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And Another Thing…

I have often discussed the “equitisation” of FX markets from a market structure perspective; now though, I can talk about it from a market behaviour angle.

I have had the good fortune to be able to spend some time with some good friends in the industry recently (yes that is code for I have had a couple of lunches) and we have had some great chats on a huge range of issues relating to the market.

Two things struck me. Firstly, that the new generation of traders, obsessed with statistics, don’t understand (or, more to the point, feel able to completely ignore) the psychology of markets; and secondly that markets are overreacting to every single piece of information available, rather than seeking to build a more accurate bigger picture.

Trading for short-term profit is nothing new in FX markets of course, but it seems to me – and my friends – that even those traders who used to take considered positions, and were patient with them, are now reduced to punting for five or 10 minutes (at the most) if they want to make money. Several longer-term macro type investors I speak to have long said that holding a position is very difficult – it seems it’s getting harder.

Partly this is because, as noted, markets are reacting to every single event as though it is unique. Take the example of recent statements by central banks, especially the Bank of England. In the big picture, nothing has changed. The Old Lady’s Monetary Policy Committee clearly believes it will be raising interest rates in the next year, but the slightest change in nuance by BoE Governor Carney is seen as a policy shift.

This is ridiculous and highlights how over-analysed markets are. It strikes me that the only way a central banker can avoid this type of overreaction is to deliver the same speech time after time (although having said that I believe the Reserve Bank of Australia has done that to all intents and purposes, and that hasn’t stopped markets interpreting the same words differently).

Partly this is an attempt by the huge band of analysts to justify their existence or retain their retail customers’ attention when equity markets are doing better; and partly this reflects a desperation to have something – anything – happen in FX markets.

The other issue that came up during these chats was how the new generation of e-FX traders – even in some major liquidity-providing banks – who are responsible for more and more of the business, don’t have a concept of real risk. This is partly a continuation of a theme from this column a month or two back on last look – too many liquidity providers seek to use this mechanism to avoid taking a loss, or even assuming risk.

Often you meet with voice traders who are less than flattering about the risk-handling skills of their e-trading brethren. Now I accept that this is probably prompted by a degree of bitterness towards a new way of working that is eroding their responsibilities; but knowing the people concerned, I would say there is some truth in it. Put simply: if the numbers add up, the trade is OK – but to add up there needs to be an immediate exit trade.

Of course, I need to stress that this is not all e-traders, and there are several I know very comfortable with risk. But the rise of the short-term player, specifically HFTs and some non-bank market makers, allied to some in the banking world taking this attitude, has meant there is now a significant and influential group of traders who do not want to have significant risk on their books. And if they do have some, it is never for more than a few seconds.

This all adds up to a market where the hot potato is passed around until it finds an end user or comes up against natural interest (which thankfully the FX market has in abundance still), and within this market very few people are willing to assume risk – unless it is taken by committee which seems the modern solution to avoiding responsibility!

While this hot potato is passed around, occasionally there is a statement or economic release to generate some excitement. But the mean reversionists are soon proved right and we end up where we started, looking at each other and asking, “what happened there?”

This is the equity markets of the past 10-15 years and suggests to me that the influence of retail players and small prop shops is bigger in FX than we think – for this is from where this type of market behaviour is generated. There have been recent warnings that the current environment in the FX market is leading to a serious lack of risk taking, where dealers just don’t see the point of getting involved at a time when their job is under threat – and they seem justified.

We have to hope that wider events work to help empower the risk takers, for if they don’t we could be looking at a further “equitisation” of FX markets. And if anyone wants to know how that ends, just look at the continued arguments over the market structure in equity markets – 20 years after they were first electronified.      Twitter @lamboPnL

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