The Bank for International Settlements’ Markets Committee recently published the Sterling ‘Flash Event’ Report, presenting analysis of the October 7, 2016 sterling flash event. It draws on detailed analysis conducted by the Bank of England as well as intelligence gathered by the members of the BIS Markets Committee.
The report analyzes several factors which could have contributed to the crash and details key points including:
- There appear to have been no material losses incurred by major financial institutions. A number of market participants highlighted the impact of the lessons they had learnt from the January 2015 Swiss franc event for the calibration of their risk appetite and trading methodologies.
- The initial sharp depreciation in sterling retraced rapidly, and market functioning recovered relatively quickly with it – indeed, faster than in some previous events.
- Despite the seeming fragility of market liquidity, large volumes could be transacted around the event window.
Given the fragmented nature of FX trading, analysis struggles to build a complete picture of market activity. BIS illustrated this on page 3 with a MarketFactory graph.
The crash appears to have been the result of a confluence of factors. Whatever the initial cause, the time of day – early Asian hours – is more vulnerable to sharp moves and associated withdrawal of liquidity by market makers. Also, this may have been amplified by factors including options-related hedging flows and execution of stop loss orders. The complete absence of resting orders on major platforms for short periods was highly unusual. The CME triggered its velocity logic mechanism causing a 10 second trading pause which may have caused systematic traders that rely on the CME to withdraw liquidity.
As stated in the report, flash crashes are not a new phenomenon. They remind us that there is a continuous need for research on market vulnerabilities. These relate to automated trading, the reduced role of traditional market-makers and the increasingly important role of prop trading funds (PTFs) and other non-bank liquidity providers in FX and other markets.
This combination of new participants, changes in market-making and the advance of technology raises important questions about the evolving nature of liquidity and resilience in financial markets. Market makers should continue to realize the need for a robust trading infrastructure and make sure their staff have the tools, training and technology to handle unexpected market events.