Declining returns on investment in illiquid strategies such as private equity, real estate and infrastructure have heightened the impact of currency movements on the performance of these asset classes.

As a result, for the first time in his 20-year career, currency trader and fund manager Hélie d'Hautefort, says these investors are paying to hedge FX exposures. This is helping generate new business for currency specialists such as Paris-based Overlay Asset Management, where d'Hautefort is chief investment officer.

Demand tends to come from asset owners, rather than the private-equity fund managers, says d'Hautefort, who helped found boutique FX investor Overlay in 1998 and sold it to BNP Paribas Investment Partners in 2001. The firm now manages $20 billion of assets, 98% of which are third-party external to the BNP Paribas group.

Not only are returns gradually ebbing, but institutional investors are increasingly required to value their assets by marking them to market. Such accounting requirements can create paper losses (or gains) on long-term investments from day one, when currency markets are as volatile as they have been in the past two years.

For private equity managers on a roadshow to raise capital for a new fund, such marks can make potential limited partners very nervous. In some cases, general partners are therefore also looking to hedge currency exposures, to provide these investments with a semblance of stability.

That, of course, comes at a price, which further dilutes the total return on long-term illiquid investments. But it's a price that asset owners are increasingly prepared to pay. Gone are the days when private equity deals could return 30-40%, in which a 10% currency move was acceptable. Today such FX volatility can seriously erode total returns.

Moreover, the low interest rate environment across the G7 markets means buying FX forwards is now very inexpensive.

Hedging traditional asset classes -- stocks and bonds -- had been straightforward because FX forwards are cheap and efficient. Now hedging tactics are being extended to alternative investments.

The financial crisis has, however, exposed vulnerabilities in the FX markets. Traders have told AsianInvestor that FX liquidity is a "myth", because there are now so few counterparties, and any investor that makes too much money out of them will be cut off.

When asked about this, d'Hautefort agrees that liquidity issues are a trend. The top FX banks once numbered 20, but have consolidated, as have market-makers. Electronic trading has made it easier for smaller investors to access banks directly without going through specialist brokers. Spikes in volatility have led to spread widening, even for big clients like Overlay Asset Management.

He says, however, that as markets have stabilised, spreads for big buy-side players have returned to normal levels. And currency markets remain liquid to open or square positions 24 hours a day, even when spreads are wide. D'Hautefort says that in 2008, investors taking pure currency positions -- as opposed to those using FX markets to hedge equity or bond exposures -- were able to go to cash. Investors in stocks and bonds often could not.

A second area of growth for Overlay Asset Management, in addition to investors in long-term illiquids, is from mainland Chinese financial institutions, says Hai Xin, head of Asia-Pacific at Overlay. These groups can only tap forex markets via non-deliverable forwards, so their hedging costs are very high. The NDF market is thinly traded, and often Chinese institutions aren't allowed to trade in it at all.

Because Chinese overseas exposures are almost all in US dollars, Overlay is working to hedge these into a basket of other currencies, including sterling, euro and yen. What it cannot do, at this stage, is hedge directly back to renminbi, given China's capital controls. But it can hedge offshore assets into a basket of other offshore currencies, which creates a more stable exposure for mainland investors.

The acceleration of renminbi appreciation and the growing size of Chinese institutional exposures overseas have made this a new business for currency specialists.