Last night the British Pound shit the bed. Full stop. Can’t really couch it any nicer than that. There is no other way to describe the 6% swoosh lower at the start of Asian trading.
Actually, Guy LeBas from Janney come up with a far wittier line:
I am long and wrong with my long term Pound position, but that’s not what I want to discuss. Although as a trader I thoroughly enjoyed flipping around cable last night and this morning, this low volume flush is deeply troubling. This is not how financial markets are supposed to work.
There was no real news to account for the extreme move. Yes, Hollande mouthed some tough talk rhetoric about the Brexit negotiations, but that should not have sent the British Pound plunging.
As far as I can tell, during the NY session the Pound broke to new lows, and then a lack of liquidity, combined with a minor headline caused a chain reaction of selling when Asia opened.
It has been a long time since I have sat on a sell side trading desk and until recently, I didn’t understand how much they have changed in the past decade. The other day over beers, one of my old trader buddies (who moved on to create an extremely successful Canadian hedge fund), described the full extent of the hollowing out of the sell side. He told me how desks that used to be stuffed with twenty salespeople/traders are now staffed with two. Not only that, when you phone them up, their usual response is to simply shove the order in the machine.
In our day, we were allowed to trade for the bank’s balance sheet. We were constantly monitoring markets looking for inefficiencies we could exploit. For proprietary traders like myself and my buddy, although it was better form to provide liquidity for clients, we didn’t need a client order as an excuse to trade. If there was an opportunity to profit, that was good enough. In doing so, we kept the markets in line.
Fast forward to today. The Volcker rule has mostly eliminated this sort of behaviour. Dealers have strict rules where they can only trade principal when a client initiates a trade. Not only that, but many dealers have concluded that proprietary trading is not worth the risks and hassles.
Therefore this next chart should surprise no one:
Dealers are extremely reluctant to use their balance sheet to keep markets in line.
Increasingly traders are being replaced with machines. When I was a young buck, financial securities used to trade up and down in a much more choppy pattern. Nowadays, with the prevalence of VWAP and other algorithmic trading, it is a constant drip, drip, drip one way all day. Then the next day some fundamental news changes the direction, and it is the same drip, drip, drip, the other way.
My millennial aged replacements might argue this is a much more efficient way to trade, and maybe they are right. But what we need to recognize is that with all these changes, there will be many more GBP type flash crashes.
You can’t have fewer traders and less capital arbitraging the markets, combined with computers pushing the “real orders” one way, and not expect accidents.
And although I used the word crash, it could just as easily be the other way. As was the case during the October 2014 bond melt up:
There are unintended consequences to the rules put in to safeguard us from previous crises. Remember everyone hedges for the last crash and regulators are no different. Just instead of hedging, they are busy regulating. And in fact, given the crash, the market would probably self adjust without any need for new rules, so all the regulators end up doing is creating new problems.
The financial markets are not better off today with all these new rules. The Volcker rule was not needed to stop the banks from doing stupid things with their proprietary trading - the dumb banks should be out of business.
Regulators will continue to be surprised by these GBP type flash crashes, and no doubt they will probably come up with some more rules to try to eliminate them, but in reality all they need to do is ensure a level playing field for all participants, and get out of the way.
I will leave you with a link to this great piece from Polemic’s Pains describing last night’s trading from a sell sider’s perspective. Anyone who has ever worked on a dealer trading desk might find it a little too accurate…
Monday is Canadian Thanksgiving so there will be no MacroTourist. Have a great holiday everyone.
Thanks for reading,
Kevin Muir the MacroTourist