The FX market has experienced notable periods of stress in recent years, albeit not on the scale of the Swiss National Bank’s decision to abandon its peg to the Swiss franc in 2015.
For example, during the January Yen move, the market traded more than $1 billion in USD/JPY on EBS Market in less than a minute.
However, while Euromoney has previously reported on ambivalence towards circuit breakers as a mechanism for reducing market risk, opinion seems now to have hardened against these ‘collars’. This comes despite the ambition to grab a larger share of the FX market shown by exchanges – a trading environment where circuit breakers are well established.
“It is a significant challenge for systematic circuit breakers to be employed uniformly across the FX market,” says Curtis Pfeiffer, chief business officer at Pragma Securities. “Instead, each venue and liquidity provider has to create their own circuit breaker, which creates inconsistencies and additional complexity for market participants.”
Circuit breakers have traditionally been used by exchanges, perceived as efficient marketplaces.
Arjun Jayaram, CEO and founder of Baton Systems, says: “However, the presence of circuit breakers alone would probably not be enough to convert market participants [market makers and directional traders] to switch to exchange-based trading.
“Better mandates around reporting to ensure price transparency, especially for market makers, would help.”
While it is theoretically possible to implement circuit breakers in an over-the-counter (OTC) market, it requires multiple parties – potentially across multiple countries – to agree on operating rules.
“In addition, FX volatility has been at an all-time low with only brief periods of volatility resulting from illiquid markets,” adds Jayaram.
In the spot FX market, the ultimate shock absorber is the availability of visible liquidity in the primary markets to absorb a large amount of trading in a short amount of time.
During times of market stress, participants return to the central limit order book for consistent pricing and liquidity, according to Seth Johnson, CEO of cash markets at CME Group, who makes the point that the dynamics of the OTC spot FX market are very different to other markets.
“It is open 24 hours a day, five days a week and the primary market serves to provide a central reference price,” he says.
“If circuit breakers were implemented, participants would not stop trading, but they would effectively be pricing blind, and this causes further repercussions when it comes to the trading and settlement of contracts derived from the spot price.”
For this reason, Johnson reckons there is limited appetite to implement circuit breakers and effectively shut down the one place where participants can get a price and trade.
“The spot FX market is unique in that nobody is designated as a market maker and therefore required to provide liquidity at any given point in time,” he adds.
“There is certainly a debate to be had as to whether the market needs a market maker in place to stabilize markets when a price hits a certain point in the order book, but there would need to be incentive to do so – and at this point it is not clear who would stand to benefit and who would pay for liquidity.”
There is a desire to implement consistent standards, which would help the market operate smoothly without introducing unnecessary operational risk, adds Pragma’s Pfeiffer.
“However, FX is a global market that operates across borders,” he adds. “With no single regulatory or governing body, this makes the probability of achieving consistent implementation very low.”
Despite the challenges, Baton’s Jayaram says trading houses, broker-dealers and prime brokerage houses continue to assess the merits of circuit breakers as a means of increasing efficiency and reducing risks.
He also suggests that circuit breakers could have a role to play in protecting FX algos from manipulation by cyber criminals, alongside other tools such as monitoring and reporting, settlement risk mitigation with on-demand settlements, and liquidity efficiency through compression and netting.
David Murray, chief business development officer at Corvil, agrees that circuit breakers could be used to halt trading in the event of anomalous trading activity resulting from cyberattack.
“The challenge – as with all surveillance mechanisms – is detection of the most advanced (and obfuscated) threats,” he concludes.
“Circuit breakers can also be disruptive and could take a firm entirely out of the market, so the risk of false positives would have to be considered.”