What happened?  – some historical context.

I have been in the City for over 25 years. My first year was 1986, and I started life in Stock Broking. One year on saw the Crash of ’87. As a youngster I was pretty taken aback by what happened, but on reflection not as aghast as some of the older chaps I was working for, who had never seen anything like it. I think this stood me in pretty good stead for the next 25 years, and what went on last week didn’t really surprise me. Nothing does any more, especially when it comes to Central Banks.

So what exactly happened? Well after 4 years of effectively pegging their currency to the Euro at 1.20 EUR/CHF the Swiss National Bank finally gave up the battle and said “okay, do what you want”. This came as a surprise to almost all of the market and saw the Swiss franc roar higher. The two main currency Crosses that are traded for the Swiss Franc are USDCHF and EURCHF.

EURCHF had a “floor” set by the SNB at 1.20. They removed this floor in one surprise announcement and this prompted a move down to 0.80-0.85 (depending on who you get your data from!) in the immediate aftermath before prices recovered to steady out around 0.85-0.90. This 40 point, or 4000 tick move in 15 minutes is pretty much unheard of, especially as there was NO prior warning. Often these sort of extra-ordinary events are called a “Black Swan” but as one of my clients pointed out it was not that, because the SNB would have removed this floor AT SOME POINT.  Maybe in hindsight it wasn’t such a surprise, but there’s plenty of hindsight thinking going on about this now and I’ll try and avoid that here.  One thing’s for sure, it took pretty much everyone by surprise, and was one of the most violent moves I’ve ever seen in my career, and I’ve seen plenty in between 1987 and Thursday January 15^th 2015.

I like Twitter. It is one of the better “forums” for sharing of information. Here at FuturesTechs we send out our thoughts on the charts once a day in the morning, so Twitter can be a good place to post updates if things veer from our morning Analysis. It also gives me the news as quickly as most outlets I’ve relied upon previously. Here are some of my early tweets on Thursday in the immediate aftermath:

9.31:  Eurchf peg gone?

9.51am:  There will be a lot of stories over the coming weeks or months about P&Ls & what just happened. That’s a Black Swan the size of a Jumbo jet.

9.56am: Where will SB and FX firms fill stops for Retail mob, and who will wear losses to those in negative? Gonna be lots of questions like that…

12.14pm: Looking at monthly chart for EURCHF. Bigger move in that 15 mins than we’ve ever seen in a single month… Wow.

This dramatic move in the market saw an almost total “dry up” of liquidity, so no-one could trade, all the way down the chain, from the big boys to the Retail “punter” trading with a Spread Bet firm or FX trading operation.

Who did it effect and how?

At any point on the “food chain” if you can’t trade you’re stuck with what you’ve got. This means if you were long EURCHF (same applies to USDCHF, GBPCHF and any other Forex Pair related to the Swiss Franc, but I’ll just refer to EURCHF from now to try and keep it simple) you were pretty much STUFFED, whether you were Deutsche Bank or Joe Bloggs with an account at Alpari. If you were short EURCHF you suddenly saw a big jump in your P&L, probably bigger than anything you’ve seen before in such a short space of time. The problem is there was no liquidity, so if you wanted to BANK your profits you couldn’t. Arguably (although there will be less sympathy for this group than others who lost their shirt) they too were STUFFED; unable to trade out of the position.

So there were winners and losers, and in this instance the losers seemed to outweigh the winners, at least that we’ve heard about.

At each stage of this food chain who won and lost then? Let’s try and pick over the wreckage.

 – Market Makers/Liquidity Providers/Large Banks

FX Market Makers are in and out of the market all day every day and will generally make money by “nicking” ticks; tiny increments between the bid and offer. This is done on a large scale by all of the big banks, and its big business. These traders have access to up to the minute information on news, order flows, the fastest computers/algorithms, and the best Analysts money can buy (allegedly!). Arguably they should be best placed to take the best/fastest advantage of anything that’s going on and to profit from it. Until you get caught with a position on an extreme move that no-one anticipated. USUALLY in these situations they can quickly work out what’s going on and find a price that they should be quoting on that basis, thus fulfilling their brief to provide a market.

However last Thursday’s move was so out of left field that these guys, in the main, just STOPPED quoting prices. As they’re the business end of the entire FX market this was not very helpful to anyone other than themselves. They all work for big banks though, and since the financial crisis have been told in no uncertain terms that they’re not to take excessive risk. In this instance they took that as “Don’t quote anything, because no one really knows where this should be”.  If you don’t give a quote you can’t get hit. Simple!  They may also have been busy trying to get out of their existing positions, let alone taking any more. So the fortunes of the “big boys” may well have been mostly linked to which way round they were when the news hit. The SNB didn’t even tell the IMF and this appears to have been a well kept secret, judging by the way it was greeted. You can be assured if anyone in this echelon of the industry DID get a “tip off” they’re not going to shout about it!

So far we have heard rumours that Citibank took a big hit, there has been some talk about Barclays, and also some whispers about JPM and Deutsche Bank, all BIG players in this space.  I’m sure they can “hide” anything that isn’t too disastrous!  There are MANY other operations/trading desks within Investment Banks that would have felt a knock on effect, but having not been in this space for 15-odd years I am not best placed to comment. I would welcome any comments or observations people may have, but by e-mail please (I ignore Blog post replies as they’re pretty much all “spam”).

 – Hedge Funds

Hedge Fund Managers are bright people, in the main. I would bet we won’t hear too many horror stories. There has been one (a fund in the US called Everest has gone under according to this story from Bloomberg).  Hedge Funds can deal direct with the big banks and would likely be the first people to get any fills. They are the best customers, so they will be looked after. I’m sure we’ll hear more from the Hedge Fund world in the coming weeks and months re any hits or wins from last week. From a reputational point of view a fund that made money on this will be a lot happier to tell the world than one of “those Fat Cat Banks” (Yes, the inverted commas are deliberate as I’m kind of tired of “banker bashing” in general. It’s so last decade). Let’s move on…

 – Retail FX Firms

This is where the headlines have hit, and probably not surprisingly, as we’re talking about a world that is largely unregulated, often undercapitalised, and very much the bottom of the pecking order as far as the big banks are concerned. But they rely heavily on the liquidity providers (the big Banks). This is a cornerstone of their business model, and in my opinion last Thursday they were let down (Sounds like banker bashing to me!!).  The way it works is these firms get orders from clients and have the choice of doing one of two things: Take the risk that the client will be wrong or will lose (many of them are/do, some say up to 90%) like a bookie or a casino would, or pass the risk on to another party (the big bank/liquidity provider/market maker, call it what you will). Taking the risk on your own book is known as putting it on the “B-Book”. This relies on clients being wrong, and can be very profitable. As I’ve already suggested it’s often said that Retail customers are very good at buying high and selling low, so if you take the other side you should be fine! In the main (and in hindsight!) this would have been a very profitable approach last Thursday, because there were A LOT of Retail customers were long EURCHF, certain that it would not go below 1.20, thinking that buying just ahead of here was a “no brainer” with minimal risk and big reward. If you had been on the other side to these orders you would have been very short, and made a lot of money.

The alternative is running an “A” Book operation, where you don’t take on any risk from your client orders; you just pass the trades on to one of the big boys, and take a small turn on every trade. This means no risk. Well, let’s re-phrase that. This SHOULD mean no risk… and this is where it all went very wrong last Thursday.

But there are a few other things we should know about these firms before we move on to what happened to them last week.

1. Some firms stick to either an “A book” model or a “B book” model. Some have trading desks or algorithms that mix and match the two approaches. As far as I’ve seen over the years the ones that have found the right mix do so by taking on a certain level of client business until their “book” becomes too heavily weighed either long or short, at which time they’ll “hedge” the position. However market conditions can make either approach preferable over the other.
2. These firms make a small amount of money every time a client trades, so they want their clients to trade lots! Therefore…
3. …they offer the opportunity to trade with leverage, sometimes VERY HIGH leverage. Like 500:1. In other words you can trade £500 a point by putting up just £1. This can mean very quick profits. It can also mean very swift losses, and oftentimes sees accounts “blown up” very quickly, as clients are not fully aware of the risks involved (This is why these firms spend so much on marketing, sponsoring Premier League football and the like; they need a continuous flow of new business).
4. All of these firms offer a number of (sometimes sophisticated) trading “front ends” for clients, and offer the opportunity to place “Stop loss” orders. I felt the need last week to tweet the definition of a stop order. It is this: “A sell stop is a market order once the market price drops to or below your trigger price”. In other words if your order was to sell on stop at 119.90 and the first available bid was 110.00 then that’s where the stop order should be filled.  This statement will upset people, but it is FACT.
5. There is a second type of stop order often offered by the Spread Bet / FX firms; a GUARANTEED stop, eg Sell at 119.90 guaranteed. They charge you extra for this on the spread on entry, but arguably it’s a good insurance policy against “slippage”, which can sometimes see fills 10+ points below where a client’s stop was triggered.

As far as I am aware Alpari was working an “A” book, and have been for a while (having suffered losses on the “B book” in recent years). So they had no risk, but high client volumes, the perfect model for safety.  – Not so as it turns out. Why not?

Because their Liquidity Provider(s) basically said, to paraphrase the Little Britain sketch “Computer says no”. They had clients with highly leverage accounts that were deep in the red but were unable to close the positions. They are unlikely to be able to recoup these losses from the clients, especially very quickly, so suddenly they had a big black hole. Meanwhile at IG, as far as I can understand, they had to fill a whole heap of guaranteed stops that were triggered, effectively meaning they needed to go to the market with sell orders and “wear” the difference, except there was no one to sell to. The clients had their fills, they’d taken their small loss. They were fine. IG were stuck with these positions, and couldn’t find anywhere to sell without taking a big loss; £30 million at first blush. I have to say I was pretty impressed with how quickly IG knew this and announced it, and IF this figure remains in this ballpark a lot can be said for their risk procedures, and the way they honoured the stops.

This is the crux of the whole thing. Stops are market orders. You need a market though, and for at least 15 minutes (and arguably for over an hour) last Thursday there wasn’t one, particularly for these sorts of firms. They had no one to trade with, but their clients wanted to trade and be filled on their stops. Oh dear, what a bloody mess.

 – Retail firms’ clients

When you sign up for a Spread Bet or Forex account the Terms and Conditions and/or disclaimers say that you can lose more than your initial deposit. The higher the leverage the quicker your money can disappear, and the quicker you can go into the red. Many firms don’t allow this and will cut your positions if you go into negative, because an account in the negative become a debt, and debt can be tough to chase and recoup.

If there are alarm bells that go off at these firms when an account goes negative they would have been deafening last Thursday at 9.31am.

But they were unable to cut these losing positions at that moment, because there WAS NO MARKET; nowhere to sell!

So if you were told by an old mate that EURCHF could NOT go below 1.20, and you should open an account with Arthur Daly FX, who will give you 1000:1 leverage, put £500 in the account, and buy £50 a point at 1.2008 with a 10 tick stop at one point last Thursday morning, if it hadn’t been closed, that position would have been showing a loss of £200,000. I’ve embellished this on purpose, although SOMEONE sold at 0.80 last week. I heard a number of stories of stops being filled for Retail customers 1000-1400 ticks away from their trigger price, which still would have been a £50,000 (to £70,000) hit to our chap who bought £50 a point. “Sorry, but that’s madness” would have been many a Retail traders’ retort on seeing their accounts swing into such negative equity. They soon realized that actually it very was real. Now if you were a plumber from Croydon earning £25,000 a year and suddenly owed a spread bet firm £50,000 I’m pretty sure I know what you’d say to them. What a mess.

But here’s the thing. If the firm got filled at 1.10 and then filled the client at 1.10 they’ve not made a bean. In fact they’re most likely to lose the negative balance in the client’s account because it’s highly unlikely they’ll get it back (is £50 a month for the next 83 years okay?).

So while there will be stories of the man on the street “blowing up” at the hand of unscrupulous Spread Bet/FX Firms there are two things to say about this:  “Joe Bloggs” put the trade on, and he/she signed the Ts and Cs. This sounds like I’m sticking up for the Companies. In this instance yes. I do believe there are some sharp practises going on in this space, but that’s for another time. I’m pretty sure on this occasion there were very few winners (apart from those on the right side of a guaranteed stop).

Lessons to be learnt

There has been talk that it was completely irresponsible of the SNB to surprise the market in this way. Central Banks have a responsibility to facilitate fair and orderly markets, and this move went completely against this. One commentator I saw suggested that they should have stopped buying above 1.20, let the market drop through here, let stops be triggered in a (relatively) orderly manner, then pulled the rug. Seems reasonable…

One of the biggest lessons that must surely come from this is regulatory though. How many times do we have to have “extra-ordinary events” that were never even thought of in risk models? The FCA are responsible for firms operating in the UK and have been far less keen to hand out licences to firms like this in recent years, however it is the FSCS that has to “bail out” firms that go bust and leave clients owed money. Surely the FCA have a responsibility to do what they can to make sure firms are adequately capitalized and prepared for this sort of event, so that the FSCS pockets do not get raided. On the other hand FX is a global business, and we come back to the same old problem of “Regulatory Geography” as I call it: If the FCA come down too hard on these firms they risk that business leaving London, and the clients may end up worse off under other countries “lighter touch” regulatory regimes. Again, what a mess.  

To sum up from where I sit (on the sidelines mostly, being an Independent Technical Analyst with no real “skin in the game”) there are going to be few winners out of this, all the way down the chain. There will be more stories of casualties. The best we can hope is that lessons will be learnt re risk and commitments and responsibilities different parties have to each other. Without doubt this will reverberate for a while, but my hope is the FX markets can emerge from this stronger.

Thank you to all my Twitter followers, clients and friends for some excellent updates and also to Forex Magnates, who have been pretty much on the money with most of their updates in recent days. They are keeping a “crib sheet” of businesses affected. Here’s the link:  http://forexmagnates.com/forex-industry-battles-eurchf-meltdown-real-time-updates/

I will sign off by repeating something I said on Linkedin last week:

“Oh dear. what a mess. This one will run and run, and shows that the FX Markets are pretty much dysfunctional. Best wishes to all my friends and colleagues in this industry and I hope you all come out of this okay. To those who don’t, remember some things are more important than money, and tomorrow is another day… Take Care all”.

Clive Lambert is the owner and chief contributor to FuturesTechs, an Award winning Independent Technical Analysis company producing daily reports on Fixed Income, Equities, Commodities and Forex Markets. Click here for a free trial.

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