The instruments that require no conversion for a dollar denominated account are largely American ones, and American market hours fall in the Gulf evening and the small hours. A universe that is arithmetically convenient is not therefore chronologically convenient, and the two facts are independent of each other.

The second is transactional. Funding an account in a currency other than the one earned locally involves a conversion performed by a bank, an exchange house or the firm itself, and that conversion is a service with its own terms. A fixed official parity is not a promise that a conversion will be executed at it: retail conversion is priced by whoever performs it, and the difference between the official rate and the rate actually applied is a cost like any other. What that cost is, and who charges it, is read from the published terms of the provider performing the conversion.

Where practitioners disagree 

The first argument is whether a Gulf resident holding a dollar denominated account should regard themselves as carrying currency risk at all. One position holds that the arrangement has stood for decades, that the conversion is a constant in every practical sense, and that treating it otherwise is a theoretical scruple with no operational content. Another holds that a fixed rate is a policy commitment rather than an identity, that concentration is concentration whether or not it is currently moving, and that the honest description names the exposure even when it is quiet. Both positions accept exactly the same facts.

The second argument is whether the conversion exposure on non dollar instruments deserves attention. One tradition treats it as a rounding item, small relative to the movement of the instrument itself over any horizon on which most positions are held. Another points out that it is unhedged, undisclosed as a position, and capable of being the largest single term on a small result, and that an exposure nobody is monitoring is the one worth naming. The disagreement is really about position holding period, which is why neither side convinces the other.