Liquidity, Kill Switches Are the Talk of the Currency Universe

What's Going On in the Currency Markets?
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The specter of shrinking liquidity gripping fixed-income desks globally is creeping its way into the world’s biggest, most liquid financial market.

Amid conversations about central bank policy and algorithmic trading, it was concerns about diminishing liquidity -- or the prospects of it drying up entirely during times of market stress -- that dominated discussions this week at the TradeTech FX conference in Miami.

Pension funds, hedge funds and other asset managers were seeking answers after a string of so-called flash crashes in recent months sent some of the world’s most-traded currencies plunging. New Zealand’s dollar, the Norwegian krone and South Africa’s rand have all become victims to the phenomenon, as regulation pushes banks to reduce their size and cut down on market making. The ability to exchange currencies rapidly and cheaply is vital to everyone from importers and exporters to central banks seeking to ensure the smooth functioning of global markets.

“There are certainly challenges -- technology, regulation, the global backdrop in terms of unprecedented monetary policy,” Lee Ferridge, the Boston-based head of macro strategy for North America at State Street Global Markets, said at the end of the gathering. “Every year we hear that the death of the foreign-exchange market is coming - but we are still here. It doesn’t mean we can be complacent.”

Here’s what the industry’s top investors couldn’t stop talking about at the two-day event:

Liquidity Is Vanishing

Liquidity was the buzzword of the conference, namely because some say it’s drying up during periods of turbulence. That’s making the execution of large orders more difficult amid bouts of volatility that have flared up since the Swiss National Bank shocked markets by abandoning its currency’s cap against the euro last January.

“We are concerned,” Collin Crownover, head of currency management at State Street Global Advisors Inc., which oversees about $2.4 trillion, said during a panel discussion. During volatile periods, market participants are backing away until conditions settle down, making it harder to complete large orders, he said.

New Zealand’s dollar fell 3 U.S. cents in just 10 minutes last August while South Africa’s rand plunged 9 percent in 15 minutes last month, according to data compiled by Bloomberg. The Norwegian krone weakened 2.1 percent versus the dollar to a 13-year low in September when the central bank surprised the market by cutting interest rates. It tumbled by more than 2 percent on four occasions last year, compared with none in 2014.

“A lot of the electronification of the market, which by and large is a good thing, has led to kill switches on a lot of that algorithmic-provided liquidity,” Crownover said. “The liquidity just dries up in a stressed market.”

Daily average turnover in currency markets dropped 18 percent to $4.6 trillion in October 2015, compared with $5.6 trillion a year earlier, according to a report by the Association for Financial Markets in Europe.

Investors Don’t Like ‘Last Look’

Several companies raised their objection to a currency-trading practice known as “last look,” which gives market makers a defense against faster, more sophisticated traders while enabling them to quote prices on a wider range of platforms. The practice can be abused, allowing firms to trade or glean the intentions of other market participants virtually without risk to themselves.

“I don’t want any last look coming back to tell me I didn’t get that fill when I thought I had it,” said Glenn Graham, who runs hedge fund Golden Point Capital Management in Chicago. He was referring to unfilled orders.

Barclays Plc agreed to pay $150 million last year to New York’s banking regulator after allegedly using the practice to cancel its clients’ regular market-making trades when they would have resulted in losses to the bank. A group of central banks will determine whether brokers can continue to use last look and are working on a single rulebook to govern currency trading in every country where it takes place.

Griffin Frank, a foreign-exchange trader at T. Rowe Price Group Inc. in Baltimore, said his firm is tracking the use of last look more closely through data collection and analysis.

“We’re going to request a formal policy from the banks regarding what their policies are and actually outline exactly what they’re doing to ensure that our flow is safe and obviously maintain our relationship,” he said.

Algorithms Are on the Rise

Institutional currency investors are adopting more algorithmic trading that uses mathematical models to make transaction decisions, conference participants said. 

While algorithmic trading in foreign exchange is growing, it remains limited compared with other markets such as equities, according to Kevin McPartland, head of research for market structure and technology at Greenwich Associates.

That presents opportunities as firms that create algorithmic systems seek to target institutional investors, according to Alfred Eskandar, chief executive officer of Portware LLC, which offers systems to manage and execute trades.

Investment firms have tripled algorithmic trading in the past year, and “we actually think that’s going to triple again this year because there’s a couple of very large asset managers who now want to use algos,” Eskandar said during a panel.

The Dollar Rally Is Down, Not Out

A gauge of the dollar has fallen 0.6 in 2016, interrupting its 20 percent surge in the past two years, on speculation global market turmoil would scupper the Federal Reserve’s ability to raise interest rates while other central banks ease monetary policy.

Steven Englander, Citigroup Inc.’s New York-based global head of Group-of-10 currency strategy, sees the dollar strengthening to parity with the euro in the next 12 months.

“A little bit of divergence goes a long way,” he said, adding that policy makers from the European Central Bank and Bank of Japan will ease more aggressively than markets expect, prompting the euro and yen to resume their declines.

“The U.S. dollar rally is intact -- we see corrections of course, as always, but the driving force is this policy mix,” said Marc Chandler, global head of currency strategy in New York at Brown Brothers Harriman & Co. He forecasts the dollar will reach record highs against the euro in 2017 or 2018.

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