Two of my pet hates over the years have been the blurring of lines between retail and institutional in FX markets, and the Fix. The start of the Mark Johnson trial, and many peoples’ reaction to it, have only served to increase my rage.
I don’t whether or not Johnson is guilty of the charges brought against him by the US Department of Justice – that is for a jury to decide – but I do know that some of the hysterical comments being bandied about, indeed some of the “reporting” of the event on certain blogs, is inaccurate and shows an absolute lack of knowledge about how the “real” FX market works.
I remain of the opinion that it will depend upon who the HSBC traders did the trades for – if it was pre-hedging the order for the client there is no issue as far as I am concerned – and, as seems increasingly the case in this day and age – it comes down to numbers.
Let’s run through two scenarios.
The first is the client asks their bank to buy 2.5 yards of Cable (roughly the $3.6 billion involved in the Cairn trade). The bank takes this as a market order and acts as an agent for a fee. If the trader or traders have anything about them they will take their time, buy it gently and step back if they think the market is getting carried away, and they will probably prompt slippage from arrival in the single figures assuming the time of day (London hours predominantly) is good.
I would hazard a guess this order could take in the region of five-to-eight hours depending on the market, and would probably mean buying GBP 5-8 million every minute. Obviously there is event risk involved, so the slippage could be more.
The second scenario is the client asks the bank to buy the 2.5 yards at the Fix.
If the bank actually does what many “experts”, “reporters” and bloggers believe is the right thing and buys actually at the Fix it would mean someone buying 2.5 yards in one minute. That’s about GBP 41 million a second.
That is flash crash territory and we have all seen what can happen when a market starts moving in the electronic era.
I have noted before that the average daily volume of Cable in London was around 80 yards a day in October 2011, which is the closest measure we have. That means that, on average, GBP 148 million is traded every minute. So pushing that order through a one minute window would have meant volume increasing at the Fix by almost 17 times.
The review of FX benchmarks carried out by the BIS FX Working Group in the wake of the chat room scandal indicated that volumes through the window were up to 10 times an average minute, so we are talking nearly doubling that for the 2.5 yard order.
It is impossible to know what the slippage from arrival would be on that order but if they got lucky and got a match for part of it I would still suggest the level and intensity of the buying would have meant we are talking double figure slippage and, if we had slipped into flash crash territory, recent history shows us it could have been in the hundreds of points.
The problem is too many people commenting on this are from the retail sector where they are trading (at high leverage) maybe one or two million units – the institutional FX market is a world away from that. Yes, of course if someone is buying two million it shouldn’t have an impact and shouldn’t be front run (last look anyone?) – but try that a billion times over and see how well you go.
Hopefully the above examples highlight why using the Fix is not the best solution and why, if the customer does want it, pre-hedging has to be part of the strategy for large orders.
Now I would also suggest that the client think about this and ask about an improvement on the Fix. The prosecution is going to go hard over the $8 million that was allegedly made from the trade, had that been $1 million and the customer got a $7 million improvement I doubt we would even be here (not would we if it was a $2-6 million or maybe even a $4-4 million split).
I am sick and tired of reading people complain that Mark Johnson’s defence is “everyone does it” which is inevitably followed by a stream of vitriol about what should happen to them. The reason “everyone does it” is, as I explained before, because it’s the most professional and lowest impact way. The old Fix was a shambles (so is the new one but for different reasons), you simply cannot put those amounts through in a one minute window without damage, therefore to preserve the integrity of the market a more studied (and longer) approach is required.
I can guarantee if the order was pumped through the one minute window we would have had a serious move and a lot of the complainers who are making such a noise now would have been wiped out – what would they be saying then?
The retail/institutional blur and the Fix have caused this industry plenty of angst – to prevent even more trouble wouldn’t it be better to separate the two sectors out (thus returning to a ‘consenting adults’ market) and to stop using the Fix? It may cause a few clients issues in that they have to change processes and the odd legal documents, but they would get better execution I would argue and I wouldn’t have to listen to these ignorant, know-nothing whingers. Now that would be a win-win.