There was a
little flutter of excitement this week when a news agency published a headline
proclaiming “Rookie Currency Traders Are Causing Big Problems”.
The story was
inspired by a small piece of a BIS white paper I happened to be reading at the
time which looks at foreign exchange liquidity in the Americas – it can be
accessed here – and in
one paragraph notes that “…during the GBP/USD flash event, the presence
of staff less experienced in trading sterling outside the currency’s core time
zone, with lower risk limits, more limited risk appetite, and less expertise in
the suitability of particular algorithms for prevailing market conditions,
appears to have further amplified the movement.”
Given how I raised this very point in my column
of January 16 – and reinforced it following a mountain of feedback on
January 19, I can’t very well dispute the claim, and I have no intention of
doing so. However – and you all knew there was a “however” coming didn’t you? –
while this is an issue I believe it is only part of the problem.
The BIS paper makes, as these things always do, some very
good points. It notes “some indications” that global FX liquidity may have
declined in recent years, especially after the SNB debacle, and highlights the
role of technology, internalisation, regulation and the aforementioned juniorisation
of traders in this apparent decline.
All of these factors do play a role and while the “junior”
story makes for a good headline, I found the comments in the report on
internalisation much more interesting. I have long stated that access to an internalised
pool of liquidity at a major dealer is an essential aspect of intelligent
execution of larger tickets (which now seems to be anything in double figure
millions!), and this report would appear to reinforce that opinion.
The report states, “A leading bank dealer reports that the
internal liquidity book can be as big as the turnover of a major FX trading
It adds, “Liquidity conditions in these internal markets are
reportedly quite favourable, as banks are able to quote tight bid-ask spreads.
Furthermore, a recent analysis by a large bank dealer indicates that liquidity
is higher in the bank’s own internal market than in the external FX market. In
particular, one large bank notes that the price impact of FX trade execution in
its internal market is smaller and less persistent than in the open FX market.”
Internalisation is not a panacea, rather it is an excellent
mechanism when markets are reasonably normal, but when things get busy and very
directional dealers will inevitably internalise less. That said, the
internalisation process should provide something of a buffer in taking some of
the volume and volatility out of a move.
Going back to the issue of “junior” traders I would clarify
my thoughts a little, however, because the fact is we all start somewhere and
we were all juniors in our given role at some stage. Yes, I accept there are
less mentors on desks but they have not disappeared totally – at a push I could
even be brought to suggest the odd veteran on the sales desk could help!
Either way, the only way the industry evolves is through
experience, and as
I noted a few weeks ago, a friend raised the very pertinent question of how
the next generation of traders is going to be trained if the first thing their
institution does is pull out of the market or go ridiculously wide?
This is addressed in the BIS white paper and again, I think
the analysis provides backing for some of the arguments heard in the FX
industry over the past year or two (especially in this column!)
Two paragraphs stand out for me. The first states, “…some
market participants perceive that post- crisis financial regulatory reforms
designed to reduce risk-taking in the aftermath of the Great Financial Crisis
(GFC) has lessened the incentive for dealers to warehouse risk, helping to
reduce their participation in FX markets and to lower their provision of FX
The second is, I believe, even more pertinent. “…the impact
on bank behaviour of regulation to discourage risk-taking in the FX market is
uncertain, as the characteristics of FX markets differ from other market
segments. However, some market participants indicate that other types of recent
regulatory development, such as fines and requirements for participants to
closely monitor trader behaviour, have reduced incentives for dealers to engage
in discretionary risk trading. Some have suggested that these developments
prompted large bank dealers to shift more of their market-making activity from
the open FX market into their own internal market.”
I actually think there are two distinct issues addressed in
this paragraph, for there is no doubt that large bank dealers do not, under the
broader regulation, have much of an incentive to give their best pricing and
liquidity to public platforms.
More striking for me is the use of the phrase “other types
of recent regulatory development, such as fines and requirements for
participants to closely monitor trader behaviour, have reduced incentives for
dealers to engage in discretionary risk trading.”
This is, I believe the heart of the matter, because we are
in a situation whereby we have a younger generation of traders who need more
experience and the only way they will get that experience is by, well,
experiencing the vagaries of the market. This means assuming some risk, but who
is going to do that in the current institutional environment of fear?
The answer is, of course, no one, and that is where the real
problem lies. We are in a Catch-22 situation because we need the new generation
of traders to experience the market in all conditions, but the current regime
does not allow the to assume risk, or, perhaps even worse, instructs them to
shut up shop the minute things get tricky.
The liquidity debate will, I suspect, go on for years to
come and fill many more column inches and academic publications. This is fine
because we need open and in depth debate if the industry is to continue to
reform and then evolve.
There is one aspect of this whole issue that does bother me
a little however. I am not sure liquidity has changed that much in the near 40
years I’ve been in this business. When events happen liquidity disappears and
dealers are either slower to quote, or quote wider (often both) – it has always
been the case. The definition of liquidity that stands the test of time and
changing market structure remains (yes, I know I’m rolling this one out again
but I will continue to do so until someone provides a better definition) “you
can get as much done when you’re wrong”, but there is one other thing we might
want to consider in our debate.
If liquidity conditions haven’t really changed when it comes
to events, is our real problem the sense of entitlement that has blossomed in
the FX markets over the past decade? The belief that there will always, should
always, be a tight price available 24/7? History shows, and continues to show,
that this is an illusion and as such perhaps the best service we can pay as an
industry is to dispel this myth once and for all.