We have “too big to fail” firmly embedded in the market’s lexicon, and we now can add “too big to move”.
I had an interesting conversation with a youngish trader the other day who was firmly of the opinion that EUR/USD “never moves very far and never will”. The trader’s view was that the market was too big, too liquid and as such no order was big enough to move it more than 50-100 pips.
You will be unsurprised to hear that I disagreed, but not as much as I would have maybe five or six years ago. We obviously currently exist in a low volatility environment and as such the past two years is probably not the best place from which to build an analysis; however I still feel it is dangerously complacent for anyone to believe that this low volatility will stay with us forever – and that liquid markets cannot move.
It is an interesting aside that for all the complaints the industry makes about HFT making lives harder through nicking points and jumping in and out of the stack, perhaps the real impact – assuming academia is right about HFT reducing volatility – could well be, somewhat perversely, that HFT has contributed to the slowdown in activity. Were we all blinded by the number of trades that were being done and didn’t realise that general activity was declining?
The nature of the current market – again driven by the influence of HFT – is also part of my reasoning that big moves will happen again, even in EUR/USD. As more banks fall into the “hot potato” trading style, fewer are risk warehousing anymore – as I was asked a week or so ago, is holding a position for 10 seconds really internalisation or risk warehousing? It certainly isn’t the latter, and I argued that internalisation means the trade goes into the trading book and doesn’t come out – at least publicly.
So as “hot potato” grows in influence, the likelihood is that fewer and fewer players – and this is a slow process it won’t happen immediately – will stand up as a liquidity provider of last resort. This is a tremendously important function that those that fulfil it do not get nearly enough credit for. It ensures that the end users of our market, in the real economy generally, are able to risk manage and hedge exposures in even the wildest conditions.
If a bank’s desire to be an FX market principle is being diluted, they are more likely to rely upon a bigger player to provide that liquidity provider of last resort service. The problem is, does a third party market maker have to fulfil that role? Probably not is the answer, which is a little worrying for the market.
Add into this mix the increasing percentage of EUR/USD that is priced by non-bank market makers who (quite rightly, they’re not charities) will inevitably pull back in the face of a thin market and you have the conditions for an event-driven move that will clearly shock many traders.
It is only recent history but the aforementioned trader I was speaking to was shocked to hear that USD/JPY moved over 20 big figures in a day an a half as recently as 1998. I am not suggesting the same sort of move will happen again, but to think it never will seems over-complacent at best.
It could be that the vast number of market makers will ensure that there is always a price and that EUR/USD never again dumps five big figures in a morning (the sharp moves always seem to be down!), but I am not convinced. Just as I would argue it is darkest before the dawn in terms of volatility, so would I argue that things will look absolutely rosy in the garden with an abundance of liquidity…right up until the moment it goes horribly wrong.
It is the nature of markets to be unpredictable and I don’t see why the next decade or so should be any different. This means that complacency in the form of risk management, or indeed in the staff numbers populating a business, should be unthinkable to everybody.
But if my trader friend is representative of the industry now, I am not sure they are thinking the unthinkable.
Colin_lambert@profit-loss.com Twitter @lamboPnL