The
Bundesbank paper on high frequency trading caused a mild stir – as all things
on this subject does – and triggered the usual round of claims and
counter-claims surrounding this segment’s benefit to the financial markets
industry.

The paper
didn’t look at FX markets, rather it was a look at national equity and bond
markets so already there is a different dynamic at work, but I found some of
the conclusions interesting and relevant to FX markets.

Firstly, I
am intrigued that globally some regulators seem keen to push FX to a fully
transparent equities style trading model, however at the same time others are
seeking to adopt a recent FX initiative, the speed bump. I feel there is a
mixed message there where some are saying, “yes, let’s get FX onto a single
exchange-like model” which inevitably levels the playing field and empowers
high speed traders, but on the other they are saying that those very same HFTs
are behind a technological arms race which, as the Bundesbank notes, its of
“questionable social value”.

I
understand that I am very pro- the FX industry, having been in it for so long
this is natural, but I do consider myself fair and in that vein I have to say
that – again – the FX industry has got the balance right and proved it is truly
a innovative, dynamic and inclusive ecosystem.

What the
Bundesbank paper is saying – as so many others do when they discuss HFT – is
that there is still a divide between the “slow” and the “fast” traders (the
concept is relative of course) and that the equities market structure sometimes
struggles with this.

I continue
to feel, when I read these papers, that the equities industry s still having a
“them and us” debate over HFT and non-bank market makers. In FX this
occasionally still happens but, I am happy to report, it is much less
frequently. As more platforms have started to preach the message, and more
players on both sides have accepted they can co-exist, the whole non-bank/bank
debate has largely become irrelevant.

Obviously
what we saw on October 7 in Cable would suggest that FX faces exactly the same
issues, however I would argue they are still different – even if that was a
flash crash similar to the moves the Bundesbank is warning of.

The Cable
event was clearly a case of someone, for whatever reason (and we may find out when the working group
delivers the results of its investigation in November), hitting the market at
the wrong time. We all know liquidity is low in that period, which is why I
don’t believe it was a genuine market order, it was, possibly and if so
unfortunately, someone trying to trigger some sort of level.

In short,
in spite of some seemingly willing to bash them, the Cable flash crash was not
the result of HFTs suddenly pulling out of the market, because they are rarely
there in any size at that time of day – and nor, it should be pointed out, are
the major (and minor) bank liquidity providers.

The period
between the New York close and the Tokyo/Singapore open is, and always has
been, horribly illiquid, which is why, in a classic chicken and egg situation,
the vast majority of participants avoid it.

I do wonder
if there is one influence shared by equities and FX markets however, and that
is the growing influence of retail traders. Last year I gave a speech in Sydney
in which I discussed the risk of further market dislocations partly due (and I
stress partly) to the phenomenon of crowded trades (in number not notional)
created by the growth of retail traders.

The Tokyo
open (such as FX has an “open” of course, but the broader market does) is often
a busy time for retail punters and I wonder what role these play in some of the
moves we are seeing. They are, generally speaking, less informed, short term
traders looking for any move to scalp a few points off. In such circumstances
as we saw on October 7 and the Bundesbank refers to in its paper in equities and
bund markets, these retail hordes with their sudden rush of orders could seem
to a price engine like a huge wave of selling interest.

The reality
in FX terms is, of course, that the amounts are relatively small, even when
aggregated, compared to some of the tickets that do go through but which are
handled by professionals. Notwithstanding that, they have an impact and their
influence is exacerbated in the thin, early Tokyo hours.

A
characteristic of markets in recent months has been for liquidity providers to
reduce participation and in some cases step out completely. I do not like the
impact this has on markets but it remains their right (as long as they don’t
bleat on about being “client-centric” or “a benefit to the market”). In equity
markets the issue is the same, market makers step out and if I am honest, I don’t
see why speed bumps will solve the issue.

What this
debate should not be about, as it it appears to be in equities, is the
bank/non-bank or “slow”/”fast” issue. Speed bumps may help ease the imbalance in
favour of “fast” traders, but ultimately the real issue facing all markets is
that the crucial function of liquidity provision is under threat from
regulation and the changing market structure.

Talk about
speed bumps all you like but I would prefer to hear a debate over how we can build
a more robust liquidity stream – that is the real issue facing markets.

Colin_lambert@profit-loss.com

Twitter
@lamboPnL

Twitter
@Profit_and_Loss

Colin Lambert

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