FX - The next big crash?

The news around foreign exchange suggests a storm is brewing, as speculation and light-touch regulation converge. Spot foreign exchange trading will reportedly become more automated where, until recently, it has been very opaque, with voice traders able to obfuscate their margins and - it has been alleged – to rig the market. This has annoyed their customers and now their managers. Trading foreign exchange electronically looks to be the way to go.

With the announcement at the end of last year that the foreign exchange derivatives market will be more lightly regulated than other derivatives trading, a heady mix of execution technology and unsupervised specualtion may be building up in the FX market. 

Q: What would it take for another big firm to go bust?

A: Based on recent examples it might a) hold a large portfolio of derivatives whose underlying product suddenly collapsed in value b) suffer an automated trading malfunction, buying high and selling low at an enormous volume c) bet everything the wrong way on a single asset class to compensate for the removal of an established cash flow.

Q: How could these play out in FX?

A: The market is relatively unregulated; firms trading FX OTC derivatives are not required to put up collateral to cover the cost of the trade, which makes the cost of OTC derivatives trading lower than that for other asset classes. It is entirely possible that firms could build up speculative positions in FX derivatives and see a sharp move in currency, for example the renminbi or the Mexican Peso, and suffer enormous losses. That could trigger a chain reaction of panic.

Alternatively a ‘flash crash’ scenario could develop. In 2010 an equity derivatives trade led to a sudden price change in assets and triggered a withdrawal of liquidity by electronic ‘market makers’ leading many automated systems to go haywire selling stock, as it appeared a big sell-off had been reacted to by a withdrawal of buyers. Although globally FX is liquid, emerging market currencies are far less so, and the BIS reports:

“The trend towards more active FX trading by non-dealer financial institutions and a concentration in financial centres is particularly visible for emerging market currencies. A decade ago, EM currency trading mostly involved local counterparties on at least one side of the transaction. Now, trading of EM currencies is increasingly conducted offshore. It has especially been non-dealer financials (often trading out of financial centres) that have driven this internationalisation trend.”

Finally, an algorithm trading FX the wrong way at high volume could disrupt the market. FX is an asset class like no other; it is a 24-hour market with a mix of every business and retail customer, so the effects could be very widespread indeed.

Q: Aren’t we protected from another big crash?

A: The regulations that are being rolled out across the G20 countries are trying to make sure that when a big firm does go bust, its derivatives trading does not trigger a series of bankruptcies amongst its counterparties.

Q: There was a bit more to it than that in the 2008 crash wasn’t there?

A: Yes, several big firms had simply got too great an exposure to the wrong assets – subprime mortgages, credit default swaps etc. It was not the case that these simply fell apart, in the case of Lehman Brothers, an accounting trick that Ernst and Young employed hid some of the banks losses from investors for some time. That trick wasn’t illegal but it meant nobody had confidence that other banks were not also concealing massive losses, and that lack of confidence helped to bring trading to a halt.

Q: Is there any reason to think that financial services firms are going to be exposed in the same way?

A: Yes, their job is to make money and this is one of the only asset classes left in which they can do that. This is backed up by data. In the three years to 2013 the global FX market saw average daily turnover increase by 35%, with spot trading contributing 41% and derivatives contributing 59% of this growth. London and New York contribute 60% of global turnover in FX and the turnover between dealers trading with non-dealer financial customers exceeds that of trading with non-financial clients by a factor greater than 10 in these centres, according to the Bank for International Settlements (BIS). In 2010 that ratio was a factor of four.

Q: Who are the non-bank financials?

A: Well 38% of spot FX trading in London and New York is done via prime brokers, so over a third of spot is being run by hedge funds. Hedge funds and high frequency trading prop shops are estimated to account for 11% of turnover in global FX, the same percentage that long-only money managers generate. The latter were holding US$68 trillion in assets under management (AUM) in 2012, according to Watson Wyatt, while hedge funds held about 4% of that with US$2.63 trillion AUM, according to Hedge Fund Research.

Q: While you have your crystal ball out, when will this happen?

A: That is the six billion dollar / rupee / euro question…