The Bots of FX

By Greg McKenna, aka Deus Forex Machina. He is the CEO of Lighthouse Securities and has spent past two decades in financial markets in a number of senior roles including Head of Currency Strategy at the NAB and Westpac. Cross posted from MacroBusiness

High Frequency traders (HFT) have been around for a long time. What else were the locals on the SFE back in the floor days and at the establishment of many contracts except HFT? But we never thought of them in the way that many, myself included, think of the HFT guys these days. No, we thought of these locals as important providors of liquidity and a defence against markets gapping.

Sure you knew if you worked at a big bank that could move the market from time to time they would get in front of you sometimes or snipe away to take a point or two but equally you knew that some of the big guys, Rambo for example, would often take on big opposing positions to you.

But much has changed since those niave days when it was a local’s skill and cunning around the pit that made him or her an integral part of the market, loathed by some but respected by most, as just trying to make a quid.

Since the “flash crash” on May 6th 2010 the spectre of HFT rampaging with their computers around the financial landscape sniping points in nano-seconds has raised not the respect of market players but their ire.

But once again even this new computer generated version of locals is not new. For many years traders have been trying to build algorithms that could wander through markets making money. A large FX fund in Melbourne has been doing something along these lines for well over a decade now, and has built a successful track record.

But still high frequency traders are vilified. Recently I called them the Velociraptors of finance roaming the financial jungle devouring all in their wake. It’s a bit over the top as one of our readers pointed out and even changed his Avatar to Velociraptor to remind me I think, which is hilarious by the way.

My view on HFT hasn’t really changed though, I still think they need to be regulated but in a manner that doesn’t ban them from markets but seeks to regulate their size and influence in the markets. Some markets are just too small for these guys when they are in, but particulalry if for some reason, they are suddenly out.

But not FX it seems.

The BIS released a report this week on the impact of HFT in FX markets. The BIS says that the study group was chaired by Guy Debelle from the RBA so we know there will have been a lassiez faire hand on the tiller but still this is an important study.

In the Exec Summary the report says,

Having come to prominence in equity markets, high-frequency trading (HFT) has increased its presence in the foreign exchange (FX) market in recent years. This development is one aspect of a broader trend facilitated by the wider use of electronic trading in foreign exchange, not only in the broker-dealer market, but also at the customer level. HFT in FX operates on high volume but small order sizes, low margins, low latency (with trade execution times measured in milliseconds) and short risk holding periods (typically well under five seconds). As such, it occurs mainly in the most liquid currencies. While, to date, HFT has been most prevalent among the major currency pairs, it has the potential to spread to other relatively actively traded currencies, including some emerging market currencies.

In equities, where HFT accounts for a significant share of turnover in some markets,1 the rapid growth of HFT and the perception of predatory practices have generated heightened scrutiny and debate about the benefits and risks posed by this type of trading activity. A number of regulatory initiatives are being considered. A similar discussion is now emerging about the role of HFT in FX.

If you’d asked my what impact I thought HFT traders would have had on FX I would have said negligible because it is such a big, deep market. Although I have been chatting with mates on the desks in FX recently and heard the phrase “the robots are buying” more than once. But that of itself is not a bad thing.

The key findings of the report are essentially that although HFT in FX is something new it doesn’t look evil in “normal times”:

HFT has had a marked impact on the functioning of the FX market in ways that could be seen as beneficial in normal times. HFT helps to distribute liquidity across the decentralised market, improving efficiency, and has narrowed spreads. But the introduction of HFT to the market has affected the ecology of the FX market in ways that are not yet fully understood.

However:

Questions remain about HFT participants’ willingness to provide liquidity on a sustained basis under different market conditions. While HFT generates increased activity and narrower spreads in normal times, it may have reduced the resilience of the system as a whole in stressed times by reducing the activity of traditional market participants (eg major market-maker banks) who may have otherwise been an important stabilising presence in volatile environments.

Importantly it also says:

…recent experience suggests that HFT participants are not necessarily flightier than traditional participants in times of market stress and may be quicker to re-enter the market as it stabilises.

This is superb news but while this is only the thinest of slices of the report there is a sting in the tail that I must point out.

First, let me say I am excited that the BIS is talking about the “ecology“ of FX markets. This is an important step in the evolution of market theory and economics – those of us who belong to the school of economics that believe markets and economies are complex adaptive systems will be excited by this recognition. The BIS is evolving and with it so will economics.

But I digress, the sting in the tail is clearly about how the market evolves and what impact these traders have on the ultimate providors of liquidity in FX – the banks. The BIS says:

Many of the “predatory” or “unfair” practices attributed to HFT participants, in the light of their technology-driven ability to detect orders and take advantage of latencies, are in fact not new. HFT is but the latest high-tech, high-speed manifestation of them. A key question is whether other market participants are able to adapt to the presence of HFT, and how the market environment will be affected when those failing to keep up change their trading behaviour or exit the market completely.

Bank traders have a tough job. You can sit there all day trading your 5′s and 10′s and then a client can in at the end of the day and ask for a price in a couple of hundred million or more. I did it to a bank about 2 minutes before an important figure one morning. The guy read me wrong. He thought I was a buyer when I was a seller, got caught with a position, had no chance of clearing it and would have lost a heap and had a bad day. I’m not so rude now by the way.

These HFT guys roaming through the landscape will complicate what is already a complex and difficult job. So we might actually see a retreat from the market by these guys as they ask a reasonable question of why they should put their job at risk and their bank’s capital on the table for the “robots” to attack?

The BIS says:

In sum, HFT in FX is a rapidly evolving phenomenon. It is having a notable effect on the structure and functioning of the FX market, and is prompting behavioural changes in other market participants. All these influence the resilience of the system as a whole, although the impact will continue to change as various participants – including major FX dealers, prime brokers and trading platform operators as well as HFT firms themselves – adapt to the new ecology. Policymakers should continue to keep abreast of this development by maintaining contact and dialogue with the evolving set of relevant market participants.

Amen to that last bit.

So HFT has in some way or form been around for a long time. I still believe that with the curent level of trade in FX markets daily and the current structure FX is one market that can accomodate the HFT guys and girls. But evolution is a strange thing and as the BIS says their presence will change the behaviour of other participants. It may have already – the volatility of the Australian dollar, amongst others, over the past week suggests the market is not functioning as it once did.