It’s been a busy 20 years since Profit & Loss launched. Colin Lambert and Galen Stops have picked out 20 key events or trends during that time and asked senior industry figures for their perspective on them – here’s numbers 10-6.
Putting aside the (ongoing) politics, the night of the Brexit vote showed the FX market could still handle surprise outcomes – as long as it was expecting them! It was a classic case of the “known unknown” – the market knew there was a vote, it didn’t know the outcome, but it was prepared, and risk settings were adjusted appropriately.
“We were ready for anything that night,” says the head of FX at a bank in London. “Cable moved 20 big figures – 20! – and we barely blinked because it was orderly. Yes prices went wide after Sunderland, but we priced throughout, as did, to be fair, most of our competitors. It was just a good, well-functioning market reflecting outcomes.”
Inevitably, the underlying competition between bank and non-bank providers saw claim and counterclaim about who stayed in the market, who dropped out and who was first back in, but that is really only white noise.
“We had pricing all day, in reasonable size,” says an execution trader at an asset manager in Australia. “Even though we were surprised by the outcome we were able to trade easily – although I should say we had reduced our exposures as much as we could ahead of time so I don’t know what would have happened if we tried to shift a couple of hundred million.”
The liquidity manager at an ECN believes the day of the UK referendum showed the FX market in its best light. “There was pricing all the way down, even after Sunderland. It went wide occasionally, but the best way of showing how well the market handled it was a customer who told me they went into the vote with a long position and after Sunderland, they were able to not only get out of it – for a hefty loss apparently – but turn it around and go short. They ended the day with a small profit having been disastrously wrong at one point – that is a good market to operate in.”
9. Sterling Flash Crash
If Brexit night shone a good light on the FX market, the aftermath was a little different. As politicians from all sides and states sought
to make sense of the surprise outcome, rumours, comments and news suddenly became highly influential as sterling bounced around 1.30 to the dollar. Then came October 6, 2016, just months after the vote.
Again, the drivers of the move are unclear. An official report into the Cable flash crash failed to uncover one particular trigger, but in
a matter of minutes in the early hours of the Asian day, Cable fell through 1.2600 and then accelerated down to 1.1500 before bouncing back to the 1.23/1.24 level. Liquidity disappeared, most liquidity providers turned off their streams and some platforms initiated circuit breakers. The “Unknown-Unknown” event traumatised the market and it even took several hours for an official low to be set for the pair – and all this time, other markets barely moved.
There are several theories as to what happened to trigger the move, from option barriers to stop-losses, but there is little doubt that the changing market structure played a role – and is likely to do so going forward.
“We learn from every event and one thing we have worked out is that flash moves offer opportunity – all that is needed is someone to recognise the true extent of where the market should move and take advantage of any overshoot.”
“We’ve had the rise of flash crashes because when you have HFTs making markets they’re in the business of making money, not facilitating order flow,” says the head of one US-based hedge fund. “So when things get crazy, they either just turn it off, widen the spreads, back away or all of the above, and I don’t have anyone that I can call to complain. In the old days in a fast market I could call my bank, they might not have had the tightest spread or the best price, but they had to make me a price because if they didn’t, then I probably wasn’t going to call them for six months. You just don’t have that anymore; the liquidity just evaporates.”
George Athanasopoulos, global head of FX, rates and credit at UBS agrees, suggesting that flash events will continue to occur. “The decline in banks’ ability to risk warehouse allied to more machines handling the trading means you will inevitably get more liquidity gaps,” he says. “The liquidity safety net has got much thinner thanks to structural changes since the financial crisis.”
This view does not get universal support, however, for as the head of e-FX trading at a bank in London observes, “We are much better at pricing these events now…I think the time of day also played a role in that event – it was 7am Singapore, the market wasn’t up and running.”
Maxine Dennis, an FX trader with 35 years’ experience who recently left SocGen/Newedge in London, also points to this year’s flash event on January 3 as evidence the market can handle these things easier. “We learn from every event and one thing we have worked out is that flash moves offer opportunity – all that is needed is someone to recognise the true extent of where the market should move and take advantage of any overshoot.”
A dealer in the Australian market agrees, noting, “January’s move could have ended up the same way as Cable in 2016, but it didn’t because traders like me recognised the opportunity – it was a clear out of positions, there was no new information that fundamentally changed the picture, it was a liquidity event, and they are opportunities for anyone who can figure out what has happened.”
At the time of writing, China is probably an even bigger story than it has been for the past 20 years thanks to the ongoing trade war and, it seems, currency wars that have accompanied it, but the China story is much more than that – it is the rise to a significant position of a currency that most people had never handled 20 years ago.
If there is one moment that stands out above all others it is probably August 11, 2015, when the People’s Bank of China (PBoC) took a decisive step towards floating the renminbi exchange rate. However, due to a misjudging of market sentiment at the time and bad luck, the reform experiment caused market panic and the renminbi quickly devalued. As a result, the PBoC halted the experiment and introduced a new central parity rate-setting mechanism. Notwithstanding the chaos that ensued, the move did offer the strongest signal yet of China’s intention to liberalise and enter the international market’s ecosystem to a much greater extent than previously.
“The world is as much a China story as it is US, and a lot of things happen in this time zone. China dominates Asia now, but as the trade and currency war escalates, it could easily dominate world markets”
Whichever way you look at it, China is a big deal.
As UBS’s Athanasopoulos observes, “20 years ago no one was thinking about China, but now if you have not been focused on that country in recent years, you are going nowhere in this business – it’s been one of the biggest changes in the market and it’s not just an Asian story, it has a global influence.”
An interesting sub-plot to the China story is how the FX industry, for the first time since 1993 when EBS launched, saw a significant market move from one primary venue to another. Thomson Reuters had first mover advantage in CNH but EBS first challenged for, and then took, pole position.
“EBS won the battle thanks to good oldfashioned broking skills,” says the head of e-FX trading at a bank in Singapore. “They came in offering revenue splits and five or six banks took them up and started pricing and taking on the platform and the rest is history.
“There were strict rules around what you had to do to retain the revenue split,” the e-FX head continues. “If your numbers weren’t good enough for two months it was ended so it was quite an aggressive campaign, but it worked.”
An Australian-based hedge fund manager believes China has offered the broader Asia region an edge when it comes to exploiting events. “The world is as much a China story as it is US, and a lot of things happen in this time zone. China dominates Asia now, but as the trade and currency war escalates, it could easily dominate world markets. The challenge will be for Asian markets to be able to handle the demand, there is still the temptation to wait until London comes in before doing anything – that will have to change.”
Much-maligned, especially by those in the prime brokerage space who see CLS as a huge chunk of their costs, CLS remains an emotive subject – even though it is hard to see how the FX market could have functioned without it for the past 15 years.
“CLS was a game changer,” says a senior figure at a trading platform in the US. “The development of electronic trading, innovative ways to mitigate settlement risk and to access all these fragmented pools of liquidity around the world led to opportunities for people to trade more and caused the market to grow substantially. 2008 would’ve been a horror story, well it was a horror story, but it would have been much worse if it wasn’t for CLS. The 2008 financial crisis changed the world and if it wasn’t for CLS, the FX market right now would probably look very different.”
“Banks, prime brokers in particular, are quick to jump on the cost of CLS, but how can you put a value on the safety net it provides?”
There is little doubt that CLS managing to handle the aftermath of the Lehman collapse saw its stock rise considerably in the market, but as noted, not everyone is happy. “CLS is a burden, it’s cumbersome, it’s expensive and, frankly, I think it will be overtaken by technology and be defunct in three years’ time,” says one source in the prime brokerage world.
Notably, however, there are just as many willing to defend what remains a critical market infrastructure. “Banks, prime brokers in particular, are quick to jump on the cost of CLS, but how can you put a value on the safety net it provides?” asks a risk manager at a bank in Asia. “The problem is not CLS, because it has proven it can save the market in times of extreme turmoil, the problem is the PBs are charging too little for their services. One party has the pricing wrong and it’s not CLS, and one party is being extremely complacent about the risk of a large institutional failure – and again, it’s not CLS.”
Overall it is hard to see CLS as anything but a positive development for the market, in spite of the length of time it took to actually get the project up and running and the occasionally technical issue that has required a solution.
As Joe Hoffman, CEO of the currency management group at Mesirow Financial in Chicago, observes, “On the settlements and operations side, allowing asset managers to start using CLS was a huge accomplishment. Prior to that it was a leap of faith that the custodian and the bank would actually settle the trade correctly. You’d send the Swift instructions to the custodian; your bank would have the custodian settlement instructions and the payments would move, but you wouldn’t know until the next day if the trade settled or not. CLS has mitigated a lot of that risk.”
6. Precision Pricing
It seems strange now, with the benefit of more than a decade of hindsight, that something so simple as adding another decimal point to the exchange rate could be so emotive, but it was.
The FX industry had toyed with the idea of a fifth decimal place, but until early 2005 it was only in less volatile crosses like EUR/CHF (which is very ironic given the events of January 2015!) and EUR/GBP that it existed. That changed in May 2005 when Barclays unveiled Precision Pricing, which saw the bank stream in five decimal places and one-tenth of a pip increments on its BARX platform.
“I remember Tim Cartledge, who was co-head of e-FX at the bank, coming back from a holiday and saying, ‘I know what we are going to do next’, and he explained to us about the fifth decimal place,” recalls a senior source who was at Barclays at the time. “It was a defining moment for the industry, not just the bank, although we were looking for something to give us an edge at that time and it did that.”
“I am not sure it has been a great development for the industry as a whole, but for Barclays it really put them on the map”
As always, there are dissenters, of course. “I hated Barclays for doing that, in fact I think I still hold some resentment!” says the former head of e-FX at a rival bank (with a degree of tongue in cheek it needs to said). “That was the kind of disruption we just weren’t ready for. There had been whispers something was coming, Barclays wasn’t the only bank looking at going to five places, but it was still a shock when they came out with it.
“I definitely think that moment signalled Barclays’ rise to the top of the e-FX tree. They had a jump on everyone because clearly they had the risk management expertise to manage the tighter pricing and that meant they grabbed a lot of business,” the head of e-FX continues. “I also don’t think they wanted all the business they saw – they got quite aggressive in cutting off the wrong sort of flow if I recall correctly – but it established them as the one we all had to keep up with. It also meant they had something different to everyone else – and clients will always engage with someone offering a different approach. I am not sure it has been a great development for the industry as a whole, but for Barclays it really put them on the map.”
There are some who believe that Precision Pricing empowered latency arbitrageurs into the FX market, but others believe the shift was just a matter of time. Either way, there are plenty in the market who know no different to five decimal places and clients generally have welcomed the development – all thanks to an idea generated on a sunbed in Hawaii!
Next week we’ll be publishing numbers 5-1 on our list – “Chatrooms”, “FX Global Code”, “EBS Prime”, “Lehman and the GFC” and “SNB Day”