The Last Look…
Posted by Colin Lambert. Last updated: August 29, 2022
Why the FX industry should not follow the all-to-all, fully transparent, equities style market structure, part 106.
Just when we thought the issue had gone away, the retail army in the shadows has run up another low-rent stock, causing untold pain/wailing/wringing of hands (delete as appropriate) in certain areas of the community. That a relatively unknown stock can move over 2,000% – and in a day – just highlights the market structure weakness. Put simply, there is too much information available about participants’ positions and people are taking advantage of that weakness and squeezing short sellers all they can.
I should stress I have no torch to bear for the short selling community, but these moves highlight what happens when you don’t have risk absorbers in the market. It has become clear that while some newer market makers have made markets more “efficient” that efficiency is only in price discovery, not market depth or quality.
The fact remains, if players are allowed, without an inflated capital charge, to take on risk, then moves like this would happen less often, if at all. I make the point on the ACI Australia Dealing Simulation Course that the ability to take and hold risk is an important part of the FX market. In the SNB debacle, human traders made an absolute fortune (before some of it was taken away unfairly) by recognising that while the SNB accepted a lower cross, it didn’t mean 0.50 or even 0.80. These traders recognised, where the machines didn’t, that EUR/CHF at 0.2 would mean the Eurozone had effectively ceased to exist as an economic entity, which was clearly nonsense.
If there were more risk absorbers in these equity markets, especially if they were well-informed and knew there was nothing behind the ridiculous rally other than chat-room generated rumour and innuendo, they would soon put a halt to the silliness.
We will, no doubt, get to hear more about whether this is market manipulation and it will be interested to see if the authorities start sniffing around events, but to me it is not manipulation, it is taking advantage of market structure and therefore no different to an HFT strategy which, apparently, is perfectly acceptable in equities.
If there were risk absorbers, those trying to send the stock to the moon (who are also, naturally, the first out of the trade) would find it much harder to push the market and, as happened eventually in GameStop, they will do their boots (technical market term) – or at least those at the tail of the chain will, which in turn will create a reluctance to engage in the fun and games.
If there was also more risk-assuming interest in these markets, those pushing the stock higher will also struggle on the way back down. A human market maker will be awake to what is occurring and price accordingly – the market “efficiency” provided by automated market makers means they price according to the data, which is reactive and has no concept of the strategy driving the market.
It beggars belief that some regulators like to look at FX markets and see it as some sort of “wild west”, while in their preferred market structure, this sort of thing happens time and again and liquidity is, generally, poor. Yes, there have been flash moves in FX, but they have been exactly that – a short-term move corrected in minutes, or even seconds, with the help of risk warehousers and human risk takers.
These regulators will be well-served analysing the impact of some of their ideas on the FX market where the real economy comes to execute valuable and crucial hedges. If the FX market structure heads further away from the risk absorption model, then the chances of moves such as these – created in online fora – are increased.
How good will that be for corporates and investment managers? It’s one thing getting professional traders being hit by a short squeeze, that comes with the territory, but it’s something else when a corporate or pension fund hedge suddenly costs a lot more than it should.
Equally, do these firms need the whole world knowing what their positions are? Obviously not, especially if they trade to a pattern. We have a hint of the impact of too much information with the price action around the Fix, where everyone keys on the algos around 3.45pm UK time.
Market structure has to evolve, this is not a Luddite call for the status quo, but there are certain fundamentals that underpin a strong market structure, and chief among them is the presence of participants willing to take risk onboard for potentially hours, and who understand the psychological drivers of price action.
The latter is quite important, because even in an increasingly automated world, the majority of moves are still driven by human factors.