"The Liquidity Just Dries Up In A Stressed Market" - How HFT Killed FX Trading

Two years ago, when looking at the first available public data out of HFT frontrunning powerhouse Virtu, we observed the surge in net income from FX at the expense of all other traditional product categories, and reported what we thought was "The One Financial Product Now Targeted By The HFT Swarm" - currencies and FX in particular.

We made the following forecast:

"for those trading FX, our condolences: because the typical bizarro, idiot moves that previously were reserved for stocks are now sure to take over the final bastion of capital markets. In other words, the next time you feel like the USDJPY is trading as if it is in need of a software update, you will be right."

We were also right, and two years later not only have thousands of FX traders lost their jobs (in no small part due to massive criminal collusion which has sent hundreds of riggers packing) to algos, but Bloomberg reports that in true HFT fashion which provides copious liquidity when it is not needed, and pulls all bids and offers the moment there is a violent move in the underlying, leading to an instant evaporation of all liquidity in what is now known as an "HFT stop" moment, "the specter of shrinking liquidity gripping fixed-income desks globally is creeping its way into the world’s biggest, most liquid financial market." FX.

Bloomberg adds that "amid conversations about central bank policy and algorithmic trading, it was concerns about diminishing liquidity -- or the prospects of it drying up entirely during times of market stress -- that dominated discussions this week at the TradeTech FX conference in Miami."

 

The so-called experts, who apparently could not see this coming from two years away, were stumped:

Pension funds, hedge funds and other asset managers were seeking answers after a string of so-called flash crashes in recent months sent some of the world’s most-traded currencies plunging. New Zealand’s dollar, the Norwegian krone and South Africa’s rand have all become victims to the phenomenon, as regulation pushes banks to reduce their size and cut down on market making. The ability to exchange currencies rapidly and cheaply is vital to everyone from importers and exporters to central banks seeking to ensure the smooth functioning of global markets.

Among the experts was Collin Crownover, head of currency management at State Street Global Advisors Inc., which oversees about $2.4 trillion,  who during a panel presentation said that "we are concerned. During volatile periods, market participants are backing away until conditions settle down, making it harder to complete large orders."

“A lot of the electronification of the market, which by and large is a good thing, has led to kill switches on a lot of that algorithmic-provided liquidity,” Crownover said. “The liquidity just dries up in a stressed market.”

Yes, it's called "high frequency trading" - get used to it.

The biggest irony is that even as investors lament disappearing liquidity, they are doing everything to make sure there is even less of it in the future: "Institutional currency investors are adopting more algorithmic trading that uses mathematical models to make transaction decisions, conference participants said."

While algorithmic trading in foreign exchange is growing, it remains limited compared with other markets such as equities, according to Kevin McPartland, head of research for market structure and technology at Greenwich Associates.

 

That presents opportunities as firms that create algorithmic systems seek to target institutional investors, according to Alfred Eskandar, chief executive officer of Portware LLC, which offers systems to manage and execute trades. Investment firms have tripled algorithmic trading in the past year, and “we actually think that’s going to triple again this year because there’s a couple of very large asset managers who now want to use algos,” Eskandar said during a panel.

In other words, so if currency traders though FX flash crashes are bad now, just wait until virtually all trading is done by algos whose only directive is to frontrun major flow orders, and just in case it is still unclear - the only time HFTs provide liquidity is when they know there is a solid order behind them willing to take actual market marking risk; if the HFT is itself the market maker in a thin and illiquid market, it will simply do what HFT have done since when Reg NMS first made them legal: quietly pull all bids and offers.

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