Sterling's Flash Crash .....

Friday 7th October 2016

Sterling's Flash Crash ..... it only lasted a couple of minutes and one way or another was clearly erroneous, but it asks all sorts of uncomfortable questions.

ref:- "Flash Crash of the Pound Baffles Traders With Algorithms Being Blamed", Bloomberg Markets

WOW! ..... What the hell was that? As we write, GBP / USD is trading at $1.2370 --  that represents a drop of about 2% overnight and would normally be seen as a pretty dramatic move. If however you'd woken up in the early hours of the European morning to check its price (and let's face it, who doesn't?), you'd have seen something a lot more dramatic than that. In the blink of an eye, Sterling fell through the proverbial floor with such velocity (though not volume) that they are still arguing about how low it actually went. Bloomberg's compilation of prices made by dealers registered a low of $1.1841 (down 6.1%), but apparently at least one electronic-trading platform recorded a deal at $1.1378 (yes really, that's $1.1378 !). That may yet be adjusted to $1.1491 but frankly apart from the two parties , who would care ! It's still a crazy, crazy move .....

So what caused this mayhem? First of all, one's got to remember that this happened in extremely thin Asian trading with conditions even quieter than normal at that time of day due to dealers sitting on their hands ahead of today's US employment numbers. Some are putting the crash down to French President Francois Hollande's comments last night which in effect can be translated as "if Britain wants a Hard Brexit, than that's exactly what it's going to get". Doubtless his contribution added to the generally bearish mindset towards Sterling, but with the greatest respect Mr Hollande is unlikely to provoke that kind of move in foreign exchange markets all on his own. 

It's very possible that a "fat finger" was the catalyst for the collapse  --  for those unfamiliar with the expression, it refers to that form of human error when a dealer hits the wrong key on his terminal and makes a transaction at an unintended price. Sounds a bit ludicrous but it happens  --  often. History is littered with examples of huge (albeit brief) market moves being initiated by clumsy fingerwork.

What is not in doubt is even if they didn't necessarily start things off, much of the blame can be laid at the door of automatic algorithmic trading systems. The move lower triggered computer-generated "Sell" signals that take no account of thin market conditions and certainly not of the possibility of a "fat finger".

We are seeing more and more of this kind of event. Without having to think too hard one can remember recent "flash crashes" in US stocks (twice), US Treasuries, the South African Rand and the Kiwi Dollar. They become self-fulfilling until such time as systems or individuals realise something is amiss and the selling dries up. Usually, the way is then clear for the market to regain most of the lost ground almost as quickly as it lost it, although plenty of blood might have been spilled in the interim.

Part of the reason for the dangerously thin markets that occur all too frequently these days can be put down to regulators. It's not that their intentions are not honourable, even sensible in most cases, but it's a fact that the extra costs involved in position-taking has caused many players to withdraw from the market and seriously damaged liquidity. If you combine that with increasingly large market-share being assumed by algorithmic traders, it's a problem on a grand scale and it's getting bigger. It's not as though the authorities are unaware of the issue, but so far they have failed to do more than pay lip-service to it.

Incidentally, rather than just be number-driven some algorithmic trading systems these days can also collate breaking news (such as Mr Hollande's remarks last night, for example), analyse it and act upon it. They can also extract the data responsible for trading decisions from Twitter feeds, apparently. Naming no names, but there'll be plenty of old dinosaurs out there thinking that it's all fiendishly clever, but wondering whether it represents progress or not.

Worrying flaws in the business of trading aside, did last night's action teach us anything about Sterling? Well, it taught us that it's EXTREMELY vulnerable ...... we knew that already of course but notwithstanding fat fingers and algorithms it underlines just how bearish underlying sentiment is. Beyond fundamentals including the increasing likelihood of a messy and economically costly exit from Europe, traders will have something else to consider. Erroneous or not, for technical trading systems the downward spike will have removed levels of support in GBP / USD (and GBP against anything else, for that matter). Suddenly, those calls for $1.15/16 look very real.

And it's not just Foreign Exchange traders that will have to be on their toes. Consider UK Gilts : a tumbling currency is inflationary, especially for an importing nation like Britain. Chancellor Hammond's move away from austerity towards fiscal expansion is likely to increase the supply of government issuance. And investors from abroad, a sizeable percentage of gilt holders, will likely shy away from any extra yield provided by gilts in the face of potential currency losses incurred by buying sterling instruments.

So yes, it was probably just an error that got out of hand ..... but on all sorts of levels it doesn't bode well.

*** NOTE: For newcomers, GBP / USD is often referred to by FX market traders as "Cable"  --  a reference to the transatlantic cable laid about 150 years ago that allowed prices to be relayed for the first time. For convenience, and because it's common parlance in a market attracting a lot of attention, we may use the term in the future. Also, as we talk about tweet-driven algorithms and the like, it's reassuringly quaint .....