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How ‘Flash Crashes’ Raise Exchange Rate Risk for International Business

By Frances Coppola

On January 3, 2019, at about 5:40 pm Eastern time, the U.S. dollar exchange rate suddenly dropped by more than 8 percent versus the Japanese yen. The Australian dollar’s exchange rate also fell sharply versus the yen, as did the Turkish lira. These sharp falls were very short-lived, lasting only for a few minutes, though FX markets remained volatile for some time afterwards—potentially working havoc with corporate foreign exchange risk management.

This “flash crash” was not the first of its kind. Since the financial crisis of 2008, there have been similar flash crashes involving the British pound, the South African rand, the euro, the Swiss franc, and the New Zealand dollar.1 There have also been flash crashes in other markets. For example, on May 6, 2010, U.S. stock markets lost a trillion dollars in 35 minutes,2 and on October 15, 2014, there was a sudden sharp fall in U.S. Treasury yields.3

 

In FX markets, a flash crash can be defined as a sudden episode of extreme exchange rate volatility affecting one or more currency pairs. Although the extreme exchange rate movements are usually short-lived, the turbulence arising from them can last for some time. This can make FX risk management more complex for international businesses. But what causes these dramatic events—and are they becoming more frequent?

 

Complex Relationships Between News and Extreme Exchange Rate Risk

 

Some flash crashes are directly caused by news events. For example, on January 15, 2015, the Swiss National Bank (SNB) suddenly announced that it would immediately end the asset purchases that had been preventing the Swiss franc from rising versus the euro.4 The franc’s exchange rate promptly shot up, rising by 41 percent versus the euro in 25 minutes.

 

But for most flash crashes, the relationship with news events is more complex. The sterling flash crash on January 7, 2016, was initially blamed on the publication of an article in the Financial Times that said French President François Hollande would demand “tough Brexit negotiations.” However, subsequent analysis by the Bank for International Settlements (BIS) showed that the information in the article had been available to markets for some hours before the crash. Thus, it was unlikely that publication of the article directly caused the crash. However, the news that Brexit negotiations could be difficult might have made the sterling exchange rate more volatile, and thus more sensitive to other market conditions.5

 

Some think the dollar-yen flash crash in January 2019 was triggered by an unexpected profit warning from a giant international technology firm based in China.6 But the profit warning occurred several hours before the flash crash and did not affect the Chinese yuan.7 In this case too, it seems that other factors determined the time of the crash and the currencies affected.

 

Do Automated and High Frequency Trading Drive Flash Crashes?

 

Analysts say that flash crashes tend to occur when there are unusual strains in the market. This can be due to human behavior: for example, in the stock market flash crash of May 6, 2010, a rogue trader set up so many fake sell trades (known as “spoofs,” because their purpose is to move markets by fooling other traders into selling8 ) that he caused the entire market to crash.

 

However, flash crashes mostly seem to occur in markets where there is a high proportion of electronic and automated trading, particularly high-frequency (algorithmic) trading (HFT).9 Some analysts think that the spoofer responsible for the 2010 stock market flash crash would not have been able to cause a crash were it not for the amplifying effect of HFT.10

 

Analysts blamed “robots gone wild” for the dollar-yen flash crash of January 2019. The crash occurred during what FX traders call the “witching hour” between market closure in New York and market opening in Tokyo, when automated trading dominates because the humans have gone home. Trading volumes tend to be low during this time, which reduces market liquidity and raises exchange rate volatility.

 

Similarly, the sterling flash crash of January 2016 occurred at midnight London time, when the London and New York markets were closed but Asian markets had just opened. Detailed analysis by BIS showed that the crash happened when liquidity suddenly dried up. Several other flash crashes examined by BIS have also occurred outside normal trading hours, which tends to support the argument that HFT makes flash crashes more likely. However, BIS was unable to confirm that HFT was the main cause of the liquidity freeze. It said that major dealers, principal trading firms and firms representing a retail client base all withdrew liquidity from the market during the flash crash.

 

Research by the U.K.’s Financial Conduct Authority shows that in equity markets, HFT, far from causing episodes of extreme volatility, may help to mitigate them. “Our evidence suggests that, contrary to received wisdom, high-frequency trading (HFT) firms potentially act as a partial stabilizing force during these periods,” the FCA said, adding: “In contrast, large investment banks appear to contribute the most to the price fall by selling heavily during the decline.”11

 

How Ordinary Trading Activity Could Cause A Flash Crash

 

According to BIS, in a deep and liquid market with significant automated and algorithmic trading, a flash crash can simply result from ordinary trading behavior. It identifies two activities in particular that can considerably amplify exchange rate movements:

 

  • Option hedging
  • Stop-loss orders12

Of the two, the first may be the most significant. Dealers typically hedge option positions by buying or selling the underlying security (or currency, for FX options). When the options price moves, dealers can be forced to buy or sell large quantities of the underlying asset. These trades may be automatically executed when the position becomes unhedged. In FX markets, this can cause sudden exchange rate spikes.

 

Automatic execution of stop-loss orders can also contribute to exchange rate moves. BIS observes that “both retail and institutional investors often leave such orders with dealers in order to close out positions quickly and thus limit potential losses or to initiate new trades at specific entry levels,” and comments that these orders can be executed regardless of the impact on the market.13 If large numbers of stop-loss orders are simultaneously executed, the exchange rate can move precipitously.

 

Simultaneous unwinding of yen short positions seems to have helped to cause the dollar-yen flash crash of January 2019. Traders simultaneously sold dollars and bought yen, causing the dollar exchange rate to fall precipitously.14

 

The

Takeaway:

In the last decade, FX markets have become deeper and more liquid, and electronic trading has proliferated. Concurrently, episodes of extreme exchange rate volatility have increased. Many explanations for these “flash crashes” have been advanced, but as yet no definitive cause has been identified. While this remains the case, flash crashes seem likely to remain a risk for international businesses active in FX markets. Businesses may wish to identify tools and strategies for handling extreme exchange rate volatility.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “The Sterling ‘Flash Event’ of 7 January 2016,” Bank for International Settlements; https://www.bis.org/publ/mktc09.pdf
2. “The 2010 ‘flash crash’: how it unfolded,” Guardian; https://www.theguardian.com/business/2015/apr/22/2010-flash-crash-new-york-stock-exchange-unfolded
3. “The Sterling ‘Flash Event’ of 7 January 2016,” Bank for International Settlements; https://www.bis.org/publ/mktc09.pdf
4. “Oh, Switzerland, What Have You Done?” Forbes; https://www.forbes.com/sites/francescoppola/2015/01/17/oh-switzerland-what-have-you-done/#16706b205e31
5. “The Sterling ‘Flash Event’ of 7 January 2016,” Bank for International Settlements; https://www.bis.org/publ/mktc09.pdf
6. “Three Theories On The FX Flash Crash: Robots, Apple, Yen Shorts,” Bloomberg; https://www.bloomberg.com/news/articles/2019-01-03/dissecting-the-fx-flash-crash-robots-apple-yen-shorts-blamed
7. “Yen flash crash: what happened and why,” Financial Times; https://www.ft.com/content/45d3807a-0f5b-11e9-a3aa-118c761d2745
8. “What Is Spoofing?” FXCM https://www.fxcm.com/uk/insights/what-is-spoofing/
9. “The Sterling ‘Flash Event’ of 7 January 2016,” Bank for International Settlements; https://www.bis.org/publ/mktc09.pdf
10. “Guy Trading At Home Caused The Flash Crash,” Bloomberg; https://www.bloomberg.com/opinion/articles/2015-04-21/guy-trading-at-home-caused-the-flash-crash
11. “Catching a falling knife: an analysis of trading halts,” Financial Conduct Authority; https://www.fca.org.uk/publications/research/analysis-circuit-breakers-uk-equity-markets
12. “The Sterling ‘Flash Event’ of 7 January 2016,” Bank for International Settlements; https://www.bis.org/publ/mktc09.pdf
13. Ibid.
14. “Three Theories On The FX Flash Crash: Robots, Apple, Yen Shorts,” Bloomberg; https://www.bloomberg.com/news/articles/2019-01-03/dissecting-the-fx-flash-crash-robots-apple-yen-shorts-blamed

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