Brokers beware!

The Brexit and the Pound: a Tale of $16b Worth of FX Options

Liquidity conditions in GBP pairs are deteriorating amid increasing uncertainty.

Today being an Easter holiday across Europe with markets closed is a good opportunity to assess liquidity conditions across the spectrum. No you’re not reading wrong: while liquidity today is thin, this day provides us with a rare opportunity to get a glimpse of which pairs remain liquid despite the majority of traders being away from their desks.

While spreads across most majors like the EUR/USD, the USD/JPY and the AUD/USD have been fairly normal at between 1 and 3 pips, the conditions in the GBP/USD pair are notably worse than usual. This morning spreads on the pair have been fluctuating between 4 and 10 pips, which speaks a lot about the liquidity conditions on the market.

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As the Brexit vote in the United Kingdom is approaching, the British pound volatility premiums continue rising. The pair has been declining steadily against its all major counterparts, while the public in the UK has been contemplating whether an exit from the European Union would have any negative effect on GDP growth and living standards.

While the “leave” camp is advocating the resilience of the financial sector, traders have been profiting from and continuing to bet on a falling British pound. Since the start of the year and the intensification of the Brexit debate, the currency has lost 4.1 per cent against the U.S dollar, 7 per cent against the euro, almost 10 per cent against the Japanese yen and about 7 per cent against the Australian dollar.

Brokers Should be Prepared for More Poor Liquidity

While we are a year on from the Swiss National Bank induced foreign exchange crisis, British referendums tend to have a profound impact on the British currency. That said, last year’s Scotland secession poll is nothing when compared to the vote today. In fact, should we see a ‘leave’ result in June, Scotland would most certainly vote on its secession once again.

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All of this uncertainty means that brokerages should be prepared for more poor liquidity conditions across the GBP pairs and manage their exposure appropriately. The three month implied volatility premiums on the GBP/USD pair are the highest since the heights of the European sovereign debt crisis in 2010.

According to market information cited by Bloomberg, while British voters are wondering how to vote and contemplating the impacts of a prospective Brexit, traders are taking advantage of the situation and are calling on a crash of the British currency to levels last seen in the 1980s.

The data cited by Bloomberg suggests that over 11 billion pounds (almost $16 billion) worth of bets have been placed this year on a Brexit and on a subsequent decline in the value of the pound to below $1.3502, which is only 4.5 per cent lower than current levels. About half of these bets have been placed after the announcement of the date of the referendum on February the 20th.

Volatility Up Until and Possibly Beyond June

While the Brexit is far from inevitable, the amount of volatility in the currency markets is likely to be substantial leading into the event. Moreover, in case of a divorce between the UK and the EU, volatility will continue beyond that.

What does this mean for the industry and for brokers? Simulation of extraordinary market conditions, risk management with out of the money options, controlled risk exposure, counterparties checks, liquidity providers preparedness, warnings to clients… we can continue with a long list that goes beyond. But this is not the point of this article, the point is that now that winter is officially over, brokers should prepare themselves for a tumultuous spring season!

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