By Samuel Chesworth/ The Market Mogul
The event dubbed “the pound flash crash” represents an event which has highlighted what a robotic programmed algorithm, operating alongside an emotive and fragile state of political affairs, can create.
The quick effect
The last week events were catastrophic for cable, causing an avalanche of sell orders. The pound was in freefall for a number of minutes, losing 800 pips (6%) against the dollar, which resulted in a 31-year low between the pairing for the pound ($1.18). How is this possible? The answers only became clear when the dust settled, and a number of contributory factors were considered.
With such a dramatic dive it is usually the case within FX that a major event on an economic calendar had unfolded – for instance, the recent US non-farms figures or Janet Yellen’s speech at Jackson Hole.
As this was not immediately apparent, it has transpired that in fact, algorithmic trading systems (“trading algos”) were to blame for the crash. Algorithmic trading revolves around technical programmes reacting to events or actions of key political or economic agents, their appeal being that they do this quicker than any individual trader could.
Still, what sparked the sudden crash? It is believed that “trading algos” reacted to comments made by French President Francois Hollande regarding Brexit. He said that “Britain must suffer the consequences of leaving the EU in order to save the institution from an existential crisis.”
“There must be a threat, there must be a risk, there must be a price. Otherwise, we will be in a negotiation that cannot end well.” tweet
This still did not supply enough reasoning for an 800 pip drop in the fourth most liquid currency pair. A combined effect of multiple different trading algos is the more likely reason why there was such a sharp drop. This is because as some algorithms were picking up on comments made by Hollande, others traded off the back of a shift in the buy/sell ratio on cable, thus creating a snowball effect.
So as some picked up on Hollande’s remarks, others picked up on the sell movement resulting in a mass selloff. This could be seen in many ways as a modern day Soros effect. During Black Wednesday, when Soros shorted roughly £10bn, traders and institutions followed suit and ultimately caused a much larger devaluation than was necessary in order to stabilise the pound and the aggregate UK and European inflation.
A fat finger error?
Another theory was that a fat finger error had occurred. This was also touted when the Dow Jones suffered a similar “flash crash” in 2010. Essentially what this means is that there has been an order input error whereby a trader making a large order entered too many digits and taken the trade from millions into billions for instance.
However, even in 2010, this was deemed unlikely due to all the protocols and regulations that any significant institution will have in place to prevent this from happening. Thus it is very unlikely that the recent pound “flash crash” was the result of a fat finger error.
Another key reason behind the sheer size of the drop can be explained by a shortfall in liquidity. This may be hard to rationalise given the trillions traded in the currency markets and cable being the fourth most liquid pair.
However, the statements and articles were released during the so-called “twilight zone” of FX trading therein creating the environment for such a “flash crash.” This is due to the fact there is a period of low liquidity between American trading desks shutting and Asian trading desks opening, meaning sharper changes may occur.
Politically-driven currency frailty
Ultimately, new Prime Minister Theresa May, someone who not so long ago campaigned to remain in the EU, has been a key source of the fragility within the pound in recent weeks. Her comments of a hard-line and fast Brexit have taken many by surprise and thereby left the pound more prone to speculative attacks.
As an economist and passionate Briton, one has faith in the pound, even post-Brexit. Seeing an economy move away from periods of overheating, and instead towards a period of export-led growth emanating from exciting new trade links amongst emerging markets instilled confidence.
However, the apathy of UK voters and disillusionment with ailing political regimes both at home and within the EU has created a dour and damp environment for the pound, perpetuating stagnant growth sentiments. All of these factors and this recent “flash crash” have changed the outlook on cable and pound in general: while not fearing euro parity, the pound will not recover to pre-Brexit levels anytime soon.
With respect to algorithmic trading systems, it is perhaps surprising that this kind of event is not more frequent. While there will be calls to scrutinise these machines in more detail, the efficiency and cost-effectiveness of running these programmes will prevent them from being overhauled.