This is a tricky one for me because I believe in open markets – I don’t like circuit breakers or enforced spreads; I think a market should be what it is, especially in times, like now, when it accurately reflects the uncertainty in the world (and business models). Spreads are wider, and rather than complain about it as some are doing (the ultimate demonstration of entitlement if ever there was one), it should be accepted. The market reflects conditions, normally very accurately. You may not like it, but to my mind you have to lump it.
So, why is this a tricky column to write? Well I am starting to think we should consider suspending the use of certain algo strategies.
This subject is touched upon in this week’s In the FICC of It podcast where my guest John Crouch – like me a former trader – sees the problem as one of illiquidity. He is right, it is, but where I think we need to go a little further in our debate is by looking at the consequences of that illiquidity. Like wider spreads, illiquidity in FX markets is the current situation, therefore do we have to look harder at the execution strategies we are using?
I ask this because talking to people in the market over the past week and a half especially – some of whom have had orders go wrong – there is a common theme. When there has been a gap move in markets most often a liquidity seeking algo has been at work.
In normal times this strategy works fine, the problem now is the crust which represents top of market is as thin as it can be, but like a crevice in the polar regions, there is absolutely nothing behind it. People are nervous, activity is slowing down, and showing interest is, for some reason, not seen as the way to go.
I would disagree with that and as someone who has traded markets where Cable has been a big figure wide for hours on end I can point to experience. In wide spreads, as some algo providers are observing, placing an interest – for a small amount with an iceberg – can bring serious benefits. I do not hold with the theory I heard last week, that showing an interest sends the market away from you, because for every prop trader trying to take advantage of information, there is probably a genuine trader, with opposite interest, who will meet in the middle. In these circumstances, the passive algo strategy works well.
Where it doesn’t appear to be doing so is when the strategy involves more than two or three aggressive sells or buys – it is especially the case when, as I have been told several times over the past week and a half, the algo not only hits down the stack, for example but it offers on. The headline on Principle 12 of the FX Global Code states:
Market Participants should not request transactions, create orders, or provide prices with the intent of disrupting market functioning or hindering the price discovery process.
I am not suggesting for one minute that people using more aggressive algo strategies at the moment are seeking to disrupt the market, but the fact of the matter is, they are. It is not even the case that they are triggering a sustained move, most of these gap moves are followed by a reversion, often of more than 100%.
I would argue that in the current circumstances we have to accept that illiquidity is a fact of life that we need to adjust to, just as we have, mostly, for social distancing rules. If we accept that illiquidity exists then why are we promoting and using aggressive algo strategies?
I have no doubt there are customers out there complaining that the algos are badly built – they’re not, they’re just built for a different environment. Some providers no doubt are recalibrating their more aggressive strategies to take into account current conditions, but the fact is an aggressive algo is an aggressive algo – and that is what is causing these gaps.
Part of me thinks if a customer wants to use one of these algos and sees 50 points slippage then it’s their problem, but another part thinks that if we try to promote an environment in which people post interest passively, we may well see a slightly better market emerge for everybody. There will no doubt be gaps and times when an interest has to sit there for some time – indeed on occasion it may not get filled, but looking at the markets over the past week one thing is clear – the ranges are wide, but within reason, most levels are trading at some stage.
This is not a long term problem needing a drastic solution, but it is a problem nonetheless that can be tempered with short term action. Not for the first time – the foreign exchange market is reflecting wider society…patience is required.