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Are FX Brokers Prepared for Another Black Swan?

As "Grexit" talk grows stronger, trading industry insiders weigh in its ability to survive another round of extreme volatility.

According to the latest indirect communication between Greek and German finance ministers Yanis Varoufakis and Wolfgang Schaeuble, the likelihood of a Greek exit from the Eurozone is increasing. This spells trouble for the main lenders to the country – the International Monetary Fund (IMF), the European Financial Stability Mechanism (EFSF) and the European Central Bank (ECB).

Speaking at sessions of the 2015 IMF/World Bank Group Spring Meetings both debtors and lenders expressed firmness in their tone. Varoufakis insisted that his country is on an unsustainable path (which is probably true), while Mr. Schaeuble highlighted that fiscal consolidation is part of the medicine, instead of the problem (which is also probably true).

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How strongly would a “Grexit” scenario affect the foreign exchange industry?

In both cases, the wording used by the finance ministers was strong and uncompromising. The word “grexit” has again become a key search term. Can the possibility of Greece exiting the Eurozone impact the foreign exchange industry as strongly as the Swiss National Bank move in January? Or will it be more of a Lehman type event, which gently increased spreads for a couple of months?

Finance Magnates spoke with a number of industry insiders to get their take on the matter.

ThinkLiquidity is a company which is primarily focused on providing risk management technology and services for brokerages. The firm’s Managing Director, Jeff Wilkins said, “The Greek crisis will certainly drive volatility and volume, but to compare the potential to what happened on January 15th is an ‘Apples and Oranges’ situation.”

In the short term, volatility will kick into high gear as we approach payment deadlines.

“Brokers need to be ready for increased volatility, but this event will not unfold in 15 minutes like the SNB announcement. This has been brewing for well over half a decade and the market impact may last just as long. In the short term, volatility will kick into high gear as we approach payment deadlines,” Mr. Wilkins explained.

If the Lehman Brothers crisis is any guide, then the impact of a Greek exit on the currency market should be materially different from January’s SNB black swan.

That said, a couple of insiders do not think that the industry is prepared to handle another event deemed as ‘extremely rare’.

Most firms do not have enough capital.

CEO of Middle East based clearing house Fortress Prime, Mitch Eaglstein, explained, “Most firms do not have enough capital and the clamping down on leverage from tier-one prime brokers have only exacerbated this problem. Companies require more capital to operate post-SNB than pre-SNB. This means that existing players must forge partnerships with stronger firms. Only then can they maximize the profitability of their client base in order to thrive in the new post-SNB industry paradigm.”

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Divisa Capital is an FCA regulated boutique prime broker offering bespoke bank and non-bank forex and CFD liquidity. “Some of the large and most regulated brokers definitely took notice of their shortcomings during SNB event, but we can see that most of the industry went back to business as usual,” opined CEO Mushegh Tovmasyan.

“There is a big gap of knowledge in the industry between brokers that proactively dealt with the situation from SNB first hand and others who got lucky and simply took it for granted and continue as business as usual.”

Some prime of primes genuinely navigated the last black swan event, but others just got lucky

“Some prime of primes genuinely navigated the last black swan event due to various factors, but others just got lucky because their technology conveniently failed or they happened to be on the correct side of the B-booked trades. These are the brokers at risk that continue to operate thinking it was their brilliant risk management practice or counterparty choice that helped them avoid disaster when in fact it was sheer luck that might not be there next time around,” he concluded.

The next stress test for the FX industry, could be lurking around the corner, but none of us know what it is yet. In the words of Mr. Eaglstein, “Black Swans are inherently unpredictable and only obvious to the market as a whole in hindsight.”

How exposed is the rest of Europe to a Greek default?

A report by Reuters over the weekend highlighted that if Greece misses a payment to the IMF, the international last resort lender could be facing various difficulties. But what about those European institutions which are on the hook – the EFSF and the ECB?

According to the latest data available, the financial mechanism designed to backstop the European sovereign debt crisis from spreading is exposed to the tune of €142 billion. The countries which will be affected the most from a Greek debt default would be Germany (€38.4 billion), France (€28.9 billion), Italy (€25.3 billion) and Spain (€16.7 billion).

With the dire straits which have haunted Spain and Italy in the past, this could be a loss these countries cannot afford.

The EFSF was devised as a crisis fighting tool in 2011. It was set up to provide a backstop for European governments that needed direct financial assistance. The fund has been capitalized with €780 billion. No cash has been distributed, instead the fund is put together with explicit guarantees from European governments.

Worst of all, the exposures do not end here. The ECB has become somewhat of a bad bank for the Eurozone with its current holdings of Greek debt in public or private form totaling €137 billion. Of these, €27 billion are in Greek bonds and another €110 billion have been lent by the central bank to the Greek commercial banks via the Emergency Liquidity Assistance program.

Eurozone finance ministers are scheduled to meet in Riga, Latvia on the 24th of April to discuss the prospects for Greece going forward.

The meeting is symbolically held in the European country which has taken the most proactive approach towards austerity in the aftermath of 2008’s global financial crisis. Latvia adopted what was deemed at the time as draconian public expenditures cuts, which contributed to a relatively healthy recovery when compared to Southern Europe.

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