“Confluence of Factors” Behind Sterling Flash Crash: BIS

The Bank
for International Settlements’ (BIS) Markets Committee has released its
analysis of the 7 October 2016 “flash event”, arguing that a range of factors
rather than a single driver catalysed the event.

During the
flash event, sterling
depreciated by around 9% versus the dollar in early Asian trading, before
quickly retracing much of the move
.

The new report
from the BIS, drawing on the analysis conducted by the Bank of England as well
as intelligence gathered by the Markets Committee, concludes that “a confluence of factors” cause this flash
event, noting that “the time of day played a significant role in increasing the
sterling foreign exchange market’s vulnerability to imbalances in order flow”.

In its
analysis, the report divides the flash event into three distinct phases. The
first phase that it identifies is the rapid sterling depreciation from 1.26 to
1.24 against the dollar in response to significant selling flow. But it notes
that, although rapid, this depreciation happened “in an orderly fashion and
with broad participation on key venues”.

The report
characterises the second phase as a number of minutes of extreme dysfunction
during which sterling fell further, rebounded and then traded in a wide range.

“This phase
involved lower volumes and narrower participation, pointing to a greater role
for the actions of individual market participants as a driver of the sharp
moves,” observe the authors of the report.

Then it
says that the third and final phase was the gradual recovery in market liquidity
over the following hours.

The report
goes on to say that a number of factors contributed to and amplified this
market dysfunction, in particular noting that significant demand to sell
sterling to hedge options positions as the currency depreciated appears to have
played an important role in this.

It also
says that execution of stop-loss orders and the closing-out of positions as the
currency traded through key levels may have had an impact, but adds that a
media report released shortly after the move began – which it claims would have
been interpreted as sterling negative – would have added only marginal weight
to the move as it did not contain any new information.

“These
factors appear to have contributed to the mechanical cessation of trading on
the futures exchange and the exhaustion of the limited liquidity on the primary
spot FX trading platform, which encouraged further withdrawal of liquidity by
providers reliant on data from those venues,” it says in the report.

In
addition, it says: The presence, outside the currency’s core time zone, of
staff less experienced in trading sterling, with lower risk limits and risk
appetite, and with less expertise in the suitability of particular algorithms
for the prevailing market conditions, appears to have further amplified the
movement. Other factors such as ‘fat finger’ errors and potential market abuse
cannot be ruled out, but there are little, if any, hard data to substantiate
them.”

In a
statement issued alongside the report release today, Guy Debelle, chairman of
the Markets Committee, claims that there are “direct lessons” from the sterling
flash event that the Foreign Exchange Working Group is taking into account as
it continues developing the new FX Global Code of Conduct.

“These
include market participants’ obligation to consider the disruptive consequences
of their trading activity, governance around algorithmic execution of trades,
and how market participants might best determine the low (or high) point of
pricing in a flash event,” he says.

The BIS
report observes that this event, rather than representing a new phenomenon, is
just a new data point in what appears to be a series of flash events occurring
in a broader range of fast, electronic markets than was previously the case in
the post-crisis era, including those markets whose size and liquidity used to
provide some protection against such events.

Although
the report says that there are a number of commonalities between the sterling
flash event and other similar episodes, it claims that the sterling event was
unusual because there were few spillovers to other currencies or asset classes
and no systemic financial institutions incurred material financial losses in
this instance. It adds: “This might point to market participants having learnt
lessons from past episodes”.

Commenting
on these flash events, Debelle says, “Since such events have the potential to undermine
confidence in financial markets and impact the real economy, it is important
for policymakers to continue to develop a deeper understanding of modern market
structure and its associated vulnerabilities.”

Meanwhile
Mark Carney, Governor of the Bank of England says in a statement that it is
“vital” that the financial industry learns the lessons this flash event and
similar episodes, because orderly market functioning underpins market
confidence.

He adds:
“It is also important that firms have adequate governance, systems and controls
and give due consideration to the potential impact of their activity on market
functioning.”

galen@profit-loss.com

Twitter @Galen_Stops

Twitter @Profit_and_Loss    

Colin Lambert

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