‘Witching Hour’ FX Brexit Prep Conjures Ghosts Of Flash Crashes Past

Theresa May is going to try to cram her Brexit deal through Parliament on Tuesday and it’s probably not going to work.

As far as I can tell, that sets the stage for a scenario where she either i) resigns/is ousted, faces a second referendum or else goes hat in hand to Brussels to seek changes to a deal eurocrats have insisted is the best/only deal she’s going to get, or ii) loses the vote by a “small” enough margin to try and move forward with this farce on modified terms that are more palatable to some lawmakers. Winning the vote seems virtually impossible at this juncture. Here’s Barclays outlining the various scenarios:

Rejection by a small majority (fewer than 25 votes) may be followed by constructive statements suggesting that a second vote could lead to a different result. Rejection by a mid-range majority (between 25 and 75 votes) is likely to lead to delayed decisions as MPs try to agree on whether there could be a second vote or not, and markets are likely price in a wide range of uncertain outcomes. Lastly, rejection by a large majority (more than 75 MPs) could open up the potential for a new parliament, a new PM, a new WA, or another referendum. Ratification of the WA would shift the focus onto how quickly the economy could recover, and consequently to how quickly the BoE could return to its intended hiking path. Meanwhile, rejection would bring to the forefront the risks associated with a ‘no deal’ Brexit and a race to implement contingency plans.

Whatever the case, the prospect that the vote could run late has currency traders freaked out, which is amusing. Bloomberg ran an entire piece on Sunday documenting the extent to which money managers, FX platforms and banks are compelling relevant personnel to cancel whatever they had planned just in case the announcement of the outcome ends up coinciding with the “witching hour”.

“The result is due around 8:30 p.m. U.K. time, but a delay could see it pushed between the end of the New York close and the start of trading in Tokyo”, Bloomberg writes, adding that “a late-running vote wouldn’t just see investors trapped at their desks, but could exaggerate any moves in the pound due to the thin liquidity [as] volumes dwindle to just 2% of peak turnover” during that window.

You can read the linked post from Bloomberg for the amusing anecdotes from the folks who will be tasked with making sure nothing goes awry, but the broader point here is that the pre-vote panic to ensure proper preparedness is yet another reflection of the extent to which everyone knows that modern market structure is inherently fragile.

Market participants got a stark reminder of this last week when S&P futures dove on Wednesday night as the Huawei news collided with the reopening of trading following the national day of mourning for President Bush and thin liquidity to catalyze what you see highlighted in the second red oval below (the first red oval is the lunchtime plunge that played out on Tuesday).

(Bloomberg)

In the Bloomberg piece mentioned above, several of the folks who are quoted refer to the “lessons” that were learned in January 2015 when the SNB threw in the towel on the franc peg, leading to this infamous insanity:

(Bloomberg)

Naturally traders are also citing sterling’s 2016 flash crash as an example of why it’s necessary to take an all-hands-on-deck approach to the Brexit vote.

While any acute action in sterling on Tuesday will at least have a fundamental catalyst that everyone can point to, the concerns headed in are at least in part a begrudging admission of market fragility. That, in turn, is a tacit admission that in the absence of carbon-based supervision, an already volatile situation has the potential to morph into a black swan. With that in mind, we thought we’d roll out the following four-pane visual which documents some of the more notable “flash” moves that have transpired over the past ten years.

(Bloomberg)

As you can see, that includes the sterling crash mentioned above. Here, for those who might have missed it over the summer, is a handy pocket guide to those episodes from Goldman:

(Goldman)

“The growing frequency of flash crashes during the post-crisis period provides some reason to worry that liquidity may have become less reliable–or more ‘fragile’–during market stress events”, Goldman’s Charlie Himmelberg wrote in June, adding the following color:

I see reasons to worry that the rapid growth of liquidity supply from newer market participants like HFTs has a “feast or famine” quality to it. In normal times, machines are more nimble than human traders, and liquidity is great. In distressed periods, by contrast, evidence suggests that HFTs may withdraw liquidity more aggressively than human traders, and the resulting reduction in liquidity can interact with selling pressures in a way that results in outsized price declines.

When it comes to the pound on Tuesday, you can probably assume that because everyone is expecting chaos, any selloff or rally will unfold in a reasonably orderly fashion.

Or not.