48 hours into the CHF debacle, it’s always healthy to carry out some post-mortem analysis to learn the lessons of why it happened, and what we could have done to weather it better.
Since we’ve done it, why not share it?
The Macro Story: Black Wednesday, Redux
What happened is crystal clear with the benefit of hindsight (as it always is).
The CHF is a currency safe haven, albeit a rather illiquid one, since it’s only backed by a tiny and financially hypertrophic economy. Ever since the EUR crisis, everyone and their mother placed some of their safety net in CHF – so much so that the Swiss National Bank was forced to ¨intervene¨ to peg CHF at 1.20 to the EUR.
The intervention mechanism was: whoever bought CHF close to 1.20 sold to one counterparty, and one counterparty alone – the SNB. In broker parlance, the SNB became the daddy of all market makers by being the only player in the market with “unlimited” access to CHF close to the 1.20 EUR/CHF cliff. This filled the balance sheet of the SNB with foreign currency reserves… above all with a boatload of EUR, for EUR area is the Swiss’ primary commercial partner and the home currency of nervous Europeans who by now trust neither their “unbreakable” currency, nor their tax agency (the latter being food for another post).
With the EUR crisis on its way back (it has never really left…), the EUR has gone on a free-fall, and EUR reserves were drilling the daddy of all P&L hits in the SNB balance sheet. That was before Herr Jordan got Mario’s phone call kindly announcing QE. Herr Jordan’s press conference is (financial) history being written as we speak.
Black Wednesday on September 16th, 1992, George Soros hit the headlines.
Actually, he didn’t until after the dust settled. On the January 15th Donnerstagsdebakel (made this up, but it’s fitting, for Thursday is the day of Thor and Thunder, depending on the language you choose), someone else hit the jackpot.
We just don’t know the name of the winner yet: journalists are still chasing around for a name and a photo to head their scoop.
The (Retail) Micro Story: Dancing on a Cliff
We (traders, brokers, broker-dealers and dealers) went about our business, unabated.
Traders saw juicy price action dynamics at that level, and we brokers readily offered (leveraged!) trading access to the CHF. Again with hindsight, we were all dancing on a cliff… not wondering too much what would happen if (actually, when) Hoover Dam fell.
So far, all pretty standard, really.
The interesting (and sad) bit is that the Fall affected brokers (A-Book) and dealers (B-Book) in tragically different ways – just as you’d expect it, for brokers trade with customers and dealers trade against them.
a-book, aka Involuntary, Contingent Market Makers
The moment the previous market maker (the SNB) went on strike, Hoover Dam fell and sent the EUR on a free-fall against the CHF – which called the next market makers to action: customers short the CHF and their collateral posted with their agency only brokers and Prime Brokers (we’re pure a-book).
Once that was exhausted (the higher the leverage offered, the faster), brokers’ and Prime Brokers’ stop-losses triggered, but there was no market, so the margin we had posted with our Prime Brokers was the market. We, a-book brokers became involuntary (and ill-equipped) market makers of sorts.
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Technically we ran no risk since actually it was our customers shorting the CHF who got smacked. In practice, FXCM (and us) now know better: you can’t hire an army of lawyers to track thousands of micro debts because each debt is smaller than 30 min of lawyer fees.
So there you go. If you’re looking for victims of Donnerstagsdebakel, you’ll find more than your fair share in the lines of pure agency Brokers and Prime Brokers who catalysed spot foreign exchange flows between macro (Tier 1 Banks and Central Banks) and micro (Hedge Funds, retail traders, Tier 2 institutions) market makers.
b-book, Bucket Shops
The retail spot forex trading arena contains close to a 1,000 unregulated, undercapitalized, over-levered dealers (= bucket shops) who make markets against FX punters.
How did they fare?
Just fine, thank you.
They kept the deposits of those that short the CHF, as they always do – and they didn’t have any losses with wholesale counterparties to match (all they do is trade against customers, remember?).
So how about the winners? You can bet that 99% of those outfits will keep the P&L of winning customers, as they always do. That’s when operating an unregulated casino comes in particularly handy.
So there you go. If you’re looking for more victims of Donnerstagsdebakel, go find would have been George Soroses… who discovered a tad too late that trading with an unregulated bucket shop is a variation on the age old “heads I win, tails, you lose” coin toss.
For our part, we came out of this just fine, partially because we did some things right, and partially because we were small & lucky as Donnerstagsdebakel hit.
What we did right was to anticipate the on-exchange move. We have been clearing all our flow with LMAX (a MiFID regulated MTF), partially because we think that there’s too much information asymmetry in OTC forex, partially because Exchanges facilitate clearing and settlement (go ask Saxo customers being re-quoted on their CHF trades), and generally because we think that on Exchange is the proper way of doing things.
We were lucky because we had minimal CHF exposure, both in absolute terms and in relative terms both to the bulk of our business and our capital base. So we got hit, but it was pea-nuts.
All in, this was the cheapest life-saving lesson we will ever learn. And you bet we’ve learnt it.
The Road from Here
It was probably going to happen, and the regulators were probably looking for a justification… and now they’ve got it.
Spot currency exchange market is the biggest in the world. Because it’s also the oldest in the world, it had stayed OTC way after technology and common sense recommended that it got moved on exchange. The only thing holding it back was the mess of having to put in place an alternative to the network of broker-dealers that kept it going.
What went down the drain last Thursday were the internal pipes keeping the OTC foreign exchange market flowing (the largest in the world). Tens, possibly hundreds of legitimate financial outfits went belly up, and most likely the man on the street doesn’t know a single one of the casualties by name.
With that gone, the inconvenient regulatory ought to do has become an urgency… so if you have an opportunity to invest in a Multilateral Trading facility that clears foreign currency, you can bet they’re going to be faceless big time winners of this, alongside the next George Soros.