Any time there is a market event, it is used by people for their own ends. It happens, but it is not particularly helpful at a time when we may need serious, open-minded and honest debate over what happened.
Following the Swiss episode I have received plenty of correspondence from people telling me how their systems worked perfectly (it wasn’t a system issue), how their model worked well (their customers still did their boots), and, inevitably, how this would not have happened if FX was traded on an exchange.
What we saw was a Flash Crash, of the same type that happened in equities markets just a few years ago. The surprise was that it happened in FX, where the OTC market is meant to be of sufficient depth to avert such an event; but this does not mean that the OTC model is broken, or that an exchange would have performed any better.
CME Group is the highest profile exchange when it comes to FX products and on 15 January it saw its activity levels go higher, but not by as much as other venues, most of whom saw activity levels double at least.
Part of the reason for this may have been a decision taken by CME last month and published on 11 December. Rule 589, which came into effect on 22 December, applied price fluctuation limits to the Merc’s FX futures and options of futures contracts. In describing the process it goes through, CME’s announcement says that, “…triggering events result in monitoring periods, possible temporary trading halts followed by the re-opening of trading, and price fluctuation limit expansions.”
CME experienced a “dislocation” in its CHF FX markets on 15 January, unsurprising really given how most did, and this led to the exchange publishing an amendment to the rule on 21 January, which allows its Global Command Centre to: modify the amount of a price limit expansion; remove price limits at any time; determine whether a specified trading halt will be observed; and determine the products considered a Primary Futures Contract for purposes of expanding price limits.
Using price fluctuation limits is nothing new. Several OTC trading platforms operate a similar model, which at least warns the user they are inputing a rate too far from the last price or trade. Equally, CME was far from the only platform to experience such a problem – historically CME has been a stronghold for market makers, most of whom, rightly believing discretion is the greater part of valour, chose to stop making markets for a short time.
My point is hopefully clear but in case it is not, I will elucidate.
What happened on 15 January was an event. They happen and impact everyone in the industry. More importantly, the damage was felt in both OTC and exchange markets, with the former probably handling it better because of the existing market structure where bilateral relationships still count for something.
Yes, if spot FX was cleared then the clearing house could handle the aftermath, but the fact would remain this was a market liquidity issue and as such the victims from 15 January would still be bankrupt or severely under water financially. Better balance sheet treatment and capital usage would not have made prices magically appear, because the price maker would still have been run over.
It would be nice to think that people could put their self interests and prejudices to one side during what is going to be a crucial debate over the future market structure. Being a little contrarian of course, I question whether we even need that debate?
The issue was liquidity and no regulator (sorry Commissioner Bowen) is going to make people put prices in when they are on a hiding to nothing.
Personally speaking, my view is the institution that created the mess should have been better prepared for what happened. One of the roles of a central bank is to maintain market stability. I always enjoy hearing a central banker roll out the mantra that “exchange rates should reflect fundamentals” because normally they do just that – unless a central bank is distorting the market through its market activities.
EUR/CHF was not reflecting economic fundamentals, but that doesn’t matter – it was the SNB’s choice to support that pair and it did so. The only way we avoid the bloodbath of 15 January then is for the central bank pulling the plug to be well prepared to step in if things get out of hand. A few well prepared bids at chosen levels – 1.15, 1.10, 1.05 and 1.00 spring to mind – would have taken some of the volatility out of the market, but the end result would have been the same: a stronger Swiss franc but far less blood on the streets.
This is something for people to consider when viewing the events of 15 January through (hopefully) less emotional lenses than many currently are. This was not something that made the exchange model more attractive, in fact it actually doesn’t say much about the FX market structure at all beyond what I would argue is the simple and obvious truth.
FX needs both OTC and exchange/cleared-based markets so that participants can choose the model that suits them best and trade accordingly. There is no right and wrong, only victims of circumstance and, perhaps, their own complacency.
Colin_lambert@profit-loss.com Twitter @lamboPnL