Brexit is trigger for market liquidity migraine

June 20, 2016

The author is a Reuters Breakingviews columnist. The opinions expressed are her own. 

If asset managers are anxious before Britain’s European Union referendum, the traders who handle their orders are just as troubled. Market gyrations before the June 23 vote might make it look like they are in line for a repeat of the huge profits made following sterling’s 1992 exit from the Exchange Rate Mechanism. But the industry has undergone a sea change that could leave market-makers struggling even to ensure normal service.

Some banks and stock exchanges have warned clients that trading conditions could be difficult and volatile, and flagged the risk of large gaps in the pricing of assets. The problem of one-way traffic and illiquidity is already evident in the currency derivatives market, where Brexit concerns first showed up and where it has been most pronounced.

There’s been huge appetite for options to sell sterling and very little for ones to buy it. Such skewed demand leaves market-makers saddled with more and more risk. They have reacted by pushing up the price of such options to sky-high levels. One-week sterling/dollar implied volatility hit a record peak of 50 percent on June 17, though it has since subsided. The gap between the price at which market-makers will buy and sell volatility has also widened. It has doubled since the beginning of the month for one-week sterling options, to more than three percentage points in the case of euro/sterling and just over two percentage points for sterling/dollar, Reuters data shows.

The magnitude of the shifts is remarkable, but understandable. First, market-makers have grown accustomed to prices, especially exchange rates, suddenly taking off in one direction or the other, sometimes without rhyme or reason. Machine-led algorithms tend to jump on the bandwagon when they detect signs that assets might break out of ranges. The post-2008 decline of proprietary dealing means there are fewer humans to stand in their way by betting that economic or political reality will eventually prevail.

Second, banks have scaled back risk limits, partly due to post-crisis regulation which requires banks to hold more capital when they take more risk. Market-makers were also scarred by massive FX moves unleashed when the Swiss National Bank unexpectedly ditched its currency cap in 2015. Since then, kill switches on banks’ electronic trading platforms are triggered far more quickly when there’s too much one-way traffic, which can lead to “air pockets”, where prices lurch around a lot. All this makes life a lot less fun – and profitable – for traders than in 1992.

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