After a good January, March is shaping up to be, much like February, a pretty ropey month for many in the foreign exchange industry, and this is manifesting itself in the form an increasingly louder debate about the lack of volatility. I saw this week one publication suggesting that FX markets need “a proper crisis” to get things moving, but I am not even convinced that will do it. After all, last time I checked Brexit wasn’t going that well and the White House retains its confrontational style, but neither can get markets moving.
What may be dawning on people now is what will be for many a sad reality, and that is this is the new norm.
Most of us can recall the debate in financial markets a decade ago about the benefits – or otherwise – of high frequency traders and the proponents of the strategy would always stress how HFTs reduced volatility. Not everyone bought that argument of course, but generally the sentiment was that HFTs dampened volatility in “normal” conditions and then exacerbated it when something happened, both by adjusting their pricing more aggressively and, in many cases, by pulling liquidity from the market.
I have no wish to get into that debate again at this time, so let’s take that as read and then look at what has happened in the FX industry in recent years. The HFTs have largely rebranded as “market makers” but still rely upon the speed of their technology for an advantage and they do not, in the main, hold serious risk for a serious time.
At the same time, banks have reduced, for a variety of reasons, their principal risk businesses, and some have adopted the agency model (while still claiming a principal business of course!) but even those that have maintained a principal risk business do so in a very different fashion to 15-20 years ago. In fact the risk management model of most banks have moved much closer to that of the “HFTs”.
I have had the chance to look at some bank e-FX data over the years and what is noticeable is that average risk holding times have shrunk to under a minute from multiple minutes around the start of the century (hold times are obviously longer in EM and less liquid pairs). I am not suggesting for one minute that banks are acting like HFTs, they still provide risk to the right clients in size and will hold serious risk, it’s just they do it much less often. They have, however, borrowed risk management techniques from them.
Another factor in the shorter hold times for banks is how clients are executing – people are still breaking larger tickets down, even though most analysis will show them that the more they trade the more signalling risk they incur. This means that even with the rather spurious “full amount” trading that involves executing in clips with one LP, there is no incentive to hold the risk, which again shortens average hold times.
So we have a situation whereby just about every LP in the business is seeking to manage client flow rather than position off it, they are acting more like smaller trading firms in not holding the risk for a very long time, which in turn means moves are smaller in terms of price action – you see a couple of pips on a trade or risk position, you take it seems to be the mantra.
Whether this is healthy for the FX industry can be debated, as we have seen, when things go wrong they can do so spectacularly, but the broader impact is one of reducing volatility.
So we can wring our hands at the lack of action in FX markets, but I am not convinced it will change dramatically. Even if we have a crisis there will be a very sharp move (that most people will miss of course) and then? Probably not a lot, because those that were on the move will be taking their profit and those that missed will bemoan the fact and await the next one.
This is the new reality in FX markets. It resembles the classic description of warfare in that we experience long periods of boredom, interspersed with brief, intense moments of excitement. Whether this suits the business models of most banks is open to question – I would say it does not – but I equally doubt anything will change.
Generally speaking, for a sharp move to occur without a dramatic event, we need an imbalance of positions, but how are we going to see that if people aren’t holding them long enough? The outcome will be a never-ending downward spiral of volatility. There may be sceptics out there that don’t buy this theory and that is fine of course, but I would close with one question that I think reflects this market structure view.
If I am wrong and this is not about enough positions being held, then why do most of our minor volatility events involve the carry trade – the favourite of Japanese retail clients, a group that I as far as I can see is the only that carries long-term risk?