Stops are an important risk and trade flow management tool, especially in managing books of smaller FX trades spread across multiple venues and counterparties.
As trading has become more electronic and automated, stop-loss orders have become even more useful and this trend is likely to continue into 2019, especially for market participants with an interest in currencies such as the yuan and the Turkish lira, which are expected to fluctuate significantly next year.
Automation demands better use of stops, particularly in a fragmented, smaller trading size environment, explains Brad Bailey, research director with Celent's capital markets division.
“However, users need to be aware of how exactly they will be filled,” he says. “[Stops] are best used as a tool for managing multiple FX positions, and using them on smaller trades can free up bandwidth for traders to work larger positions.”
It is vital that traders understand how each of their counterparties utilize stops, and the mechanisms that will trigger a stop-loss order. Stop-loss orders in FX are determined by the counterparty or venue that holds the orders.
Significant investment in front office trading systems has made it easier to place and manage orders. However, the specific market levels that stop-loss orders are placed at will always be a balancing act for market participants eager to gain maximum protection without incurring a large loss or triggering orders too close to the market.
“Automation has made it easier to manage the flow of orders into the market for execution, but this could have an adverse impact on market pricing by accentuating an extreme market trend on the back of a flood of orders,” says PointFX CEO Henry Wilkes. “This is common in illiquid markets where stop-loss orders are regarded as essential to protect FX risk and can result in a ‘flash crash’ scenario.”
He suggests that understanding of the stop-loss mechanism has improved alongside a general increase in levels of transparency in trading, but warns that there is always scope for improvement and that the onus is on banks to educate their clients to use stop-loss orders sensibly and to effectively manage their underlying FX exposure.
One of the major problems is that there is no standard practice in operating stop-loss orders, says Wilkes. “Banks all have their own rules and policies as to how they operate these orders and rarely publish them.”
Wilkes has previously acknowledged that it is quite possible there have been instances where banks or brokers used stop-loss orders to assist their own proprietary trading book to the detriment of the client.
An area of concern is the natural concentration of stop orders at given prices, often determined by technical trading factors, says Bailey. “Traders usually think alike when it comes to stop order placement. Given the concentration of stops at certain price points, dealers and market makers have to be careful in using knowledge of these levels with their proprietary trading books.”
According to Wilkes, regulation is a useful mechanism for shining a light on such practices, but is only really effective if it is clearly targeted and sensibly implemented at specific areas of market practice that do not protect the underlying client or could lead to market abuse.
He also accepts that regulation cannot be the only solution and that all market participants have to take responsibility for the management of their business to ensure they are providing – or receiving – a fair service.
Wilkes reckons that as they emerge from the first year of implementation of Mifid II, buy-side clients will take more control of their policies, processes and technology infrastructure to ensure they meet their business needs and this in turn will allow them to demand fair and effective services from their FX providers.
“If their current provider is not providing a satisfactory service, buy-side institutions should develop a strategy to explore other market options and implement a strategic plan to address the issue,” he concludes.