FX markets have calmed since the events on Black Thursday (January 15) when the Swiss National Bank (SNB) abandoned its cap on EUR/CHF, but the event itself has raised questions about how currency markets operate.
FXCM was one of the worst casualties, but managed to survive with a rescue loan of $300 million from Leucadia National Corporation.
Within the first 10 seconds of the SNB’s shock announcement, FXCM’s system circuit breakers kicked in to stop new quotes and trading until the market stabilized. Circuit breakers are like a kill switch, to act as a buffer against erroneous quotes and off-market prices.
Within minutes of the announcement, EUR/CHF plunged far below the 1.20 level. The lowest quote FXCM received from its liquidity providers was 0.5696 – a 53% drop – which is extreme, given that moves of just 1% to 2% are considered significant in currency markets.
However, FXCM’s market data from January 15 appear to show many of the FX electronic communication networks have few or no circuit breakers to halt trade execution in the event of extreme pricing.
|FXCM CEO Drew Niv|
“The market could have been functional if circuit breakers had existed at every level,” he says. “This would have allowed for the market to assess the move and the new rate.”
Circuit breakers are commonplace in the world of exchange-traded stocks. In 2012, the US SEC approved new circuit breakers to prevent another repeat of the 2010 flash crash when the Dow Jones Industrial Average fell about 9% in the space of a few minutes.
That seems comparatively tame next to Black Thursday’s flash crash – EUR/CHF dropped 40% in a matter of seconds.
The Chicago Mercantile Exchange (CME) introduced circuit breakers to its FX futures and options contracts in December to deter sharp price movements, which it believes sets it apart from many other trading platforms.
A CME spokesperson said: “We have a number of protections in place to ensure the integrity of our markets, including velocity logic and circuit breakers.”
CME’s velocity logic momentarily pauses the market to give market participants the opportunity to add more liquidity and restore more balanced market flow.
However, once its circuit-breaker level is breached, trading automatically stops for a period of time, after which the market reopens with an expanded circuit-breaker level. Both protections kicked in on Black Thursday.
Exchange vs OTC
Circuit breakers are widely used on exchanges, but the vast majority of FX is not traded on exchange, rather OTC on electronic platforms such as single-dealer platforms run by the banks, who in turn make prices on numerous other trading platforms. Popular FX trading platforms, such as EBS, do not employ circuit breakers.
Glenn Stevens, CEO of retail platform Gain Capital, believes the role of banks is fundamentally different to exchanges and, as such, circuit breakers are not suited to the OTC world of currencies.
|EUR/CHF Flash Crash Timeline|
09:30 (UK time) Swiss National Bank announces the removal of the 1.2000 EUR/CHF floor.
09:30:56 Major international banks who provide liquidity to FXCM begin rapidly removing liquidity as quotes go as low as 1.1659. A second later, FXCM’s system circuit breakers kick in.
09:35:16 No valid quotes on EBS, 3 bid quotes from FXCM liquidity provider bounce within a 6000 pip range in 2 seconds: 1.1078, 0.5696, 0.976909:55:40 The market finally trades somewhat consistently above parity, but volatility is still extreme. The range of bid quotes between major FX industry ECNs is 0.87 to 1.0001 (1300 pips). 10:23:00 FXCM’s trading circuit breakers are removed and execution of trades begins again. Liquidity levels are as little as 5% of normal levels, and only 3 or 4 liquidity providers are quoting consistently.
Exchanges are designated market-makers that have an obligation to be both buyer and seller, and, to protect those designated market places, they put in place circuit breakers.
However, the concept of banks having to be buyer and seller of last resort is a fallacy, believes Stevens.
“Each bank should be making determinations on how active they should be in the market, depending on [their] own commercial need,” he says. “In this situation, daily volumes of EUR/CHF continued to wane so [there was] no compelling reason to be involved.”
Before Black Thursday, EUR/CHF was perceived to have the same depth of liquidity as major currency pairs such as EUR/YEN, but this was also a fallacy. Daily trading volumes on Gain Capital’s retail and institutional trading platforms were actually “quite low”, says Stevens.
“If we had gappy moves in the Russian rouble or an esoteric currency, we wouldn’t say we should be using circuit breakers,” he says. “We would say that’s why it’s a minor currency, it doesn’t have as much daily turnover and why people don’t take big positions. It is standard risk-return.”
FXCM’s Niv acknowledges that imposing circuit breakers in FX would be “difficult”, citing the need for a cross-border agreement to agree on how and when to halt markets.
David Collins, chief executive of SDX Trading at SuperDerivatives, is sceptical.
“The proposal would be to have it at global FX level to suspend all trading in certain currency pairs … but how do you police that?” he asks. “FX is not a formalized market, so I don’t see how that would work.”