The second – and penultimate – Irrational of 2019 is the Event of the Year and obviously this had to be held back to ensure that the Great British public did not don their subversive hats again and surprise at last week’s election. They did not to any great degree (although I don’t recall a poll getting close to the final majority) and the FX market functioned well (the benefit of the known-unknown) and into the bargain gave us an interesting insight into how it functions in the modern age.
I have to confess that traditionally, in a risk-taking environment, there would have been a surge in volume as the exit poll was announced, that would have continued for some time. There was indeed quite a bit of trading during the move up to 1.3450-1.3500 from 1.3150, but what I found interesting was how volumes apparently increased once the market settled down around 1.3450.
This could, of course, have been the result of a bunch of traders believing there would be more volatility, putting positions on having missed the initial move, however it could also bear witness to the amount of jobbers, scalpers, arbitrageurs – call them what you like – that now dominate the market…and that includes some so-called LPs. It could also reflect, as one source suggested to me, the number of so-called liquidity providers who were nowhere to be seen during the initial 250-350 point move, but who all popped their heads back up when the market settled down so they couldn’t be exposed to that alien concept to them of risk or – perish the thought – a loss.
No doubt these “LPs” will be loud and proud stating they “stayed in” but in reality most of them were probably wider than the Grand Canyon during the move or not there at all due to “temporary technical difficulties”, which translates as an unwillingness to assume risk of any kind.
Liquidity is at the centre of my Event of the Year as well, and for it we have to go back to the very first trading day of 2019 when, for the first time, a flash event was triggered by retail traders – something that, quite frankly, I thought I would never have to write, but it highlights the fragile nature of liquidity, underpinned as it is by so many “fake LPs”.
A post-New York close move is not necessarily a surprise of course, it is the infamous “witching hour” when liquidity is at its thinnest, but the very fact that it was triggered by a bunch of retail traders astounded me, for it highlighted exactly how reluctant anyone is to stand in the market and absorb risk. Think of it – a group of relatively uninformed traders, most of whom are chasing yield, were systematically stopped out by their brokers and the FX market reacted by dropping the second most liquid pair by around 4%.
I understand that collectively these trades add up to a reasonable amount in total, the BIS recorded retail-orientated flow as $66 billion per dav, and I am sorry to go “old school” on everyone here, but the amounts involved are nothing new to someone used to assuming risk – especially given the source of the flow, uninformed traders. I suspect the problem is no-one analyses this flow differently – everything is on the same +100 millisecond-to-one minute basis as every other piece of business is, most of the latter comes from informed traders, however.
I reckon that analysing on a +5 minute basis would provide a very different answer because, to repeat myself, we are dealing with uninformed traders who individually are trading relatively small amounts. The problem with the latter is that, apart from a very few LPs, no-one is encouraged to hold risk that long, so why bothering analysing it?
It could be that this was just the market blind-sided by it being the end of the first trading day of the year and perhaps desks were under-populated, but even so, for a market that prides itself on its depth and robustness, this was a pretty poor showing. I understand when a central bank pulls the rug out from under the market’s feet then mayhem ensues, but this was nothing like that.
This does speak to a wider theme as well. We talk about how some brokers in the retail space are about churn and burn in terms of their clients and happily these firms are slowly being rooted out and exposed for what they are – bucket shops. But as the banks move more into the brokerage space they too will face something of a moral dilemma. Obviously if they are operating as an agent they want to client to do well, so they will come back. If, however, they are acting as a principal, then they are in the invidious position of hoping their clients get it right, but not straightaway. Because they are generally monitoring the flow on a short-term basis in terms of its profitability, they are effectively saying if a client gets it right quickly, too often, then they believe the business to be toxic, but what about if the flow is valuable over a 10-15 minute time horizon? This is an argument, when it boils down to it, over execution style and I am firmly in the camp that says LPs need protection from predatory players and that they should be more careful with how they distribute liquidity. That does not mean, however, that LPs should make money on every trade or small group of trades – but in an environment in which everything is measured by machine, how can there be room to judge, or even allow, a human to intervene and effective say “I will wear that risk”. Machine logic, typically, looks to turn a profit when and where it can – it is not in the business of taking unnecessary or un-judged risks.
I don’t think we can skirt around the issue any more, there is an underlying liquidity problem in FX markets that is being masked by the number of “fake LPs” or liquidity recyclers, and at the periphery at least this may impact genuine hedgers. The answer is a relaxing of the rules on proprietary risk on the part of the regulators (and an acknowledgement that traders are allowed to make money) and an acceptance on the part of banks’management in particular that they are risk warehousers, and not brokers. That will allow more liquidity, more views, to come into the market and will create a healthier ecosystem for customers of all types.
We have the data to be able to monitor execution styles effectively and this data should give those making decisions the backbone to turn certain “clients” off, whilst accepting that even the gentlest clients can occasionally get the timing right.
If this doesn’t happen, we end up with an equities-style market environment in which any piece of news or an order out of the ordinary triggers much bigger moves and we swing around by one or two percent a day as most equities markets do. This is great news for traders and people trying to make money out of picking the market but it is a nightmare scenario for the very people the FX market, at its core, is meant to service – the hedgers.
I must confess that I thought liquidity as an issue would be solved, or at least some of the issues around it be resolved, but it hasn’t happened. So many of my conversations with market participants on all sides are still dominated by the subject and in January 3 (and the odd day since) we have the embodiment of the problem.
Effectively, between them, the regulators and banks’ senior management, have created an environment wherein trading businesses backed by billion-dollar-a-year-revenues run for the hills when a bunch of mums and dads are squeezed out of a position. That’s what happened on January 3 and it is likely to happen again and that is why, by highlighting the continuing problem of liquidity, it is my Event of the Year.