I don’t think there is anyone out there who
doesn’t think the FX market performed well under the stress of the surprise
outcome from the UK referendum last week, but I suspect the real test is only
just starting.

Don’t get me wrong, this is not one of my
contrarian columns that will say the market got lucky – I have worked in and
around FX trading desks for 39 years, including 20-plus years as a Cable trader
and I had never seen a move like that. The unassailable fact is the market
worked – thanks to the planning of everyone involved.

As I noted weeks before the vote this was a
“known unknown” and as such everyone could put plans in place – investors could
lighten exposures, liquidity providers could fine tune their price making algos
and (possibly most importantly) central banks were able to plan for either of
two possible outcomes.

This resulted in a market that functioned
pretty well. During the 600 point drop spreads went to 30-50 points wide, but
that is exactly how it should be – and always has been. Generally speaking my
information from traders and venues is that spreads were between two-to-four
times wider on Thursday and Friday than the previous week.

This accurately reflects an event-driven market caught
by surprise. There are also some hedge funds out there who should give thanks to
the market for functioning well because I have been told of at least seven
funds (and counting) who were sucked in by the move to 1.5000 in Cable as polls closed (they were driven
perhaps by their own private polls – an experiment unlikely to be repeated!)
and caught long. Yes it may have cost them multiple big figures to get
out, but it was nothing like as bad as it could have been. These funds have
lost money but none of them have their existence threatened as some did on
January 15, 2015.

The platform owners should also give thanks
because their numbers are generally very positive – as they should be. If a platform didn’t see at least double recent
turnover I would suggest its business has gone as far as it can.

Of course we are now starting to hear from
certain platforms and market making firms that their volumes were up four, five
and even six times recent averages, I have been contacted by several of these
but in keeping with my long term policy I refuse to give these people the
publicity unless they are willing to put a number on it. Yes, you may have seen
five-times turnover, but if its from $100 million per day it’s still not very
impressive is it? People who aren’t willing to share numbers (even off the
record I need to stress) clearly have something to hide – and that is rarely
anything positive.

So with this good news all round why do I
think the real test is just starting?

This idea occurred to me during the
dramatic 600 point Cable drop on Friday morning but it had nothing to do with
that event. What grabbed my attention was how USD/JPY disappeared 350 points in
a matter of seconds – from above 102.50 to the 99.10 level – before recovering
some 150 points.

I understand there is a ‘risk on/risk off’
mentality in markets and the yen is (bizarrely given how poorly the economy
continues to go) widely regarded as a safe haven. I also understand there were
masses of Japanese retail punters playing the markets (I am told one retail
broker’s punters had GBP 3.5 billion of exposures at one stage), but USD/JPY is
meant to be one of the market’s most liquidity pairs. How could there not be
enough liquidity to sustain the market? How can this pair, in seconds, move 350 points during the Tokyo trading session?

Clearly the liquidity providers were taken
by surprise by the sudden surge in yen buying and guess what? We had a
mini-flash crash.

In other words I am still not convinced the
FX market can handle a surprise surge in activity and over the coming months,
as news dribbles out at unexpected times during the no doubt protracted
negotiations to separate the UK (or part of it!) from the European Union, we
will see more of these moves.

I understand that liquidity providers say
that conditions quickly improved and spreads were back to normal within minutes
but that is not the point – try telling that to the poor sap who just had to
sell at 99.50 because they thought something big had happened? Or those that were stopped out on such a move – they are unlikely to come back to FX. They don’t care
about spreads being normal just minutes after, they’ve already done their boots
(technical FX market term) and headed for the nearest source of whatever stress
relief they require.

I suspect the yen move was explained to me
(indirectly) by several market makers that I spoke to both during and after the
event. The phrase “more actively managed than usual” came up a lot which really
means they weren’t willing to hold significant risk during the event. That’s
fair enough, why would they in such conditions – as I have pointed out before,
market makers are not a charity – but it does highlight how there was/is little
in the way of a safety buffer in markets.

If there are no risk warehousing
facilities available then moves are going to be exacerbated. Late last week was
not a yen story, no matter how many correlations you want to run, it was a
sterling story, so why were people unwilling to hold risk in yen? I can only
surmise it is because they didn’t want to hold it full stop, which is not
necessarily great news for the FX market going forward.

Generally speaking, while the former may
have been tighter at top of book, my information is that the
non-bank and (top end) bank LPs performed pretty much as well as each other, so
this liquidity gap is not evidence of a market with or without either set of
players – it seems a potentially stark look into the future of the FX market.

A few weeks ago I discussed some very real
concerns in the industry over the potential for another fiasco in FX markets
around the UK vote, but in the event the worst happened and everybody survived –
with a few bruises in some cases – so the market does deserve a pat on the
back (and the effort this took, and its degree of success, should not be
under-estimated).

That said, however, what has really
happened is the FX market has shown it can adequately prepare for a potentially
devastating event. What still concerns me is this may be glossing over the very
real question of whether liquidity is strong enough to handle smaller
surprises.

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Twitter @Profit_and_Loss

Colin Lambert

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