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Deluged Market Sank the Pound -- WSJ

14 Jan 2017 7:32 am

Automation and thin volume blamed for a 2016 'flash crash' in the British currency
By Mike Bird and Alistair MacDonald 

LONDON -- A "flash crash" in which the British pound plummeted 9% within seconds last October was likely caused by thin volumes and the sort of automated trading that has made such dramatic events more common, according to an investigation by the Bank for International Settlements.

The crash also happened when sentiment toward sterling was negative and as traders rushed to hedge their derivatives exposure to the currency by selling, the report said.

Sterling had been falling since Britain's June vote to leave the European Union, but its swift move that day sparked concerns over one of the world's most traded currencies and speculation that market manipulation or a "fat finger" had been responsible.

Instead, the BIS investigation said that there was likely no single factor that had triggered the drop.

The pound fell from $1.26 to as low as $1.149 in a move that began at 12:07 a.m. London time on Oct. 7, 2016. Such sharp and sudden market moves are an increasingly common event in modern markets, the report and market participants said.

"People thought that forex markets were more safe from this because they're so liquid. That might not be the case," said Robert Hockett, a professor of law and markets expert at Cornell University.

The report concluded that in a 10-minute period the market had been deluged by demand to sell when there was little supply. U.S. markets had recently closed, Asian traders were starting their day and it was night in Europe. Liquidity was further impaired that day by public holidays, including in China.

Those still participating were less "experienced in trading sterling, with lower risk limits and risk appetite, and with less expertise in the suitability of particular algorithms for the prevailing market conditions," the report said.

The plunge in the pound triggered client instructions, automatic trades and hedges requiring banks to sell as much as GBP3.5 billion in total, when there was just GBP2 billion in trading volumes, the report said.

Data from 12 of the most active traders in the sterling market suggests stop-loss orders and derivatives hedging may explain the imbalance in orders, according to the BIS, which collected evidence from U.K. regulatory authorities. Some traders completely withdrew from the market for up to 30 minutes as sterling tumbled, the report said.

Traders say sharp movements can happen because algorithmic-trading programs interpret the same information at the same time, potentially during a period when there is little human buying and selling. Stop orders are designed to limit an investor's losses. But they can sometimes feed off each other, with each successive price drop triggering a wave of automatic sell, or stop-loss, orders, sending the price sliding further and starting another round of selling.

Today, more than 70% of currency trading is conducted electronically and about a quarter or more is handled by automated, high-frequency trading firms, according to market-research firm Tabb Group.

The BIS said there was no definitive evidence to suggest that the fall was caused by a so-called fat finger trade or a deliberate attempt to push the pound lower, as some market players had speculated.

Still, particular trades may have helped to drive the drop.

"Individual participants could have had a significant impact on market functioning and prices traded," said the report. "U.K. supervisory data point to a significant increase in certain market participants' share of trading activity as others withdrew."

Among the banks trading at the time was Citigroup Inc., according to a person familiar with the matter. The bank declined to comment.

After the crash, U.K. regulators sent letters to around 20 banks warning them to be prepared for trading in low liquidity and to make sure that their algorithmic trading wouldn't unduly trigger large orders to sell, according to people familiar with the matter.

Bank of England Gov. Mark Carney said in a statement that no large financial institutions suffered material losses from the event, but stressed the importance of firms having adequate governance, systems and controls.

Research by Bank of America Merrill Lynch also credited regulatory changes that have limited banks' ability to use their own money in markets, or proprietary trading, for exacerbating rapid changes in price.

"In the past banks were able to catch a falling knife," said Athanasios Vamvakidis, a foreign-exchange strategist at BAML.

Even since the pound's October crash, there have been examples of sharp moves in currency markets.

On Dec. 29, the euro surged 1.5% against the dollar in a matter of minutes just before 7 p.m. in New York -- almost the same time of day as the pound's October fall.

--Max Colchester contributed to this article.

Corrections & Amplifications: An earlier version of this article misspelled Robert Hockett's name. (Jan. 13)

Write to Mike Bird at Mike.Bird@wsj.com and Alistair MacDonald at alistair.macdonald@wsj.com

(END) Dow Jones Newswires

January 14, 2017 02:32 ET (07:32 GMT)

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