The FX industry proved resilient in the
wake of the volatility caused by the Brexit vote while also illustrating the
changing nature of liquidity within the market, according to speakers on a Profit & Loss webinar last week.

“One of the biggest concerns that came up
in terms of liquidity” was related to the fact “there’s not a linearity in the
way that one could deal in the currency market right now” said Eric Busay,
senior investment officer at Mountain Pacific Group. “On a particular day you
could do a relatively good size transaction and have no problems…then you could
do a similar type of transaction the following day and find what I refer to as
air pockets, gaps in liquidity, that take place”.

This is due to a number of factors, Busay
said, “Regulation is one of them”, and the number of principal liquidity
providers in the market has shrunk because “there’s greater scrutiny so they’re
not as willing to assume risks as they were in the past”.

During Brexit, “people realised it might be
difficult to change positions in any kind of size, meaningful size at least,
immediately” and “pricing could become discontinuous” he said.

“Liquidity across the market was there in
10s and 20s, which is pretty good, but I’m not sure you saw that liquidity in
50s and 100s” agreed David Mercer, CEO of LMAX Exchange.

Nevertheless, the panellists said that the
market overall performed well with liquidity remaining healthy during the most
volatile hours as first polls started to come through.

Liquidity sources

Kevin Kimmel, chief
operating officer at Citadel Execution Services FX, emphasised the importance of
recognising the evolution of FX market liquidity, saying, “The nature of
liquidity is changing and as a result, behaviours and execution tools are
adjusting accordingly, leading to the growth of algos, for example. Liquidity
held up well during Brexit which is an encouraging sign for the FX marketplace
as it continues to evolve.”

Discussing where liquidity was coming from
on the evening of the Brexit referendum, Mercer highlighted that “the non-banks
came to the fore in terms of the majority of the liquidity”. He said that
non-banks generally provide about 60% of the liquidity on the LMAX platform,
but during on the night of June 23 and in the morning of June 24 the non-banks
were providing about 70% of the liquidity, with banks providing the remaining

In response to this statement, Kimmel was quick to emphasise that he doesn’t
see the banks’ role in the FX market diminishing any time soon. “We don’t see
banks going away and believe that they will continue to play an important role.
However, there is an opportunity for non-banks to provide supplemental
he said.

Further volatility

Looking ahead, Mercer warned that in order
to be better prepared for the next big risk event, the FX industry needs two
things: people and an appetite for risk. “What you saw in the SNB [event] was
computer driven and the computers said “no” and you had no one able to step in
to take some of the risk or run some inventory,” he observed, adding that
having market makers – either banks or non-banks – that can run risk is crucial
during big risk events because the instantaneous hedging style of liquidity
simple doesn’t work during such events.

Mercer also claimed that there are likely
to be more large market moves going forward, a prediction that Christopher
Cruden, CEO of Insch Capital Management, appeared to agree with.

Although he noted that market participants
were “remarkably calm” following the volatility induced by the Brexit vote,
Cruden said that things could get worse before they get better in the FX
market. “Having managed money in the Asian crisis, I see the next possible
scenario being more akin to that only much, much larger. The difference between
Brexit and the SNB event is that during the latter in effect you had currencies
that became non-tradable, they basically closed the ‘pay out’ window at the
casino and that’s really not a good thing for the FX markets.”

On the positive side, Cruden said that the
Asian crisis in the 1990s was resolved, in part, because of the commonality of
interest amongst FX market participants. Thus he concluded, “Although I suspect
that there will be another big event, there’s a reasonable amount of confidence
that the tools are in place and the people are in place on the ground level to
handle it.”

Access the webinar in full here


Colin Lambert

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