I occasionally get the odd bit of grief from those who disagree with my views, no more so than when I criticise the shift towards an equities market model. Criticism has never bothered me, someone much smarter and more successful than me once told me she preferred to talk to people who disagreed with her – it was how she evolved as a person – and who I am to argue? That said, I thought I would lay out my principle reason for believing that the FX market structure works well in its current format.
It’s pretty simple; the foreign exchange market exists to service what I would call the real economy – corporations and asset managers looking to hedge. To do that it needs a risk absorption function, something the equities market does not have, just look at the current price action across markets.
As I write this, the dollar is at a three-year high, but that hides the reality which is Cable hitting lows last seen – apart from the October 2016 flash crash – in 1985 when not only did the six month outright price hit parity as spot plunged under 1.05 briefly but a young(ish) trader was learning to cope with his first real market blow out. It’s not only that of course, other pairs are hitting lows last seen at the start of this century.
Volatility is back with a bang – even that most staid currency pair EUR/USD had a 2% move the other day and the analysts at InTouch Markets noted in a piece the other day that on a three-week moving average basis, the average daily range for EUR/USD and USD/JPY was closing in on multi-decade highs.
Liquidity is holding up according to people I speak to, but it can be patchy and big tickets are proving harder to execute. Those customers using algos are reporting “decent” results as one put it to me, but they are on edge every time they press the button to hit trade – yes there is plenty of spread to capture with a good passive algo, but equally the market can very quickly run 50 or more points away in (no pun intended) a flash.
The bottom line is, though, the market is working. Maybe it is not as deep and liquid as people want – there is no doubt that people have become complacent about liquidity over the past five-eight years – but, within reason, there is a price for everything and an algo that will not crush the market.
Compare that to equities, where we have five-to-10% moves on a daily basis, sometimes intraday. This is what happens when there is no risk absorption in the market, algos mostly hit “fake” liquidity, which in turn looks to hit another “fake” stream, which leaves the market with no option but to plummet – or soar – with no obvious way to stop it. I use the word “fake” there because generally speaking market makers in equities are rarely pricing off inventory – they don’t hold it for any period of time. They are pricing off the latest price action (often on another exchange) and correlations.
This market is fine for speculators looking to grab some Alpha, hopefully they can jump on one or two percent of the ride, and the equities market is largely made up of, in one form or another, speculators. My argument as to why FX should never go this route is simple; transfer that price action from equities into FX markets and you will have a bunch of very happy speculators and, generally speaking, liquidity providers. What you will not have, is a happy hedging customer base.
At the moment, these customers are sometimes struggling to hedge in what we have – imagine if the market is kicking off five or 10 percent every day? It would be the hedgers’ worst nightmare and would cause more damage to an already suffering global economy – unnecessary suffering at that, and all because the regulators want a nice, tidy market.
The tricky part of this argument is the attitude of some hedgers, in the real money space largely, who have taken on the behavioural characteristics of some of the bigger global macro hedge funds of the past 40 years in that they begrudge every dollar the LPs make. This has seen them back the peer-to-peer concept – and good luck with that in these conditions! – and walk away from the banks in particular but LPs more generally.
I suspect these counterparties will have an interesting choice to make if this volatility continues – and at the moment there is no reason to believe it won’t. Either they step up to become true LPs, which I doubt they can do across currency pairs (and I look forward to the annual report which explains the manager had the all-important and to-be-avoided-at-all-costs tracking error because they were wiped out in Cable!), or they look to partner with a few LPs on a better mechanism. A third option is to use a multi-dealer platform, but even there, their behaviour will be scrutinised like never before.
I have long argued that liquidity has been under-priced and under-valued and current conditions are showing what happens when it is more accurately assessed. One critical aspect of being a genuine LP is the ability to actually hold some risk and take a view on future market moves (across more than a 10 second horizon), and this is something the FX market has, just.
Obviously we all hope the upheaval that is currently shaking the world ends soon, but in a micro-world it should also be hoped that the lesson of market behaviour has been heeded by the authorities globally. The FX market structure is standing up to the strain and providing a vitally important service to the global economy in times of strife. It would be a real shame if this lesson was wasted.