The increased participation of the hedge fund community in foreign exchange markets has been scrutinized over the years due to their herding behaviors that have exacerbated the already volatile and illiquid markets during times of crisis. A more recent phenomenon developing among hedge funds that has garnered attention is the growing use of algorithmic trading and High Frequency Trading (HFT) in particular.
Due to its uncorrelated properties to traditional asset classes such as bonds, equities, and commodities, foreign exchange has emerged as an asset class in and of itself for many institutional investors, fund managers and hedge funds alike. The competition in this space has created significant investments in technology and has since created a new wave of algorithmic trading, bringing about improvements and new challenges for market participants at both the broker-dealer and customer level.
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In order to grasp the implications, both positive and negative, that algorithmic trading has on the foreign exchange markets and its participants, a closer look must be taken at how HFT firms function. HFT is a specific type of automated trading that uses computer algorithms to identify opportunities through a multitude of strategies and then executes trades within milliseconds, essentially taking advantage of information before other players have had time to react. They profit by trading a large number of small sized trades making multiple small profits within milliseconds, effectively minimizing the risk per trade. HFT has been a rapidly evolving phenomenon in the equity markets for years now and has been making significant inroads into the FX markets, which will have a significant impact on the structure and dynamics of the FX market and its participants going forward. One of HFT’s most important characteristics comes from its equity origins in that it is able to act like an “order-driven” system. These firms take advantage of their high speed platforms by sending multiple small trades to several different trading venues via multi-bank electronic crossing networks (ECNs) in order to detect the order flows and create execution strategies based on this information. In doing so, they inflate the true market depth and liquidity.
The emergence of algorithmic trading has provided several key benefits to clients during normal market conditions in the form of increased volume, improved efficiency, and narrowing spreads, by increasing the flow across multiple trading venues and reducing price gapping that was often apparent in the interbank market. While the customers perceive these implications as beneficial in terms of spread compression, the longer term implication on market-making activities may have significant negative effects in the form of reduced liquidity for larger Institutional and Corporate flow that occur daily for global trade related purposes, as dealers may become less willing to make markets for block trades if the spreads are not reflective of the risk.
HTF firms are not mandated to market-making activities and therefore seem to disappear from the markets as soon as volatility increases and/or liquidity decreases, which is the case during times of crisis or immediately before key economic data is released. This hedge fund-type herding behavior has been blamed for many of the large swings experienced in both the equity and FX markets. While there is very little evidence or empirical studies to prove this, several events that have occurred recently have suggested this behavior, such as the May 6th 2010 flash crash or the March 17, 2011 JPY 3% decline within 25 minutes.1 Similar activity has been witnessed during key economic releases:
During the minutes following the US non-farm payrolls announcement, when volatility is high, the share of liquidity provided by algorithmic traders decreases relative to human traders. This suggests that it is unlikely that computer traders provide sufficient liquidity when there is an adverse shift in price due to new information. (Chaboud et al (2009))
In an environment like the current one, where event/headline risk is the single most influential risk that affects intra-day price movements, the herding behavior which has now been magnified by HFT firms is detrimental to a healthy and functioning currency market.
Another perceived problem, that has been dubbed the “Liquidity Mirage”, is the false sense of liquidity and market depth created by HFT through its ability to submit bids/offers across multiple trading venues and pulling them as soon as one is filled. In times of crisis, all their bids/offers evaporate instantaneously leaving dealers to continue their market-making activities in an elevated risk scenario. Dealers argue that the tight spreads created by the emergence of HFTs do not properly reflect the risk associated with pricing larger transactions that cannot be filled at the reflected price. This has a detrimental effect on the dealer’s market-making activities, especially during times of stress. Over time, dealers will become more cautious and selective in their market making activities; an effect that has implications for all clients needing access to the FX markets for global trade and capital flows.
Questions of integrity, which have become paramount, arise in regard to HFT’s ability to detect larger trades through its use of multi-bank ECNs and complex algorithms and to execute trades based on this information. This appears to share similar characteristics to front-running which is certainly an unacceptable practice in today’s markets. The problem is that they are using commonly accepted and employed procedures that have been around for decades, but when executed at speeds hundreds of times faster than other participants, it creates a significant advantage and profit opportunity for these HFT firms.
While regulators are beginning to raise concerns regarding these developments, there is very little evidence of the actual size of this market and whether the inferred effects of this type of trading can be directly attributed to HFT. One of the reasons for this is that HFT firms use prime brokers to execute their transactions, and therefore their trades end up going through the market as if their prime broker did the trade. However, one can make conclusions as to the growth of HFT by reading between the lines of an April 2010 BIS Triennial Survey, which measured the daily average global FX turnover increase to be $657 bln reaching $3.98 trillion, since April 2007, three quarters of which occurred in the spot market. It is well documented that the HFT firms trade primarily in the spot markets2
The HFT firms are reliant on dealers. Dealers, on the other hand, are not reliant on HFT firms. If spreads compress so much that dealers can no longer warrant the risk involved, they may retaliate with some maneuvers of their own – such as moving towards single-bank platforms that internalize flows.3 Consequently, it would be wise for HFT firms to tread water carefully when it comes to compromising the integrity of these markets. On the flip side, it would be wise for dealers to increase their investment in technology to keep up with the changing landscape. As dealers and other non-HTF players continue to improve their technology, these latency advantages that HTF firms are utilizing may become more difficult to profit from as the cost-benefit trade-off of reducing execution speed past a certain point becomes negligible. Also, both parties should keep a close watch on new regulations being developed that may impact their business.
Everyone agrees that both the broker-dealers and HFT firms provide liquidity and mutually benefit clients in normal market conditions. It is during times of crisis that the implications of increased HFT on both the broker-dealer side and customer side become most concerning. Longer term implications on the dealer’s market-making activities are becoming a serious concern for global trading partners who rely on a healthy and functional foreign exchange market. While HFT has been a part of the equity markets for years, it is still a relatively new phenomenon in the foreign exchange markets that we will continue to evolve over the coming years and change the landscape for all participants.
1 BIS Markets Committee report, Sept 2011.
2 BIS Triennial Survey, April 2010.
3 BIS Market Committee Report.
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Economic recovery likely to prove a ‘stuttering’ affair
By Rupert Thompson, Chief Investment Officer at Kingswood
Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.
As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.
Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.
We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.
Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.
Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.
China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.
Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.
An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.
Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.
European trading firms begin coming to terms with the new normal
By Terry Ewin, Vice President EMEA, IPC
In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.
The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.
We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.
Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.
In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.
Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.
Currently, many European trading firms are taking what could be described as a two-pronged approach.
The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.
The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.
It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.
Currency movements and more: How Covid-19 has affected the financial markets
The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.
Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.
Financial Markets Fluctuate During Pandemic
Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.
The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.
Currency Movements Divide Economies
In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.
The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.
Looking Towards the Future through Financial Markets
The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.
Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.
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