Flash Crash of the Pound Baffles Traders With Algorithms Being Blamed
(this article first appeared on Bloomberg)
During two chaotic minutes of Asian trading, the pound plunged the most since the Brexit referendum in June, with traders saying computer-initiated sell orders exacerbated the slump.
The 6.1 percent drop drove sterling to a 31-year low of $1.1841, according to composite prices compiled by Bloomberg of contributions from dealers. Traders speculated the crash might have been sparked by human error, or a so-called “fat finger,” with algorithms adding to selling pressure at a time of day when liquidity is relatively low.
While the currency snapped back in Asia, it resumed its freefall during European hours, as concern welled up that Britain is headed for a so-called hard Brexit that would restrict its access to the European Union’s single market in return for gaining control of immigration.
The extent and speed of the pound’s drop adds to signs that bouts of extreme volatility are becoming more commonplace in the global currency market as the volume of transactions dwindles and traders using algorithms pick up market share. In January, the South African rand tumbled more than 9 percent in 15 minutes before rebounding, while New Zealand’s dollar had its own flash crash last August.
“This is not something you would expect in a half-efficient market,” said Ulrich Leuchtmann, head of currency strategy at Commerzbank AG in Frankfurt. “We have a liquidity situation which has eroded massively over the last few years and policy makers have largely ignored it. All the regulation that we have in place, for good reason, has the side-effect that liquidity in the FX market is much more shaky and fluctuating heavily, and we have times when it’s extremely low, especially in Asian trading.”
The pound was down 2.3 percent to $1.2322 as of 1:34 p.m. in London. That brought its slump to 5 percent since Sept. 30, exceeding losses during the week of the June 23 referendum. It depreciated 2.2 percent on Friday to 90.35 pence per euro.
“We’ll probably never know why it has actually sold off, if it’s a fat finger, or just algos,” said Ryan Myerberg, a portfolio manager at Janus Capital in London. “There’s no doubt that there’s an electronic component to it.”
At least one electronic-trading platform recorded a transaction at $1.1378, said traders during the Asian day, who asked not to be identified because they’re not allowed to speak publicly.
Meanwhile in the U.K., traders were sleeping soundly with no idea of what would greet them when they arrived at their desks.
“I came in, saw my chart and thought somebody had messed around with the computer,” said Stuart Bennett, head of Group-of-10 currency strategy at Banco Santander SA in London.
The Bank of England is “looking into” the causes of the crash, a spokesman said Friday. BOE Deputy Governor Ben Broadbent said earlier this week that the decline so far had been “relatively orderly.”
One-week implied volatility for the pound against the dollar jumped to as high as 16.77 percent, the highest since July 14, from a 10 percent closing level Thursday, according to data compiled by Bloomberg.
“It caught the market wrong-footed and triggered a lot of algorithmic selling,” said Hugh Killen, Westpac Banking Corp.’s head of trading for foreign exchange, fixed income and commodities in Sydney. “We didn’t see any significant demand for sterling off the low.”
Traders also pointed to French President Francois Hollande’s remarks late Thursday that the U.K. will have to “pay the price” for choosing a hard Brexit after its June vote to leave the EU. Hollande, speaking in Paris at a dinner attended by EU officials, urged the bloc to fight hard on negotiations with Britain. “There has to be a price to pay or else the negotiations won’t go well,” Hollande said.
While sterling’s 17 percent drop since the June referendum boosts exports, which helps narrow the country’s current-account deficit, it also increases prices of imported goods for businesses and consumers.
The prospect of faster inflation and a loosening of fiscal policy by the government to mitigate the economic risks of Brexit is hurting government bonds, with the yield on benchmark 10-year gilts rising this week by 20 basis points, or 0.2 percentage point, to 0.95 percent, the biggest weekly increase since August 2015.
The outlook for inflation over the next decade, as measured by the 10-year break-even rate, climbed to 3.05 percent Friday. That’s the most since January 2014, based on intraday prices for the gauge, which is derived from the difference in yield between conventional and inflation index-linked bonds.
Other markets remained resilient. S&P 500 Index futures expiring in December rose 0.1 percent, while a gauge of Asian equities lost 0.2 percent. The FTSE 100 benchmark stocks index for the U.K. was 0.9 percent higher, extending its weekly gain to 2.4 percent. Exporters have rallied as the weaker pound buoys the outlook for earnings.
Derek Mumford, a director at Rochford Capital Pty in Sydney, said he and his colleagues were searching for a reason for the pound’s plunge, scanning news-agency reports and the internet.
“The speed of the move looks like a kind of a flash crash, some sort of failure,” Mumford said, adding that sterling is set to drop to $1.15 in the coming weeks if it doesn’t recover above $1.28. “I’m sort of struggling to justify it. I don’t think there’s any shock that the EU will be going for a hard Brexit.”
Leaving the EU was the main topic at the ruling Conservative Party’s annual conference this week, and U.K. Prime Minister Theresa May highlighted the possibility of a hard Brexit. Sterling has also tumbled since she was said to take the view that the financial industry, which accounts for about 12 percent of output, would get no special favors in EU exit talks.
The pound, 2016’s worst performer among 31 major currencies tracked by Bloomberg, has also been pressured by speculation that a weakening economy will prompt more interest-rate cuts by the BOE while the Federal Reserve is getting ready to tighten policy. Companies including Goldman Sachs Group Inc. and AllianceBernstein Holding LP have issued predictions for more pain ahead.
The volatility was “in a word, frightening,” said Karl Schamotta, director of foreign-exchange research and strategy at Cambridge Global Payments in Toronto. “Confidence in the currency markets has been badly shaken once again, and any trader who rode tonight’s roller-coaster will certainly question the quality of liquidity going forward.”
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