Why Currency Markets Are Experiencing Flash Crashes

Banks have retreated as market makers and been replaced by high frequency traders and hedge funds. The result: episodes of illiquidity.


The stock and bond markets have received plenty of attention for flash crashes that have occurred over the past five years, but they aren’t alone.

Several flash crashes have hit the currency markets too, most notably in March, when the U.S. Dollar index dropped 3 percent in just under four minutes and then gained most of that back in three minutes. Whereas 3 percent may not represent a huge move for a stock, it is for a currency and even more so for a currency index.

“We see a couple periods like this a year, where suddenly there is no liquidity, and you get gigantic moves,” says David Gilmore, a partner at Foreign Exchange Analytics in Westbrook, Connecticut.

So why the forex flash crashes? It’s not an issue of volume. Daily turnover in the currency market has risen to a record $4.8 trillion, according to central bank data. The problem is liquidity. In the past, banks stepped in to help smooth the market in times of excess volatility. But the banking industry’s consolidation and stricter regulation have caused banks to shrink or cease their currency-trading operations. In addition, high frequency traders have come to play a major role in the forex market, just as they have in stocks and bonds, at times creating massive volatility. Hedge funds and other money managers also have a growing presence and can represent a source of instability.

One difference between currency and equity markets is that whereas stock markets have grown more fractured over the past 20 years, the forex market has become more concentrated. In the old days, a substantial portion of currency trades took place over the phone between banks. Now the majority of trades occur over automated platforms, such as Reuters’s FXall and ICAP’s EBS. But the increased concentration hasn’t acted as a barrier to bouts of illiquidity, at least so far.

As for the banks, Gilmore says, “They aren’t willing to take risk, because they aren’t making money on currency trading.” The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires banks to increase the amount of capital they hold to back risk-based activity, and the law’s Volcker Rule forbids most forms of proprietary trading at banks. “Compensation and motivation [for bank traders] have changed too,” says Scott Greene, CEO of Spectra FX Solutions, a currency options advisory and execution firm in New York and London. In addition, many institutions active in foreign exchange, such as Lehman Brothers, disappeared or were taken over during the financial crisis of 2008–’09.


Put it all together, and “banks aren’t interested in maintaining the primary market-making function they did through 2005,” Gilmore says. “It’s not a business that banks view as growth. It’s more a necessity for offering customers a complete array of functionality.”

“In the heyday of the 1990s, a junior bank trader might hold a $1 million to $2 million position overnight, and a top trader might hold a position of up to $100 million overnight,” notes Sassan Ghahramani, CEO of New York–based SGH Macro Advisors, which advises money managers. “That has disappeared. Volume is at an all-time high, but it’s a situation of ‘pass the hot potato.’ People can’t hold positions.”

Although banks have cut their activities in foreign exchange, high frequency traders and money managers, particularly hedge funds, have more than taken up the slack. High frequency traders in particular can cause flash crashes, because of their feast-or-famine trading style. “You get flash crashes in the currency market when suddenly there is no liquidity,” Gilmore says. “It might just be algo[rhythmic] trading models being turned off.”

Meanwhile, hedge funds and other money managers have become the players holding currency positions for sustained periods, Ghahramani notes. “A lot of them are on the same side [of trades], and if they need to get out, banks are no longer there as a cushion. That tends to exaggerate moves.”

To be sure, it’s unclear whether these liquidity issues constitute a major worry. “It’s not a systemic threat,” Gilmore says. “It’s just a shift in liquidity, and there’s a potential for market imbalances to become highly exaggerated.” And remember that the currency market differs from stocks and bonds in that whenever one currency is plunging, another is soaring. Stocks and bonds, of course, can all fall at the same time.

Still, analysts say, there is a risk of something big erupting. “The test comes when the market breaks down,” Greene says.

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