Insights and implications of the flash crash

Wishing all our readers a Happy New Year.

The first trading days of the New Year have progressed in much the same fashion as 2018 finished. Equity market volatility remains elevated and if yesterdays currency flash crash is anything to go by, volatility is now spreading into other asset classes, including G10 FX which up until yesterday had been mostly well behaved, despite large movements elsewhere.

A lot has already been written about the cause of yesterday’s currency flash crash and having experienced a handful of flash crashes while working on the institutional desk of Australia’s largest bank, including the GBPUSD flash crash back in 2016, most of it makes sense. However, perhaps I can shed some more light on some of the mechanics behind yesterday’s moves.

Market sentiment yesterday was already delicate following the release of a weak Chinese PMI number just a day earlier and then deteriorated further after Apple cut its Q1 guidance late in the New York trading day.

At 5pm New York time each day, liquidity dries up as bank traders in New York hand over the trading books to their colleagues in Asia. Although all bank spot traders are part of a global team, trading performance within the global team is segregated according to the three geographic centres (London, New York and Asia) before being segregated at an individual trader level. Each of the banks traders is then assigned certain currency pairs in which to manage client orders and in which to generate extra trading revenue.

 A typical split at an Australian bank might see one trader charged with looking after AUDUSD and AUD cross rates, another NZD and NZD cross rates, a third looking after JPY and JPY cross rates, a fourth looks after emerging market currencies and finally a trader assigned to managing the electronic flows. Obviously, there will be some overlap in the splits above, however on the desk there are no grey areas, each trader knows their role. If the assigned currency pair of a spot trader is AUD and AUDXXX, he or she would need very good reason to take a trade in the pairs within the NZD or JPY trader’s currency domain.

Mostly the trading style of bank spot traders is very short term. In and out very quickly many times during the day, with only a small number of traders taking positions home with them of an evening. Hence, during the “changeover” period, traders in New York generally want to go home of an evening square and traders in Asia prefer to start their day without a position. This means there is 4 or 5 traders at each bank (potentially 50 or more banks globally) without any orders in the market resulting in much less liquidity at this time than is usual during the day. Typically, it is after the banks whose Asian headquarters are based in Singapore or Tokyo arrive for the morning (2 -3 hours after Sydney opens) that liquidity returns to normal.

The two key implications from yesterday flash crash includes one that I follow myself. Between the third week of December and the second week of January being out of the markets is a good trading strategy and one that most professional trader follow. It’s a great time of year to refresh and enjoy time with friends and family. It also eliminates the risk of being stopped out on gap moves caused by markets being closed for holidays/reduced holiday liquidity.

The second is the recommended use of stop losses. Although yesterdays flash crash saw reversals in currency pairs including the AUDUSD and USDJPY there have been occasions when immediate reversals did not occur. Look no further than the move in GBPUSD in 2016 and the move in the Swiss Franc back in 2015 for a reminder of how stop losses can and do work in a traders favour.

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