As the polls closed on the UK’s EU referendum, the market was heavily positioned for a Remain victory. As news came in the result had gone the other way, traders scrambled to reverse their positions, triggering heightened volumes and volatility.
On a day – and especially a night – of frenetic trading on the currency markets, retail traders largely sat on the sidelines, according to brokers and liquidity providers.
Chris Vecchio, currency strategist at DailyFX, says: “Retail definitely saw a decline in volume, with open interest on GBP/USD 40% below its 12-month average, and that is why there were no problems with liquidity. The Bank of England’s (BoE) £250 billion backstop was also a release.”
Lower-than-average participation among retail was observed by other brokers, too, but was more than offset by heightened volumes among ECNs and banks.
This meant overall volumes were elevated, particularly from around 11pm on June 23 in the UK, when the first signs started to emerge that confidence in a Remain vote had been misplaced and traders scrambled to reverse their exposures.
Kevin Kimmel, chief operating officer at Citadel Execution Services FX, says Citadel Securities traded 4.5 times its normal average daily volume on Friday, with significant share on many venues. Thomson Reuters saw FX volumes of $482 billion on Friday, of which $258 billion was in the spot market, compared with average volumes of $347 billion overall in May, of which $94 billion was spot.
However, DailyFX’s Vecchio warns we are not out of the woods, with the BoE still on alert.
“There were £6.3 billion of orders for the indexed long-term repo operations, but only £3.1 billion allocated,” he says. “The Libor spread has widened from 17 to 24 basis points. So there are definitely funding stresses and the BoE will need to be ready to act.”
The absence of retail traders might have accentuated the market moves, and it appears their re-engagement acted as a break on volatility.
Vecchio says: “Retail behave like commercial hedges: they are long at the bottom and short at the top. So they started to come back in and are net long, which provides some stability.”
|VIX, a gauge of market-implied volatility, rose in the run-up to the June 23|
Brexit vote, demonstrating heightened expectations of 30-day volatility.
Retail participation in frantic overnight trading seems to have been discouraged by warnings from the retail brokerage community, which was doubtless mindful of the losses many of its clients suffered when the Swiss National Bank (SNB) dramatically removed its peg to the dollar in January 2015.
Oanda advised clients about the risks of trading in an environment that was likely to see extreme volatility, it says, as well as raising margins. Saxo also raised margins on all sterling pairs and crosses to 7% in the run-up to the referendum – levels that remain in place – though it says a record number of orders were executed on SaxoTraderGo, its trading platform.
Claus Nielsen, head of markets at Saxo Bank, says: “Going into the UK referendum, we took significant measures to reduce our clients’ exposure to risk and promote the use of our multi-product suite to further mitigate risk like the use of long options to hedge positions and to take directional views with limited downside risk.”
AAFX, an online retail broker, also advised its traders to take a break and watch the market before making any decisions, and says most of its traders avoided trading GBP altogether.
It also cut the leverage available to its traders significantly. It normally offers leverage of up to 2000x, but considering the high levels of expected volatility this was reduced to 100x, a limit that will remain in place until volatility dies down, it says.
Not all victims
Not all retail traders can be cast as victims of the excessive volatility that hit markets. Pelican, a social trading platform, says its traders were quick to adjust their positions when it became clear Leave had won.
“Traders appear to have changed tack at the final opportunity after deciding a vote to stay was priced in – with lucrative returns,” says Peter Read, co-founder of Pelican. “It’s clear that our traders roundly backed a Leave victory and banked a four-digit point profit.
The SNB episode also encouraged brokers to review their own systems, and tighten their risk controls to ensure they were not caught out by the next severe bout of market volatility. This has apparently paid dividends.
Citadel set out a number of possible scenarios that might have played out after the referendum result and placed a heavy emphasis on risk management.
“As a market maker that holds positions, risk management was a major focus for us and we are very proud of our performance during Brexit,” says Kimmel.
Others took a similar approach. FXCM, which was badly caught out when the SNB took off its peg with the euro, says its systems performed well on the day, having raised margin requirements ahead of the vote as a precaution, in expectation of a spike in volatility.
|Drew Niv, FXCM|
Thomson Reuters says: “[Its] systems performed as planned across the board. The volumes illustrate the importance of neutral venues like Thomson Reuters on busy days when price determination is mission critical.”
Alfonso Esparza, senior currency analyst at Oanda, stressed the importance of being well capitalized, adding: “Capital requirements are vital and as a business we feel it is good to be above the minimum level set by the regulator.”
However, while the SNB and Brexit events are comparable in terms of the sheer magnitude of the market moves they provoked, the differences between the two events are more important.
While there had been speculation that the SNB might take off its peg to the euro, its move still caught the market by surprise. Brexit, by contrast, was well flagged, and while the market was on the wrong side of the news, it had at least had months to prepare for that possibility.
Vecchio says: “The move we saw following Brexit was something we have never seen before – it was the largest two-day move for the pound in its history. It wasn’t like the SNB because that was a sudden move, whereas this was a staircase leading lower.
“I don’t think it can be compared to Lehman either. If anything it is a bit like Bear Stearns, where the bubble has been pricked, but the issue is more the uncertainty it creates than the disruption itself.”
So while the markets have started to return to something like normal, financial institutions remain on alert.
Citadel’s Kimmel says: “Market conditions have started to return to normal, but volatility will likely persist as the situation in Europe continues to unfold.”
Markets remain cautious amid considerable uncertainty, related to Brexit and elsewhere. Britain will elect a new prime minister, while the UK and Europe are still to negotiate the terms of the settlement.
Meanwhile, nationalism is on the rise in Europe, and Scotland could be among the states planning another referendum. Coupled with unpredictable US elections, continued negotiations around a number of trade agreements and central-bank actions, it all points to the likelihood of further volatility.
Oanda’s Esparza says: “For now the market has forgotten about fundamentals, and political events are driving things. Traders want to see a return to fundamentals.
“It will be interesting to see how the market reacts to the upcoming non-farm payroll numbers – it’s a good economic indicator, but how much influence will it have?”