Currency Swings Worsen as Wall Street Steps Back
Wall Street’s retreat from currency trading may be reducing risk at the banks, but it is contributing to bouts of extreme volatility in the foreign-exchange market
The British pound plummeted from $1.26 to $1.18 in a matter of minutes Friday, and big banks’ retreat from currency trading may be partly to blame. PHOTO: AGENCE FRANCE-
By CHELSEY DULANEY andIRA IOSEBASHVILI
Updated Oct. 10, 2016 12:24 a.m. ET
Wall Street’s retreat from currency trading may be reducing risk at the banks, but it is contributing to bouts of extreme volatility in the foreign-exchange market.
Currency analysts say that was evident on Friday, when the British pound plummeted from $1.26 to $1.18 in a matter of minutes during early-morning trading in Asia, with some electronic platforms recording trades below $1.15.
One reason the pound fell so sharply, these analysts say, is because Wall Street foreign-exchange desks have slimmed down in response to postcrisis financial regulations meant to limit risk-taking. Those rules forced banks to rein in a service known as market-making, by which they facilitate trading by agreeing to buy and sell currencies.
Major banks’ foreign-exchange desks have shrunk by 23%, to 1,477 traders in the first half of this year from 1,916 in 2010, according to Coalition, a London consulting firm. The top five banks also accounted for just 44.7% of the market’s volume, down from 61% in 2014, according to a Euromoney survey.
Proprietary trading firms and high-frequency traders, mostly driven by quantitative strategies instead of human decision-making, have stepped in to fill that gap.
But at times of high duress, like during the U.K. vote to leave the European Union and last week’s collapse of the pound, the lack of bodies can make a big difference, some observers say. A market staffed by bank traders might have executed orders more judiciously during the thinly traded session, recognizing that low volumes tend to exaggerate currency moves, industry veterans said. Banks also often took money-losing positions that helped to slow a currency’s move in a bid to appease their clients.
The retreat of big banks from the foreign-exchange market mirrors Wall Street’s pullback from other markets at the prodding of Congress and regulators, from real-estate investments to private equity and commodities.
The sharp turns in currency and other markets have led some observers to wonder if greater volatility may be an unintended consequence of an effort to reduce banks’ balance-sheet risk.
Robert Savage, chief executive of the currency hedge fund CCtrack Solutions LLC and a former Goldman Sachs Group Inc. executive, said when volatility increases to a point that high-frequency trading programs lose money by making markets, “they just shut down.”
Bank trading desks staffed by employees would have kept the selloff from escalating to the degree it did, he said. “You would find out who was selling, if there was any news,” Mr. Savage said. “In the old days, if there was no fundamental reason to sell, you wouldn’t sell.”
This isn’t the first time analysts blamed poor liquidity and few traders in foreign-exchange markets for big currency moves:
This pound fell more than 10% in the hours after the results of Britain’s June 23 referendum on leaving the EU were announced. The euro plunged by as much as 30% against the Swiss franc in January 2015. The effect of reduced liquidity was considered a factor in both cases.
Not everyone thinks the currency market is necessarily worse off with fewer traders. Isaac Lieberman, the chief executive of quantitative hedge fund Aston Capital Management, said while electronic trading can lead to swift price moves, it also enables markets to recover more quickly. Within an hour of the initial selloff in the pound last week, the currency had rebounded by over 5%.
Kevin McPartland, who heads research on market structure at financial consultancy Greenwich Associates, thinks as more electronic traders enter the market, liquidity will eventually be improved during high-stress periods.
“The automated nature of the market causes market participants to react more quickly,” he said. “But it allows the market to come back more quickly as well.”
The shift toward electronic currency trading has been under way for the past decade. Deutsche Bank AG, once a leader in foreign-exchange trading, now claims just a 7.9% share of the market, down from about 15% in 2015 and over 20% in 2009, according to a Euromoney survey.
Citigroup Inc., which now has the biggest share of currency trading among big banks, also has retreated. Its market share fell this year to 13% from 16% in 2015. Chief financial officer John Gerspach said during a July earnings call that the bank has “adjusted our capacity” in its foreign exchange and other trading businesses. Mr. Gerspach said the business has “been under tremendous transformation” over the past five years and “and will likely continue to be so for some period of time.”
Meanwhile, foreign-exchange volume executed by nonbank traders rose to 20% in 2015 from 16% the prior year, according to a recent study by Greenwich Associates.
Computerized trader XTX Markets was the ninth-biggest global currency trader in 2016, according to Euromoney, the first time an electronic trader overtook a bank in the rankings. XTX’s 3.9% share of the market’s total volume is particularly notable because the London-based firm is just over a year old, having been spun out of hedge fund GSA Capital in 2015.
Kenneth Griffin’s Citadel Securities is also becoming a big player.
Some observers say one reason the currency market’s overall liquidity is suffering is because algorithmic trading hasn’t made up for the pullback among banks. The Bank for International Settlements triennial survey released in September showed global currency trading fell for the first time since 2001, with roughly $5.1 trillion a day of global currencies being traded in April, down from $5.4 trillion in April 2013.
“Something fundamentally had changed with liquidity provision,” said Collin Crownover, head of currency management at State Street Global Advisors. “You can hit these liquidity air pockets more readily in an algorithm-dominated trading environment.”