South Africa's Flash Crash Exposes Cracks in Currency Liquidity

  • Rand briefly tumbled 9% on Monday in turbulent trading
  • Such crashes may become more common, Insight, Citigroup say

It took just 15 minutes on Monday morning for South Africa’s rand to plummet 9 percent in what traders said may be a prelude of the new normal in the global $5.3 trillion-a-day currency market.

Such flash crashes will probably become more common in foreign-exchange trading as liquidity shrinks amid tighter regulation and reduced demand for emerging-market assets, according to Insight Investment Management Ltd. and Citigroup Inc. The rand slid to record lows versus the dollar and yen in Asian trading before recovering the bulk of the day’s losses almost as swiftly.

“The rand isn’t alone in this,” said Paul Lambert, London-based head of currencies at Insight Investment, a Bank of New York Mellon Corp. unit, which manages more than $582 billion. “The rand is another reflection of the change in the liquidity environment in which we’re all operating. We’re learning that unless there are clients on the other side, banks are very unwilling to take risk onto their books.”

Volatility in the rand versus the dollar surged toward the highest level in four years, while a measure of global currency price swings climbed to the most since October. The difference between prices at which traders are willing to buy and sell the rand, used as a gauge of liquidity, was about 1.5 times wider on average in the past six months than it was during the first half of 2015, according to data compiled by Bloomberg.

Eighth Day

The rand snapped a seven-day run of losses on Tuesday, climbing 1.3 percent to 16.5678 per dollar as of 11 a.m. in New York, compared with Monday’s all-time low of 17.9169.

In a phenomenon that’s also hit U.S. stock markets in recent years, regulation is pushing banks to reduce their size and cut down on market making, making it more difficult to trade without prices moving adversely. A reduction in liquidity has contributed to similar price swings in fixed-income securities, including the $13 trillion U.S. government bond market.

Bursts of volatility in currency markets and diminishing liquidity are another affliction for emerging economies such as South Africa, which seek to secure overseas investments amid slowing growth, a rout in commodities and domestic political challenges. Boosting international trade and capital inflows is made harder by currency turmoil as investors and banks become less willing to take on additional risk.

“You need to have a portfolio that is as diversified as you can make it, with not too much risk in any one position,” Insight Investment’s Lambert said.

Early Trading

The lack of investors trading the rand in early Asian market hours on Monday, combined with reduced interest in South African assets amid uncertainty about the country’s financial and fiscal policies, may have contributed to the rand’s price swings.

“That is why emerging-market currencies need to be risk managed differently,” said Richard Benson, a money manager at currency hedge fund Millennium Global Investments Ltd. in London. “I avoid having positions in the highly illiquid currencies.”

The rand deepened its decline as Japanese retail investors unwound bets it would strengthen versus the yen, which was a popular carry-trade strategy.

“Similar to the rand, a lot of long positions are built up by Japan’s individual investors in the Turkish lira, which could be the next victim of unwinding amid concerns over political instability in the Middle East,” said Masakazu Satou, currency adviser in Tokyo at Gaitame Online Co., a retail foreign-exchange brokerage. The Brazilian real is another higher-yield currencies with similar long positions, he said.

Record Low

South Africa’s central bank doesn’t target a level for the rand and has said it won’t intervene to support the currency. The latest selloff surpasses the slump that pushed it to a record in December after President Jacob Zuma fired his finance minister, Nhlanhla Nene, and replaced him with a little-known lawmaker. Four days later he appointed Pravin Gordhan, who had held the post between 2009 and 2014.

“It’s going to be very difficult to stabilize dollar-rand at current levels,” said Luis Costa, head of fixed-income and currency strategy for central and eastern Europe, the Middle East and Africa at Citigroup in London. “This is the medium-term story. The economy hasn’t yet found a new equilibrium level. South Africa struggles with important structural issues. That puts the rand on a huge back foot.”

Currency Spikes

A year ago, the Swiss franc surged almost 30 percent versus the euro after the central bank abandoned its currency floor against the shared currency. Banks including Deutsche Bank AG and Barclays Plc lost hundreds of millions of dollars amid the volatility and some retail brokers were forced to shut amid client losses.

New Zealand’s dollar tumbled 3 U.S. cents in 10 minutes in late August, before rebounding. The kiwi’s average daily range since 2000 has been less than a cent.

“As a real-money investor, you really have to keep your feet out of these kind of markets because that’s just too much volatility with no obvious reason,” said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages about $20 billion. “It’s really tough. I completely cut down my rand positions and I have no exposure there anymore.”

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