Following the results of the UK referendum decision to leave the European Union last week the common consensus amongst FX market participants has been that the biggest surprise – apart from the result itself – was how well the FX market handled the resultant volatility.

“Two months ago if you’d told me that we’d have a Brexit overnight I would have been worried,” says a senior figure at one trading firm. “But the reality is that it was surprisingly orderly and although volumes were high it seems as though everyone’s systems worked well.”

Similarly, another market source expressed surprise that there appeared to be no major problems in the FX market, no fat fingering and no large misfires through a big figure – on a day when there were multiple big figure moves, something that they pointed out has been unheard of the past couple of years.

“Nothing broke down, no one blew up and no venues went down, which is pretty remarkable given the huge volumes that were being done,” observes a source at one market making firm.

As Profit & Loss reported on the day, although spreads widened in many cases there was liquidity available in the market, in contrast with when the Swiss National Bank (SNB) dropped its peg to the euro.

In particular, many have noted how active the non-bank market making community was on Friday. In recent years some of these firms have faced the often lazy accusation that they simply exit the market when trading conditions become stressed. From all reports, this was not the case on Friday, with a number of them reporting record trading volumes.

Indeed, Gio Pillitteri, managing director and global head of FX at Global Trading Systems (GTS), claims that the presence of the non-bank market makers was one of the factors that contributed to maintaining orderly markets during the volatility currency moves.

“I think that the presence of alternative liquidity providers, like GTS, was beneficial to the market on Friday. Firms like GTS contributed to an ecosystem that remained orderly even in conditions where liquidity was extremely challenging and market moves were very violent,” he says.
Pillitteri goes on to add: “This is a technology intensive game and the spreads that you show to the Street will be determined by how your systems are able to cope with a major event like we saw on Friday.

“Alternative market makers such as GTS are backed by cutting edge technology and are able to leverage that to keep providing prices while efficiently managing their risk, which helped absorb some of the shocks. I think that this is positive news for the market, for regulators and for investors in general.”

Gaining market share

Certainly, Friday was positive news for these alternative liquidity providers, with the firms that Profit & Loss spoke with all reporting a significant jump in their trading volumes, both into ECN platforms and into the banks that they work with.

“As a result of our consistent and relatively tight pricing during high volatility, we picked up significant market share, both on ECNs and with our direct clients, including several major banks,” says Kevin Kimmel, chief operating officer at Citadel Execution Services (CES) FX.

Incidentally, CES FX reported that its June 24 volume was more than four times its regular volume, the latter being defined as its year-to-date average daily volume prior to the Brexit decision. The firm declined to give hard numbers, however.

The banks must have been busy on the phones on Friday, because again every single non-bank market maker Profit & Loss interviewed said that they had received calls from their bank partners on the day thanking them for the liquidity that they had provided on the day.

And what of the banks themselves?

From the non-bank market making community, the opinion seems split on this one. A senior figure at one firm claims to have seen a number of banks “pulling out aggressively”, while another says that a couple of the banks that they work with turned off their auto-hedgers and basically stopped pricing clients.

One alternative liquidity provider disputes claims that banks left the market altogether, suggesting that they were still in the anonymous ECNs but just not in the single-dealer feeds. They add that they saw both banks and non-banks widening out their prices though.

Asked about whether some banks pulled out of the market during the volatile market conditions and one non-bank market maker simply shrugs, stating that they don’t know what bank liquidity was like, but they felt like their firm was getting more flow during volatile trading conditions, suggesting that some firms – and not necessarily banks – may have stepped out of the market.

And yet speaking to market participants, the general opinion was that, although the banks widened spreads in some cases and “actively managed” their risk at a higher frequency than usual, they did a good job on the day as liquidity providers.

Whilst banks approached by Profit & Loss officially declined to comment, sources on several trading platforms and bank trading teams are more positive about how things went. “There are probably seven or eight major bank liquidity providers and they were all in the market throughout the event,” says a senior source at a trading venue. “They weren’t always top of book, but they provided depth of market and did significant volumes.”

Another platform source tells Profit & Loss that their venue saw a “significant” number of large trades during the sterling sell off on Friday and that “the liquidity provider in every one was a bank”.

The source adds, “Non-banks were great throughout the event, but so were the banks – I didn’t see much difference between them.”

A bank e-trading source is slightly more cynical over the non-bank claims, arguing, “If you measure your success by being top of book in the smallest amount possible then yes, they were better, but most real clients wanted a price in more and they got that from our feeds.”

The e-trading source adds, “We focused on our disclosed, single-dealer stream to make sure our core customers were well-serviced and there were no issues. We measure our success by how happy our clients are, not by how happy our competitors are.”

Known Unknowns Vs. Unknown Unknowns

Although the performance of liquidity providers, on both the bank and non-bank sides, no doubt contributed to the orderly functioning of the market, the fact that the UK referendum was a known risk event is probably a more significant factor that explains this.

This “known unknown” meant that market participants could prepare for either outcome of the referendum. This meant retail platforms were able to raise margins ahead of the event, banks were very careful in terms of the credit that they allocated to clients and ECNs checked over their technology and ensured that extra support staff were on hand to deal with the increased trading volumes.

Some of the non-bank market makers also emphasise the preparation that they undertook ahead of the referendum to ensure that their systems worked as expected.

“We had weeks of preparation ahead of this event. We had been in talks with trading partners at the banks, at the ECNs and with our direct customer relationships and we calibrated our technology ahead of the event? in preparation,” says Isaac Lieberman, CEO of Aston Capital Management (ACM).

He adds: “We built all this high-tech ?machinery and ?structured all our credit and trading relationships ?alongside our risk management and ?quantitative strategies?, ?but prior to Friday’s volatility, it ?felt like having a Ferrari that had never been taken out on the track.”

The head of another alternative liquidity provider says that in the build up to the referendum, their firm had been re-checking its systems to ensure that it could handle the possible heightened volumes and volatility. In addition, they explain that staff at the firm had been preparing for a variety of possible scenarios, such as if a trading venue that they are executing on suddenly goes down in the middle of a volatile market movement.

Others, however, described the build up to the referendum as “business as usual”, stating that they felt it necessary to make limited preparations for the event beyond having extra staff on the desks or monitoring the trading systems more carefully ahead of and during the vote.

Litmus Test

While it is no doubt impressive that the FX market continued to function well during a period of sizable volatility, there remains the question of whether this is an accurate barometer of the industry’s ability to cope with unexpectedly stressed market conditions given that market participants had so much time to prepare for it.

In response to this question some, while acknowledging that an unexpected risk event is always going to have a greater impact than an expected one, still claim that Friday illustrates how the market has improved its ability to handle extreme volatility and volumes.

They point out that although a vote in favour of a Brexit was always known as a possible outcome, this is not what the market expected. At the New York close, the exit polls had the “Remain” campaign in the lead and even Nigel Farage, one of the most prominent “Leave” campaigners, said that he expected his side to lose the vote.

Therefore, it could be argued, considering that the market was wrong-footed by the result of the vote and just the sheer size of the moves that were occurring in sterling, this was a good test of the FX market’s ability to function in stressed conditions.

“What was really unique about Brexit was the absolute range of the day from the high of cable to the low. The large intraday swings experienced used to be more natural FX trading behaviour, but they got dissipated over the past couple of years with electronification and all the asset class correlation? linkage?,” says Lieberman,  who claims that the response to the Brexit vote has proven the robustness of the FX market.

Others, however, say that the timeframe that market participants were working to before and during means that Friday is simply not an accurate gauge of whether the market has improved its ability to handle another SNB-like event.

They point out that firms have had weeks to prepare for every scenario, were overstaffed and had people working throughout the night to ensure that things ran smoothly. In addition, they highlight the fact that voting results were dripped into the market, meaning that trading sentiment slowly shifted as it became increasingly clear that the “Leave” campaign was going to win. Because of this, markets had time to react.

However, Jamil Nazarali, head of Citadel Execution Services, says that although a known event like the UK referendum is not directly comparable to a surprise event like the SNB de-pegging, experiencing the former can help firms to more effectively deal with the latter when they occur.

“I think that the industry’s development of playbooks for various scenarios was one of the good things to come from all of the preparation done ahead of the vote. The existence of these contingencies will help minimise disruption from future unanticipated events,” he explains.

Regardless of what June 24 tells us about the FX industry’s ability to handle future Black Swan events, both known and unknown, it seems that overall it was a positive day for the FX industry. During a highly volatile market, trading continued smoothly and it seems evident that the non-bank market makers were an important part of the eco-system that enabled this.

Twitter @Galen_Stops

Twitter @Profit_and_Loss

Galen Stops

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