Speculation has mounted since Friday’s flash crash as industry commentators and counterparties alike continue to analyse the potential causes for a sudden six percent plunge in the price of the pound. While uncertainty is likely to remain in the near-term, the lack of a clear consensus about what triggered a sudden fall and subsequent recovery in Sterling has caused concern for many.
The market event followed revelations of French President, Francois Hollande’s intention to negotiate a hard bargain with the UK over Brexit – leading to further weakness in the currency. But while some pointed the finger at macroeconomic conditions or political rhetoric, others laid the blame at the door of high speed trading algorithms – a growing feature of foreign exchange markets.
While the causes are yet to be determined, it is not an event officials are taking lightly. Mark Carney, Governor of the Bank of England (BoE) has already announced an inquiry to examine the possible causes. While the Central Bank is expected to report back in the coming months, the market is rife with speculation.
JP Morgan’s Flow and Liquidity team referred to the ability of high speed trading to determine market conditions without the presence of major contributory factors. “A step change following a significant event such the Brexit referendum or the SNB’s abandonment of its peg is not problematic as it represents a natural market resetting. But a step change triggered by an order flow is more problematic and in our opinion reflective of how vulnerable market liquidity is in FX markets also.”
The bank’s team also highlighted the issues surrounding liquidity provision in periods of market stress. “HFTs have a higher incentive to withdraw from their market-making role in periods when volatility rises abruptly as they are reluctant to subject themselves to the risk of large price moves.”
The comments reflect the ongoing debate about speed in wholesale markets. Advocates, typically led by groups such as The Modern Markets initiative, reference the narrowing of bid-ask spreads across a number of asset classes and the ability for high speed trading firms to provide liquidity at a time when banks face capacity issues.
Yet, others, such as BofAML summarise the opposing position. “Market fragility is increasing as phantom liquidity creates the illusion of stability. While on the surface, traditional measures such as bid-ask spreads in FX have indeed narrowed in the past couple of years, our volume-based analysis shows market liquidity has materially worsened. We find the market impact of a given volume is now 60% greater than in 2014. Notably, the frequency and amplitude of outsized volatility events has also increased.”
However, others are focusing instead on wider economic conditions in the UK. Themos Fiotakis, Global Co-Head FX & Rates Strategy at UBS Investment Bank, neatly summarised the differences of opinion across the market for the Financial Times. “Often, a depreciating currency is linked to a country’s declining economic prosperity. So it is not surprising that, to some, the ongoing depreciation of sterling against the euro can be viewed a precursor of dire times ahead. For others, it is merely a market miscalculation that will correct when the benefits of leaving the EU become visible.”
The publication of the BoE’s investigative report in the coming months should bring some clarity. Its release will be keenly anticipated.