The Last Look…

I think we can all agree that the T+1 changeover in North America was handled smoothly by markets, and that the major tests have been overcome, but did the switch highlight what is possibly a serious – and growing – systemic risk?

This is, naturally, an opportunity to take one of my regular potshots at the equity market structure, but there are warnings here for FX markets – especially as they become more automated (on which note, I read somewhere that algos are replacing humans on bank FX desks – I thought that had been ongoing for 15 years?)

The problem is the sheer amount of trading that goes on at the close in equity markets, estimates range from 30-40% of total daily volume in the US alone, what happens if that close isn’t available one day? We know technology goes wrong, even with the best will in the world, what happens if there is an outage on a major market(s)?

I suppose the close can be pushed back to a time when the tech is working, but as the derivatives industry discovered last year, sometimes it takes longer to gets things working again than a few minutes. What if all this trading at the close takes place too late for T+1 settlement? Certainly if it is delayed by any meaningful time I suspect the FX hedges won’t be done.

It’s just another example of the herd mentality that dominates markets and is increasingly coming into FX – there is a growing reluctance to embrace any concept of risk outside the safety net of a benchmark or time in the market when everyone else trades. After all, who can fairly be criticised if the world blows up everybody? It’s just another manifestation of the tracking error delusion – it’s OK it I stuff up really badly as long as everyone else does as well. You do seriously wonder if 100 money managers stood on top of a cliff and started jumping, if, when the 51^st one went over the edge, the other 49 would immediately go with them!

Last week saw two major elections, both called early, and looking at markets you would not know that they had taken place. The UK result was pretty much a foregone conclusion, but the French Parliamentary Election produced a real surprise – one that not too many years ago would not have been received well by FX markets. Economic policy in France is likely to be chaotic for some time to come and yet nothing. Look what happened just a couple of years ago when markets thought the UK government’s economic policy was a shambles – does this highlight just how much the data-hungry algos have taken over and that if someone doesn’t show them the way they just carry on regardless?

Some people I speak to in the industry, especially on the technology or platform side, think there is nothing wrong with all this – they are seeing volumes pick up and are raking in the brokerage. Fair enough, but a lot of the trading is short-term and directionless, which is fine until the tech playing field becomes more balanced and opportunities in this space dry up. What happens then, when the machines move onto the next shiny toy?

My fears are not so much that people can no longer make money in FX – they can, just currently in a different fashion – but more what this means for the end users of the market. I have said before, and will say again, that the segment this industry really serves, and the one that actually needs the foreign exchange market more than any other, is the real economy – corporates and investors. The concern is that taking out too many risk absorbers (in the true sense of the world, not just a market-making sense) drives firms to these periods of concentrated trading – and we have seen with our ongoing analysis of the month-end Fix how much that can cost investors.

There is also the factor that a lower risk component in FX markets risks sending price action down the equities path, where there are 2-3% moves per day, often over nothing, and often not reflecting any economic reality. I have no doubt that hedgers were delighted that there wasn’t too much volatility around last week’s elections, but be careful what you wish for – without risk takers, these firms can find their hedging efforts akin to catching a falling knife, they’ll get done, but not necessarily at the level they started at, and it could get messy!

Last week saw an event that fundamentally changed the course of politics and economics in the European Union (and to a degree the UK), and nothing happened in the FX market

I would like to stress these are not the rantings of an old man (well, they are technically!) longing for the old days back – the old days weren’t that much better for the hedgers – more it is about highlighting the genuine need in markets for enough participants to embrace risk. In a world where everyone is a broker (by name and deed), the end-customer is unlikely to get a great deal.

Some banks and non-bank trading firms have historically done a great job of being risk absorbers, but the more the industry turns towards the equity model and away from risk, the more reluctant trading teams, or individuals, will be to put their head above the parapet for fear of their job. There is nothing wrong in losing money – don’t make a habit of it of course – but there is a real benefit to the global economy in having people and firms willing to risk that outcome.

Last week’s events did depress me a little, although I hope I am wrong and they merely reflected summer doldrums and a major US holiday. The fact is though, that we saw an event that fundamentally changed the course of politics and economics in the European Union (and to a degree the UK), and nothing happened. This is either because people are scared of risk, or they are equally afraid of missing their benchmark and the chance to prove themselves average.

Neither is a good thing for the future of the FX industry.

colin@thefullfx.com