The Last Look…

Last week’s meltdown in Japan’s bond markets, a small matter of JGBs shifting in a day what normally takes a year, made me realise just how well FX markets have coped with the chaos of the last year, because the conditions have been – indeed still are – ripe for dislocation.

The thankfully few flash events we have had in FX over the past 10-15 years have largely been a result of either illiquidity due to the time of day, or unexpected policy shifts (yes, I am still looking at you SNB…) Dealers have, by and large, worked out not to try to execute large Cable trades at 8am Sydney time (it was actually 10am, but you get the point, although I am still very Oliver Stone over that event and think it was an option trigger gone wrong…or right), which means that the one overriding risk to markets has been policy dysfunction.

Well, we’ve had it, and the last month or so has only seen it become more chaotic, and while Japan’s fixed income markets took a kicking and unsettled a lot of people, in foreign exchange things just continued along their way. There was a bit of a sell-off in USD/JPY on noise that the New York Fed was checking rates – incidentally, one “expert” analyst at a retail broker was insistent it was the US Treasury checking, I don’t think that’s how it works – but as my old friend Steve Flanagan liked to say every time we spoke of events, the market traded all the way down without gapping.

I will confess to not knowing many JGB traders, but I spoke with a couple of people who are involved in the market and their thoughts are that it was a straightforward economic event, driven by fundamentals, mainly news of the election call. What we saw was a typical event scenario play out, but in very different ways across fixed income and FX.

In both cases, traders and investors headed for the exits, but their experience exiting the risk was very different. The selling of JGBs soon overwhelmed the market because LPs were not willing, or able, to hold the risk. In FX, USD/JPY took a bit of a dive, but traders were able, to Steve’s point, to get out pretty much all the way down, because there was some natural interest and a willingness on the part of some LPs, to use the trades as part of their internalisation efforts.

That latter point brings me back to last week’s column in which I argued banks in particular taking on more risk would be good for their already very healthy P&L profiles. It took one week, and the market showed me the benefit of banks not holding the risk! Under my scenario, a bunch of shorts would have been established and sellers left to their own desperate devices. Because many players auto-internalise, there were plenty of bids in the market as they exited their short-term risk.

So, good for the market, not so great for anyone trying to suggest a different trading model!

There is another lesson to be had from last week’s events, however, and it is, yet again, for those regulators who insist on FX being bundled into the basket (case) with other markets. Firms’ inability to hold risk in fixed income markets, thanks largely to capital rules and other regulatory restraints, undoubtedly contributed to what happened last week. Equally, several banks are barely involved in these markets because the regulatory framework has boosted the ability of non-banks to play in the market while at the same time reducing that of the banks.

Those wanting to change the FX regulatory structure, should perhaps think about using FX as a positive example, rather than try to enforce a weaker model on it?

This framework has not yet hit FX markets with real force – although the quarter-end window dressing is still a problem in some markets – and hopefully never will. Risk is at the heart of all markets and in their efforts to protect the end user, too many authorities want to use a broad brush – which is the last thing needed.

The sense is that in terms of financial system risk, the focus has shifted away from banks, which perhaps means there is room for a more granular approach to markets? Or at the very least an approach that highlights how the market that has largely been left alone worked perfectly well during the latest example of chaos?

The FX industry has long had the flexibility to learn from, and adapt to, different events, and last week highlighted this. It could be the JGB mayhem was exacerbated because of its source – after all, The Don seems to have the monopoly on seeding chaos, this would have come from left field – but notwithstanding that, the event served to reiterate the structural differences in these markets. This is something everyone should pay attention to, not least those making decisions that will potentially change the market structure.

There is no knowing what will come next out of 1600 Pennsylvania, but whatever it is, the FX market will probably handle it. This, I suggest, means that those wanting to change FX, should hit reverse gear quicker than The Don when someone stands up to him, and perhaps think about using FX as a positive example, rather than try to enforce a weaker model on it?

colin@thefullfx.com