There are many theories bounding around the market at the moment but no one is sure. Some of the most likely reasons would be due to fat finger trading, a wild algorithm being joined by other algos or a combination of the two. The market has one term that they love to use ‘Black Swan’. A black swan is an unexpected event that deviates beyond what is the norm which is very difficult to predict. This term was popularized by Nassim Nicholas Taleb in his book ‘The Black Swan’ (I only managed to get partway through this book).
Reason 1# - Fat finger – This is a term used if a trader miss hits a key or puts in an order that is too large or too far away from the market price. This can often have a sharp reaction on the price moving a market and can lead to further market orders and stop losses to be triggered multiplying the movement. Due to the market being out of hours it means that it is less liquid which can exacerbate any fat finger moves as there are smaller and less frequent price levels to hit on the way through. This has taken place when the UK market is in bed, New York has just closed, and Asia has only just started to warm up.
Reason 2# - Algorithms – Most traders know that robots make up an ever growing section of the trading market and positions can be entered and exited within a fraction of a second. We have seen many instances in the past few years such as the major one back in 2010 May 6th when the Dow plunged around 9% within minutes. One of the issues with a robot is the fact that they are only a product of the data that goes in to produce any trading decisions. If the incoming data is incorrect due to something such as a fat finger of an out of control algorithm, a simple move can be exacerbated when other algos jump onto the back, trading off these incorrect price signals putting the market into a spiral.
Why is Sterling so Weak
Sterling has recently taken a battering after the historic vote to leave the European Union. Immediately there was a 10% drop and that has continued in the past couple of weeks. This could have been caused by European politicians openly saying that they need to punish Britain otherwise there could be other countries wanting to follow suit eventually leading to a breakup. Many of the EUs top politicians such as Merkel and Hollande have recently been putting this line across which is worrying the markets.
The main issue with this approach is due to the fact the UK is such a large trading partner, and in trying to defend the existence of the EU, could be doing more damage to their home economies as the balance of import/exports with the UK and Europe will cause more damage on EU companies.
What have we learned
Not much, Black swan events in their nature, can come at any time and are extremely hard to predict. This is not the first and will not be the last time we have an event such as this so this needs to be taken into account when trading. Overnight during Asian sessions, the market is less liquid and can lead to large market movements and increased spreads o you need to keep stop losses in place to protect the position. As the markets become ever more computerized, speeds increase and the complexity increases we will see these sort of movements more frequently.
Below is the full note from JPM's Nikolaos Panigirtzoglou on what happened
Friday’s flash crash in sterling reinvigorates the debate about market liquidity and the role of High Frequency Traders (HFTs) as providers of liquidity. Similar to previous flash crashes such as the August 24th 2015 flash crash in US equities or the October 15th 2014 flash crash in USTs, market gapping, a step change in prices from one level to another without much trading in-between, raises questions about market structure and liquidity in FX markets. This is also because FX markets are perceived to be a lot more liquid than equity or bond markets, so the conventional view is that FX markets are unlikely to experience flash crashes or market gapping in the absence of high impact news.
The flash crash in a major currency like sterling questions the above perception and perhaps shows there are liquidity vulnerabilities in FX markets that are more similar to those seen in equity or bond markets. 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.
Liquidity vulnerabilities in equity or fixed income markets as a result of changing market structures are well documented. In equity markets the shift away from principal trading towards agency trading, where markets makers simply match buyers with sellers without holding inventory beyond a short period of time, took place well before the Lehman crisis. But the Lehman crisis caused a similar shift within fixed income markets. Regulatory and other forces have made it a lot more costly for traditional dealers to act as principal traders in fixed income markets, inducing them to change towards a more order-driven trading model of matching buyers and sellers with minimal inventory risk, or to retrench and be replaced by agent traders.
At the same time electronic trading and advances in technology has encouraged the emergence of HFTs as liquidity providers in the most liquid segments of equity, FX and to some extent income markets. These HFTs use sophisticated quantitative models coupled with speed and high trading frequency, to exploit small price moves. They do so by arbitraging price differences across venues or by detecting and taking advantage of order shifts or imbalances or by simply exploiting very short term momentum or mean reversion signals.
However, different to traditional market makers, HFTs tend to operate with a much shorter inventory cycle, meaning that they conduct offsetting trades within seconds or even shorter, in order to neutralize their original position. As a result they tend to quote for smaller sizes and for a very short period of time. This in turn reduces market depth, i.e. the ability to trade in size in markets, especially in those markets where HFTs are important liquidity providers like equity markets. So we note that while the emergence of HFTs has been beneficial for bid ask spreads and small investors, it has likely had a negative impact on the ability of big institutional investors to trade in size. This is one of the reasons big institutional investors have resorted to dark pools for implementing large equity trades.
More importantly, because HFTs’ models are typically adapted to exploit small price moves, 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. In addition, there is a similar incentive to withdraw from market making when they detect a big order imbalance, i.e. when they detect markets becoming one-sided, as they are reluctant to subject themselves to the risk of not being able to close their position in a very short period of time.
In addition, given HFTs employ similar models, this creates the risk of a simultaneous withdrawal by HFTs in periods of high volatility or stress or in periods when market become more one-sided. A simultaneous withdrawal by HFTs not only amplifies the initial market move, but also creates step changes or gapping markets as liquidity provision gets impaired and quotes are withdrawn.
How big is the role of HFT in FX markets relative to other markets? A previous report by the BIS “Highfrequency trading in the foreign exchange market”, September 2011 concluded that around a quarter to one third of spot FX trading volumes are due to HFTs. But given that this study was conducted five years ago, we suspect that this share has risen since then.
Indeed, the latest 2016 Euromoney FX rankings survey is consistent with a rising share by HFTs as liquidity providers. The biggest change in this year’s rankings has been the advent of non-bank liquidity providers led by XTX Markets who was ranked third for electronic spot FX trading with a market share of more than 10% and third for FX trading platforms. In contrast, the combined market share of the top five global banks dropped to just 44.7% for overall FX trading in this year’s survey. This market share had peaked in 2009 at 61.5% and was above 60% as recently as 2014.
Moreover, many of the banks ranked outside the top 10 for overall FX trading are understood to be sourcing liquidity from non-bank liquidity providers. According to Euromoney, these non-bank liquidity providers or HFTs are set to gain more market share in the future, helped by advances in technology, more defined business models and a lower-cost infrastructure base than traditional FX banks. HFTs are already very important in FX spot markets as mentioned above, but they look to build capability in forwards and other products in the near future.
In all, the FX market appears to be going through structural changes similar to those experienced by equity markets in the past. The advent of non-bank liquidity providers such as HFTs has reduced bid ask spread and increased market efficiency in FX markets, but at the cost of lower market depth and withdrawal of liquidity provision in periods of stress.