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Is Market Volume Proving Too Hot to Handle?

Dealers at a few Japanese banks in London are asserting that they have experienced problems over the EBS spot matching service in the dollar/yen market. These problems, they say, pertain largely to the market’s dependence upon EBS as the primary trading platform for spot FX (50% of all brokered spot trading in London is now believed to go through the system).

At the heart of the discrepancy is a seemingly minute time lag – of one or two seconds – during which these dealers say the market can trade outside large areas of liquidity. What is actually occurring seems to be a difference between how the matching service handles orders, and how the voice brokers have traditionally handled such orders.

For example, a dealer at Japanese Bank A has a large order to fill – say he needs to sell $500 million for a customer – so he puts in his offer at 105.30. Meanwhile, a large US Bank B needs to fill a large buy order from a fund manager, so he goes into the market bid at 105.33 – above the sell order at 105.30, so as to ensure that he not only manages to buy all the dollars on offer at 105.30, but also all the dollars in between.

What seems to be occurring is that once the bid at 105.33 comes in, “there’s a mad dash” to buy at 105.30 and sell at 105.33. Worsening the situation, says one dollar/yen trader, is that EBS is subject to a slight time delay of up to two seconds after each block of 10 orders has been filled. This trader says the time delay can cause both banks A and B to miss out during the “mad dash” that ensues.

“The danger is if the 105.33 bid is filled before the sell orders are taken out – the market has then traded at 105.33, and nobody will believe that you didn’t sell at 105.30 when the market was bid at 105.33. The system makes a mockery of levels by allowing banks to place buy orders above clear sell orders,” says the dollar/yen trader.

Ironically, however, EBS did not originally allow bids to come in above offers; it added this feature as a direct result of dealer pressure to bring the system more in line with market practice.

The dollar/yen trader believes such a situation would never have happened in an orderly voice brokered market, because market ethics would dictate a ‘first come, first serve’ basis in filling orders. “In the old days, the market had a chance to consider levels and take a breather during crises. That doesn’t exist today, which means we are subject to volatility like we’ve never seen before,” says the trader. “EBS is meant to be infallible – it says it will match trades, but it isn’t always doing this.”

A source close to EBS says that automatches are more likely to be missed by some participants in very busy markets, since bids and offers won’t always be evenly matched. “The fact that Trader A doesn’t get automatched doesn’t mean there was no automatch at that price. Trader A may be behind a number of other traders, who are seeking to match at a particular price. In other words, the system always automatches, but not everybody will automatch at a particular price,” the source says.

The trader claims that the situation is potentially dangerous, because it can create “ferocious volatility”. “This could be the reason why we have seen currency volatility in the yen that hasn’t been seen before,” says this trader, who adds that the instance is fairly unique to Japanese banks in London, which tend to be more order driven.

But another dealer notes, “It’s a bit of a chicken and egg situation – does the system drive the market or does the market drive the system? Is Bank of Japan intervention causing the dislocations or is it the system?”

EBS is six years old, why is this problem occurring now?

The interbank market’s lack of liquidity has a lot to do with it. About 18 months ago, the US Foreign Exchange Committee released a study on the impact of electronic trading, and warned of the potential dangers in relying on only one means of liquidity.

“There is not a lot of liquidity in the market, so everything goes through EBS. The problem seems to arise when it’s very busy and a large order comes through to buy above the highest sell order, in hopes of getting liquidity and matching all the trades out there. Sometimes it doesn’t happen that way,” says a trader at another Japanese bank in London.

This dealer says that when the market does get very busy, it appears that the machine is having difficulty coping with the volume of orders. “We have witnessed instances of such aberrations in which it appears the system is trying to work out which counterparties to match. We have not experienced any problems ourselves, but if the system is unable to cope with the volume, and it affects our exposure or profits, then obviously we would talk to the vendor,” the dealer says.

Another trader adds, “Traffic is so heavy and the market is so nervous – we’re hearing one or two rumours a day about Bank of Japan intervention or the Fed checking rates – that gaps are suddenly appearing in the market. It makes you wonder if the system can handle the high volumes in the short bursts that we’re seeing.”

A Victim of its Own Success?

EBS was formed by a partnership of 13 of the world’s largest banks, and includes Minex Corporation (a consortium of 21 Japanese banks and brokers and telecommunications company KDD which EBS absorbed a couple of years ago, largely because of its dominance in dollar/yen). The use of both EBS and Reuters Dealing 2000-2 have grown so rapidly since they first hit the market in 1992/93, that they have prompted concern from a number of market participants, who believe the systems have not yet been truly tested by a real market crisis.

However, the source close to EBS says that the system has been tested – and has performed well under very volatile conditions. “These issues are not an indication of the system failing to ‘cope’ with heavy volatility – the system traded without a hitch during the incredibly busy periods in September and October of last year,” adds the source.

“You can’t really fault EBS for being the sole supplier to the market. The market has chosen it as its preferred means for trading. But what is a concern is if the system cannot genuinely handle the business that is going through,” says another trader.

This trader likens EBS to an ATM machine: “If everyone in the world tried to withdraw £200 from their ATM machine at the same time, the system wouldn’t be able to handle it. But under normal conditions, this wouldn’t be a problem.”

EBS’s official response to the situation is: “EBS operates according to a set of Dealing Rules which were drawn up in cooperation with banks. The system is operating correctly. The fact that an automatch didn’t occur between two particular participants doesn’t mean that an automatch didn’t occur at all at a particular price. However, EBS is a single global market and there are circumstances when two deals that should ‘apparently’ match, may not. It is a factor of multiple time zones and trading behaviour. We are looking at ways to further minimise the possibility of this occurring.”

According to the source close to EBS, the dealing rules state that an order may be matched in part or not at all. If an order were submitted at a price that appears to be available and not matched, it would suggest that the quote be matched with another order that was ahead of it in the queue. The livelier the market, the more people there are likely to be in the queue.

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