A report in the Reserve Bank of Australia’s Statement on Monetary Policy looks at the flash event in FX markets on January 3when the yen appreciated some 3% in a matter of seconds before falling back, but fails to discern a single factor behind the move.
Citing the fragmentation of the FX markets across an increasing number of different platforms, the RBA says “it is difficult to draw firm conclusions on the cause of the flash event”, adding that three factors are likely to have contributed to what it terms the “brief deterioration in market conditions”.
The RBA notes that the hour leading up to the event saw a general deterioration in risk sentiment, following news that Apple had cut its quarterly revenue guidance, however this was reflected in “orderly price movements in a number of financial markets”.
The report then goes on to note that US equity prices fell, US and Australian bond yields declined slightly and the yen appreciated “modestly”, while some emerging markets currencies, namely the Turkish lira, depreciated. It stresses, however, that initial price movements in FX markets were orderly and indicators of liquidity, such as bid-ask spreads, were “little changed”.
When the event started, however, “in the absence of any material news”, spreads widened substantially from two pips to anywhere between 100 and 300 pips as the yen surged.
Interestingly, the RBA report first cites Japanese retail accounts as a factor, especially given their enthusiasm for the carry trade. “Publicly available data on retail positions suggest that Japanese investors held aggregate long positions in high-yielding currencies (including the US dollar, Australian dollar, South African rand
and Turkish lira) prior to the event,” the report states, adding that retail brokers will stop these positions out when margin limits are breached.
“On 3 January, following the initial orderly phase of yen appreciation, these automatic orders may have been triggered at an increasing rate,” the RBA report says. “This would have contributed to the outsized depreciation in some high-yielding currencies relative to the yen.”
The second factor observed by the RBA was that market liquidity was “seasonably low” at that time of day and year, with the US just finishing the first trading of the year and Japan still on holiday. It also notes that liquidity is likely to have been further reduced due to it being a vacation period for many market participants. “The relative lack of liquidity left the market vulnerable to disruptive price movements,” the report observes.
Algorithmic strategies are also named as a potential factor in the flash event, with the RBA noting that they may have “acted as amplifiers” during the episode, especially those that are programmed to automatically switch off in unusual market conditions. This pull back by automated market making models further reduces liquidity during stress periods, the report says.
More normal activity such as market participants trading the move may also have exacerbated conditions, in particular momentum-based strategies, the RBA observes, adding that systematic cross-asset hedging may also have played a role.
As noted byProfit & Loss at the time, the restoration of an orderly market was aided by market participants placing bids in the Australian dollar, thus helping to reestablish the process of price discovery and sufficient to helping market making algorithms resume quoting. The report notes that there was a “rapid” tightening of spreads as these algorithms re-entered the market.
While the RBA says that data limitations prohibit firm conclusions being drawn, it does suggest that the flash event, which “adds to a growing list of extremely sharp moves in foreign exchange (and other asset) markets” is likely have been triggered in part by “key changes in the structure of markets more broadly over the past decade”. It cites as an example, “the make-up and behaviour of principals, intermediating agents and trading platforms”.
Overall the assessment from the central bank tallies with reports from market participants at the time, although it is hard to escape the conclusion that while some factors were amplifiers, such as market maker reaction to the price move, the core of the issue lies with the heavily skewed positions held by Japanese retail accounts.
With the yen typically a safe haven play in “risk off” periods the carry trade becomes especially vulnerable post-US market close when many companies release guidance, which can, as in the case of Apple, trigger a shift in market sentiment and lead to risk aversion.