In late August, there was another flash crash in the Turkish lira, which plunged as much as 12% against the yen when trading got going on the Monday following a fresh escalation in the Sino-US trade war.
Sudden, large moves in TRYJPY aren’t entirely uncommon. Japanese retail investors sometimes get out over their skis in the pair, putting them at risk when the yen rallies amid bouts of risk-off sentiment.
But in addition to the “Mrs. Watanabe” story, the August flash event was yet another reminder that modern markets are fragile and increasingly prone to “snapping” – if only momentarily. That day’s action was reminiscent of what happened in January when things went haywire, driving the yen through levels that hadn’t been breached in 10 years in the space of less than 10 minutes. Here’s a trip down memory lane to that episode:
Well, in their latest quarterly review, the BIS is out warning that FX trading “has become more complex and fragmented over the years” which could lead to potential problems, depending on who you are.
“Financial institutions outside the bank dealer community have taken on important intermediation functions, and a plethora of electronic trading venues have emerged”, a section of the review dedicated to the subject reads. “These developments have led to ever greater choice in how to execute trades but also to a highly fragmented market structure”.
The BIS then launches into a lengthy discussion which, considering the subject matter, is actually presented in reasonably straightforward and accessible terms. Their attempt at brevity notwithstanding, it’s still a bit tedious for everyday folks. Thankfully, economists Andreas Schrimpf and Vladyslav Sushko seem pretty adept at summarizing the conclusions of their work. Consider this passage, for example:
FX trading has evolved rapidly over recent years. It has seen further electronification and increasing variety in trading venues and protocols. In spot, FX intermediation has tilted towards non-bank electronic market-makers, who substitute speed for balance sheet. Activity has also gravitated more to dealers’ proprietary liquidity pools and away from primary inter-dealer venues. Clients can use algorithms to enhance execution and navigate a fragmented market, albeit in exchange for taking on more market risk themselves. All these developments have led to more choice for tech-savvy clients, but also to some important risk-shifting and greater market fragmentation.
This is potentially perilous for several reasons, and in spirit, it harkens back to something JPMorgan’s Marko Kolanovic wrote in 2018, four months after the infamous VIX ETN “extinction event”. Recall this:
What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility, given that many market making algos (as well as business models) were calibrated during the years of low volatility. As these programs don’t have an obligation to make markets and are optimized for profits, they likely adjust quotes and reduce size.
Don’t focus so much on the specifics, but rather on the concept – markets have evolved rapidly over the past decade, and that evolution has come against a backdrop of historically low volatility. Nobody quite knows what will happen in the event the scaffolding gets a serious stress test.
In the context of the BIS’s FX trading fragmentation discussion, Schrimpf and Sushko write the following:
Furthermore, the current market configuration has emerged largely during a prolonged period of low volatility, and its resilience might be tested if the volatility regime were to change. For example, during periods of stress, FX dealers might ration liquidity and favour clients with whom they have a strong relationship, such as those using their single-bank platform. Thus, customers who spread execution across venues could face a sharp evaporation of liquidity. The question of whose risk-bearing capacity to rely on under such circumstances could become a pertinent one. In the event of stress, the resilience of FX markets could be further challenged by the declining use of payment-versus-payment systems to reduce FX settlement risk.
Again, it’s the concept that matters more than the specifics. FX volatility is sitting a six-year low. Indeed, FX vol. is the only cross-asset risk that’s more somnolent now than in 2017 during the halcyon days of the low vol. bubble.
(BofA)
We’re reminded of our good buddy Kevin Muir (of Macro Tourist fame), who in August wrote the following:
Although Trump has tweeted that it is not fair that the dollar rises, he has yet to realize that he has the authority to do something about it. When he figures it out, there’s only one trade you want on the sheets and that is FX volatility.
Right now, the JPMorgan FX Volatility Index is sitting near all-time lows. FX vol is dirt cheap.
(Bloomberg)
