Circuit breakers not the simple answer to extreme FX volatility
Recent market moves may have refocused attention on market engagement mechanisms. But there is no consensus on whether circuit breakers are the best solution for managing extreme volatility.
On January 15 2015, a lot more people working in the FX market began to talk about circuit breakers. Also known as collars, they are designed to curb large price swings by temporarily halting trading when prices hit a predefined limit. They might have come in handy on that date, which marked the decision by the Swiss National Bank to abandon its peg of the Swiss franc to the euro.
Forex Capital Markets (FXCM), an online trader, argued strongly at the time that there was a clear need for more circuit breakers; it continues to do so. “The market data from January 15 2015 shows that many of the FX ECNs had few or even no circuit breakers to halt trade execution in the case of extreme pricing,” says Drew Niv, CEO of FXCM. “The market could have been functional if circuit breakers had existed at every level.”
Bill Goodbody, Bats
Others agree that wider use of such technology would help to reduce FX market risk. Bill Goodbody, senior vice-president, head of FX, at Bats Global Markets, says: “We know from direct experience that circuit breakers, collars and limit-up limit-down mechanisms, which are in place across the markets we operate, help to marshal a more orderly market, particularly when trading is very volatile.”
Circuit breakers are naturally suited to exchange-style, order-book trading, but Goodbody says this does not mean they could not be applied to OTC markets. Bats has an off-market policy in its operating procedures and as FX markets increasingly move towards all-to-all, higher-velocity venues, he expects there will be a greater focus on mechanisms that act as checks and balances to extreme market moves.
However, he also accepts that change won’t take place overnight. “In the aftermath of multiple market events, we are hopeful the industry can start to discuss this issue. But at present there is no forum for a regulator or industry organization to implement circuit breakers.”
Steve Reilly, managing director at GTX, an ECN produced by Gain Capital, is unconvinced, and notes that the FX market has functioned comparatively well in some times of market crisis. The UK's Brexit decision, after which venues experienced record volumes and the market functioned continuously, was one such example, with clients able to execute trades throughout the entire episode.
Steve Reilly, GTX
“Clearly, bid-offer spreads were wider and the market gapped sharply at times, but there was a consistent market available to trade throughout,” says Reilly. “We think that demonstrates the resiliency of OTC cash FX and it is by no means clear that circuit breakers would have reduced market risk. We have never had a client suggest implementation of circuit breakers and we see it as applicable to monolithic market structures, not the highly distributed market structure found in cash FX.”
Reilly argues that in any case it is hard to see how circuit breakers could be implemented in the OTC market. “Circuit breakers can be implemented in environments where an exchange is a primary or significant liquidity centre and seem to work best when the market needs a moment to clarify a situation with a given company’s shares or to enable market makers to regroup before reopening trading. Exchanges also have to take into consideration their constituencies of unsophisticated individual traders for whom a pause might be welcome. The interbank FX market is organized quite differently and clients want and expect us to provide venues for them to trade under all circumstances.”
The application of circuit breakers to the FX market is highly problematic at many levels, suggests David Mechner, CEO of Pragma Securities. Two of the issues he highlights are the absence of a global regulatory framework under which to enforce them and the absence of a central market or official price that is available to all market participants to define the thresholds that trigger the halts.
Mechner says: “If circuit breakers were somehow defined and imposed on a partial or voluntary basis, but trading continued in some venues during partial halts, everyone would still be looking to the operational venues for information about price and removal of liquidity, and information from the halts would seem likely to make price formation even choppier and more problematic than it would be without the halt.
“There are also questions about whether circuit breakers would truly provide a net benefit, since their existence can change market participants’ behaviour as they get close to the threshold and exacerbate volatile price moves they are designed to protect against.”
Mechner and others also express concerns about imposing mechanisms to halt FX when the activities that create currency exposures are not subject to halt based on exchange rates. If the halts were short enough the disruption might be considered de minimis, but the CEO of Pragma Securities questions whether it makes sense to prohibit banks from exchanging currency with each other when they want to, even for a few minutes.
“I would suggest that a good focus for regulators or market participants interested in improving the functioning of the FX markets would be price transparency through creating some kind of official tape or feed,” he concludes. “That would have huge benef its for many market participants in understanding their execution quality and seems like a prerequisite for any reasonable circuit-breaker proposal.”