The currency markets are behaving like a train with faulty brakes: a little momentum can take exchange rates on a long journey. Examples include the euro's swoon in the first half of March, the dollar's biggest one-day drop in six years on March 18, and the single currency's more recent sharp rebound. In each case, exchange rates lurched far more than could be justified by economic or political news.
That may sound like the debt markets, which have also recently seen big inexplicable bursts of volatility. Bankers can blame outsized fixed income swings on post-crisis rules which forced market-makers to hold more capital to back bond trading. But currency trading is far less capital-needy, and yet exchange rates are still behaving strangely. Other explanations are required.
Liquidity is not an obvious issue for a market with an average daily turnover of more than $5 trillion. But the trading dynamics have changed. The foreign exchange rate-rigging scandals have altered dealers' behaviour. Banks' more cautious stance has been further reinforced by a mega-surge in the Swiss franc in January after Swiss National Bank President Thomas Jordan unexpectedly scrapped a cap on the franc's exchange rate against the euro. The resulting gyrations brought sobering losses to many market players.
In response to these developments, banks have scaled back risk limits and even more currency trading migrated onto electronic trading platforms. The transparency such systems offer is understandably attractive, given the lax practices disclosed in the scandals. But banks have also fine-tuned the kill switches on their electronic platforms so that activity is more quickly curtailed if there is too much one-way traffic or when currency swings are deemed overly violent. The more sensitive these circuit breakers become, the more prone the market is to enter what traders are calling "air pockets", when liquidity swiftly disappears without much apparent reason. That leaves exchange rates prone to sudden sharp jolts.
New regulations proscribing proprietary trading at banks also encourage more currency lurches. While foreign exchange trading on the spot markets is exempt, there are limits for other FX instruments, such as forwards or swaps. As a result, market-makers can no longer safely brave market trends by taking unpopular positions from clients and holding them for a few days. But when client orders are simply executed as fast as possible, the market-makers lose their past ability to slow down market movements.
Then there is the human factor. In the aftermath of the FX scandals, many experienced traders, including people who had not been accused of any wrongdoing, quit the industry. Their replacements are often less experienced, especially as banks are leery of taking on expensive old-timers who might later turn out to have tainted pasts. However, a lack of trading experience can lead to undue caution in the face of what might become runaway markets.
Combine the rise of the machine and regulation with the decline in collective currency market experience and changes in FX trading dynamics are inevitable. Periods of relative calm and good market liquidity will be interspersed with episodes of very high volatility and suddenly illiquid conditions.
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