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Will flash crashes become more common? Foreign exchange bankers believe so, for two reasons. First, liquidity is being sucked out of the market. The second, related reason is a change in the behaviour of market participants. Increasingly, disruptive periods are characterized by a collective one-way bet.
The world of S&P futures contracts is a different beast to the global trading of foreign exchange, where in the most recent crash sterling collapsed 6% in a few minutes in early October. But the academics who have studied the 2010 flash crash in the E-mini S&P 500 market that US authorities blame in part on Navinder Sarao, the trader who has lost his appeal against extradition, make a strikingly similar argument to the FX bankers that are fretting about their world.
According to the academics’ analysis, the conditions that made the S&P futures crash possible were much more likely to have been caused by a withdrawal of liquidity than by the actions of any individual rogue trader.
Foreign exchange bankers regularly complain of declining volumes and a combination of structural shifts that have sucked liquidity out of the market. The 3,500 FX clients that responded to Euromoney’s most recent FX Survey earlier this year reported 2015 volumes falling by more than 20% from the previous year, on a like-for-like basis.
The Bank for International Settlements’ triennial survey this year was a similarly gloomy affair: global daily average volumes in spot FX fell for the first time since 2001, and were down by 20% from the previous survey in 2013. Spot volumes with non-financial customers – an admittedly small part of the market, at less than 10% of the total – plummeted by nearly 40%.
Structural changes
The dynamics of risk management have been transformed over the last five years. There have been structural changes: more non-bank intermediaries with shorter decision time lines are grabbing more business from traditional players, but without the same approach to commitments of risk that were once the norm. At the same time, regulations – think Volcker rule or margin policies – are constraining those same traditional participants.
No longer does a bank have the luxury of time to hunt around for bids to cater for big sellers – they simply cannot sit on risk for the duration they used to. Alongside that, macroprudential policy is increasingly pushing large clients to exhibit less variety of behaviour. The growth of automated and algorithmic trading is exacerbating this trend – again another factor identified by the academics who have been poking around the S&P futures crash.
The result is that when the market is jolted by an external event, the bid evaporates. Between about 3am and 5am on the morning of the Brexit referendum result, for example, there was almost no liquidity on the other side to arrest the parlous drop in sterling.
FX crashes were few and far between before 2010, but the half dozen or so that have happened since then are giving plenty in the market pause for thought. It’s easy to see why authorities might like the public witch-hunt of going after individuals whenever there is a suspicion of manipulation in any market.
But when the TV cameras have moved on, they might want to spend more time considering how best to stop the liquidity rout before it’s too late.