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Regulation vs Technology: What’s Causing Market Dislocations?

The FX industry faces a plethora of risks. Understanding how to manage risk is the biggest challenge
facing the industry today, but how best to address these? Profit & Loss asked a panel of experts at Forex
Network Chicago for their views.

In the world of spot foreign exchange, correctly gauging
changing market regimes can be key to appropriately
managing risk. While risk management systems and
procedures can work most of the time under normal
conditions, how do firms position correctly for a runaway algo
or unexpected macro event?

Some of the market dislocations seen during 2015 – in
particular, the unprecedented 30% move in the CHF in January
– make the market question what has led to such instances of
gapping, the likes of which hasn’t been seen before.
As volatility sunk to lower levels in recent years, the industry
was quick to deploy technology in the race for volume, which
may have resulted in some firms taking their eyes off of some
of the more nuanced pieces of risk management, in particular,
tail risk.

When an event such as the SNB’s move in January causes
huge price gaps, and market makers pull back and clients have
difficulty exiting positions, what should be the role of the
market maker and how can these firms protect themselves
when providing this market service?

“We have to acknowledge that we don’t live in a normal
distribution world and we have to be equipped as market
makers to understand that these are not normal distributions
and our machines need to react to those conditions or at least
have overrides that protect us from those conditions,” said one
of the panelists.

“We have to be prepared for unexpected market events and
are obligated to ourselves as risk managers to accommodate
that,” the speaker continued. “We can’t only operate under
normal distribution and when something big happens, just walk
away. Some participants do just walk away, and that’s actually
where clients need us the most – so we are obligated to
address those tails.

“It’s important to understand when the market has changed
from being price sensitive to position sensitive. During miniflash
crashes, we immediately change to being position
sensitive. People want to get out of their positions and they are
less motivated by price – it’s actually an opportunity for market
makers to stand in there and make a price that reflects the risk
– you have to put something out there that lets people get out
of the risk, because if they don’t, they may not come back,” the
panellist said.


Many have asked what is causing the large market
dislocations we’ve seen in recent months? Petra Wikström,
global head, FX execution and alpha solutions, BNP Paribas,
said: “We have to remember that we came from a period of
very low volatility and spread compression for quite some time
– 2013 was notoriously low volatility. At the same time, the
electronification of the market continued to increase, but that
was far outpaced by the growth in the number of electronic
trading venues offering FX liquidity. So as we started to see
increased volatility, and big macro events such as the Bank of
Japan coming out with quantitative easing or January’s SNB
move, one of the major things that we saw was the thinning or
decreasing of order book depth, which is actually one of the
important factors that could relate to these additional risks we
see today.”

So are these market dislocations going to occur with
increasing frequency? “It’s a question of managing the risk,” replied Wikström. “As the regulatory landscape evolves and
with the changes from an electronic perspective, we could be
in the midst of a transition as we move towards even more
transparency. But it’s really all about being able to process and
gather as much information as possible in terms of volume and
monitoring order book depth.”

Perhaps part of the risk management challenge lies in the
definition of liquidity itself. James Sinclair, CEO of
MarketFactory, suggested that it is. “Liquidity is, by my
definition, the lack of market impact when you transact a
given size. If the market impact is great, then that is an
illiquid market. So while you may be able to transact a huge
amount of volume, it can still be an illiquid market because
the market moved two big figures – that’s an illiquid
market,” he said.

“The market is definitely more illiquid than it used to be, but I
feel it will correct itself to some extent over time, because there
is a real demand by end customers – people really want to do
business in this market and that means we have continuous
markets. Accordingly, the market will solve this problem – if not
by the traditional means that we have today – then by new
entrants in this market. These new entrants may be new
players, but they may also be clearing models that restore
steady continuous markets, because there is end user demand
from real money and from corporates, and this vacuum will be
filled,” he added.

Regulatory Impact

What role are regulations having on market liquidity?
“Regulation is having an impact in terms of banks establishing
smaller risk limits – they are not holding as much risk as they
used to and they’re not holding it for as long. So the
consequence of that is that people are liquidating risk quicker
and that contributes to the recycling of that actual risk until
that final customer is found – that’s important for us to
remember,” noted a panellist.

If banks are unwilling to take on the levels of risk they
previously did, who will be the market makers of the future? “If
the current players are not prepared to take the risk, somebody
else will – there is a market demand and it will be fulfilled,”
said Sinclair. “It may be new players, but it may also be clearing
models. We may be beginning to see some of the banks spur
spinoffs that are outside the bank and therefore not subject to
the same rules. It may be non-banks or other participants with
strong balance sheets that come forward – but it is a need that
will be filled.”

Patrick Philpott, Americas head of DealHub, a Markit
company, suggested that clients will be looking at a narrower
subset of liquidity providers. “Clients using FX for commercial
purposes will still get priced by market making banks – it’s
bilateral and it’s disclosed. But there’s much more focus on
analysing all of your liquidity providers, all of your ECNs, all of
your hit ratios, and making decisions ruthlessly based on that
information – deciding who is giving the best value and
determining where they are getting done,” he said.

“The reason we have these new participants and buy side
clients that want to make prices is the need to supplement
the traditional bank market makers who have smaller
appetites in general, along with shorter time horizons,” one
of the panelists noted.

“On a related note,” added Wikström, “we also see an
increased interest and appetite from the buy side to take on more
automated execution strategies, to seek reduced market impact
and costs. It naturally depends on the underlying rationale of the
trade. For example, if it’s a time sensitive alpha fund, it might be
more prudent to pay the risk transfer, but if it’s passive hedging of
an underlying equity flow, there may be more appetite when it
comes to larger sizes to spread the order out over time, which
needs to be risk managed over the course of the execution.”

The way you choose to execute can create different kinds of
risk,” added Jill Sigelbaum, head of FX, Traiana. “The FX
industry has evolved to offer custom liquidity, so depending on
the client type, one receives different liquidity. The market also
offers custom execution – voice, electronic, algo, etc. What has
happened is that each unique pairing of a client’s custom
liquidity with each execution style creates a unique set of risks
that need to be addressed.”

“Some types of execution create more credit risk, and that
has to be mitigated. Other types of execution create more
operational risk, because someone’s executing 100 trades
instead of five. Although both types of risk exist, the industry
has been forced to create a flexible risk mitigation strategy and
rely on state of the art risk mitigation technology to address
these complexities. Each participant must follow the chain of
events for each type of flow and make sure each box is ticked
and each type of risk is solved for. It’s very important to look at
every client type and not only the liquidity that you’re
customising for them, but the way you’re customising the ability
to execute transactions and follow the risk chains,” she said.

Risk is far more than just credit risk, it’s market risk, it’s legal
risk, it’s operational risk, reputational risk, agreed another
panellist. “As we automate things and use technology to solve
some of our issues, the control framework that we have around
automated risk management and automated trading becomes
as important as the ability to trade in microseconds. How do you
keep the runaway algo from going awry? I don’t think we have a
standard set of rules or guidelines about that. So how do we
define those unknown risks, how do we sit down and build a
control framework the industry can be comfortable with so we
don’t have real disasters? These mini-flash crashes are almost
victimless compared to if one of these banks has another
Euro/Swiss style incident. The pressure will just get worse and
the rules will come in prescribed by the regulators, not by us.

“We have an ideal view of how things should work, but we
have systems and architectures that are immovable, and we
have budgets dedicated to technology that are not necessarily
going down, because more and more of it is dedicated to
maintaining these legacy systems. Meanwhile, the innovation
budgets are shrinking just when we need them the most. So it’s
a very difficult balancing act, but it makes a lot of room for third
party providers for outsourced expertise,” said the panellist.

“Banks today can’t even talk to each other about how they are
handling different events, because it might be seen as collusion,”
added Philpott. “There’s a very different mindset that permeates
trying to deal with these situations that is not helpful. It would be
much more helpful for peers to be able to ask ‘what are you
seeing and how are you handling this?’, but they can’t right now.”

Paul Gogliormella

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