Algorithmic Trades Behind Pound’s “Flash Crash”

algotrading

For two minutes, the Asian trading market was baffled as the pound went on a steep 6.1 percent crash against the dollar Friday morning. The two-minute slump was speculated to be intensified by algorithmic traders.

Algorithmic trading, or algo-trading, is the trading process where computers are programmed to execute a defined set of instructions for placing a trade. This kind of trading is used to generate returns at a beyond-human pace and frequency. Also, sometimes, they are done to eliminate emotional impact on trading activities thus making it more systematic and more liquid. Algo-trading is also known by names like automated trading or black-box trading.

Anxiety over the closely-watched U.S. jobs data also filled the trading day as the data will somehow set the Federal Reserve’s tone in its monetary policy for the rest of the year.

The decline sent sterling to its 31-year low of $1.1841, according to Bloomberg’s compiled composite prices of contributions from dealers. Worries over a ‘hard’ Brexit already sent the currency freefalling for the past weeks but Friday’s slip marked its weakest performance since 1985. Traders who chose to remain unidentified due to privacy policies said that one electronic-trading platform recorded a transaction at $1.1378.

Foreign-exchange market analyst Derek Mumford, who also advises companies on foreign-exchange and interest-rate risks, set out to find plausible reasons for the chaotic phenomena. Some speculations include the French President François Hollande being in favor of a hard Brexit, and recirculation of the ‘fat finger’ trade rumors.

“I think the pound move has possibly spooked traders but in reality, it looks like a combination of a fat finger trade, low liquidity, stops being triggered and algorithms capitalizing on the move,” said Oanda senior market analyst Craig Erlam through email.

He also added, “The fact we’ve recovered most of the losses would suggest this is the case.” But for Mumford, these reasons are just too small to justify the humongous drop.

“It was out of proportion to the supposed trigger,” said Sydney Rochford Capital Pty director.

 As of the moment, the exact explanation for what triggered the drop cannot be pinned down but Mumford and other analysts have the same opinion about the matter—that sell-offs were somehow exacerbated by black-box traders.  According to Aite Group, a consultant based in boston, these so-called algorithmic transactions have tripled their number in the foreign-exchange market over the last three years, responsible for near-$200 billion of daily turnover.

A sense of déjà vu occurs to traders as this is not the first time that a trading market experienced an ‘unexplainable’ movement. Bouts of intense volatility are becoming common phenomena not only in the global currency market but in other trading markets also as transaction volumes diminish and algorithmic traders raise market share.

The South African rand slumped more than 9 percent within 15 minutes before regaining loss in January while New Zealand’s dollar also had its flash crash last August.

“This is not something you would expect in a half-efficient market,” said Ulrich Leuchtmann, Commerzbank AG head of currency strategy in Frankfurt. “We have a liquidity situation which has eroded massively over the last few years and policy makers have largely ignored it. All the regulation that we have in place, for good reason, has the side-effect that liquidity in the FX market is much more shaky and fluctuating heavily, and we have times when it’s extremely low, especially in Asian trading.”

eurozone

Although sterling’s intraday drop of 11 percent in June after U.K.’s surprise vote to exit the European Union was bigger than Friday’s plunge, the latter was considered more strident by traders as it was much unexpected and it just happened in a very short period of time.

The move was also somehow a reminder to several dealers of the reaction to the Swiss National bank’s shocking decision to leave franc’s cap against the euro in January 2015, sending exchange rates to shoot up at more than 40 percent.

For Ralph Achkar, capital markets product director at Colt, it is still a premature conclusion to direct the cause of Friday’s rout to algorithmic traders.

“We have come across several market incidents where the initial finger was first pointed at algos, only for it to turn out to be human error or otherwise,” said Achkar.

The cause of the crash is now being looked into according to a Bank of England representative.

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