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The liquidity monster and FXCM

As we have already pointed out about Thursday’s unprecedented Swiss franc move following the SNB’s announcement about removing its 1.20 euro level floor and introducing a -0.75 per cent interest rate regime, the real story to pay attention to is what exactly motivated a price surge to that level.

Was it a), that the SNB simply under appreciated the scale of the undervaluation it had been engineering in the franc? Or was it b) that the SNB under appreciated just how thin FX market liquidity is in the market these days?

So as to not sit on the fence, we’re going to take a view and speculate that it’s actually all down to option two.

To wit, check out the following statement from FX bucket shop platform FXCM on Thursday:

FXCM Comments on Swiss Franc Movement NEW YORK, Jan. 15, 2015 (GLOBE NEWSWIRE) — FXCM (NYSE:FXCM) an online provider of forex trading and related services worldwide, announced today due to unprecedented volatility in EUR/CHF pair after the Swiss National Bank announcement this morning, clients experienced significant losses, generated negative equity balances owed to FXCM of approximately $225 million. As a result of these debit balances, the company may be in breach of some regulatory capital requirements. We are actively discussing alternatives to return our capital to levels prior to today’s events and discussing the matter with our regulators.

We will remind readers of our previous posts pointing out that this is precisely the sort of thing central banks and regulators are allegedly quietly betting on. At this stage in the cycle they want a shake-out of the unscrupulous practices that have been encouraged over the last few years on the presumption of that liquidity can be taken for granted. Not only do regulators want to bring caveat emptor back into the markets — especially around the shadow banking periphery — they also want to expose the liquidity air pockets that have taken root in the market but which so far have been stubbornly ignored by participants.

As a well informed source noted to us overnight, some of the bigger retail brokers and spread betting shops can see retail FX turnovers that approach $25 bn. And the important thing to note is that presumptions are made about this flow, namely that it’s stupid and likely to be on the wrong side of the trade. On that basis, there’s a major incentive for brokers to simply presume their clients will lose money over time and to use that knowledge in the interests of their own proprietary accounts. So, rather than passing the risk over to the FX market, the risk is internalised onto the books of the brokers themselves, who wear it until the expected client losses materialise — a fact that usually translates into prop profits for them.

Think of it this way, when retail brokers demand 1 per cent margin but their own clearers demand a 3 per cent margin from them, the only way you can make money is by taking the other side of your clients’ positions. The basic point being FX brokers and spread betting shops are treating their clients as prop traders committed to losing rather than making money.

Back in the good old unregulated Wild West days of FX trading that was basically the model at hand, and it worked pretty much as chaotically and dangerously as the crazy unregulated world of bitcoin platforms today. The brokers would wear the risk and set next to no capital aside for a bad day because… well why should you when nobody is asking you to? But since the sheriffs swept into the market post the financial crisis, to operate legally these companies are now obliged to set capital aside whenever market exposure goes over certain parameters.

Over at the biggest FX banks, this has had the effect of under-pricing the leverage and margin cost versus the enormous net open positions some retail brokers generate, largely because the FX banks don’t see the true scale of the risk being internalised by these sorts of players.

Whilst that’s great for fees during the calm volatility suppressed days, it also amounts to a form of poor-quality shadow liquidity which the market as a whole has come to over depend on.

When the volatility unexpectedly pops up, as it did on Thursday, that rumbles the models these brokers depend on. And/or exposes them to the most obvious problem of all, if you’re strategy is focused on beating your own clients, you should take more care to make sure your clients actually have the capital to pay you — especially if you yourself take on their risk and represent them in the wider market.

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Izabella Kaminska
Izabella Kaminska joined FT Alphaville in October 2008, which was, perhaps, the best time in the world to become a financial blogger. (Added bonus: there was a free breakfast trolly.) Before that she worked as a producer at CNBC, a natural gas reporter at Platts and an associate editor of BP’s internal magazine. She has also worked as a reporter on English language business papers in Poland and Azerbaijan and was a Reuters graduate trainee in 2004. Everything she knows about economics stems from a childhood fascination with ancient economies, specifically the agrarian land reforms of the early Roman republic and the coinage and price stability reforms of late Roman emperors. Her favourite emperor is one Gaius Aurelius Valerius Diocletian. She studied Ancient History at UCL, and has a masters in Journalism from what was then the London College of Printing. And yes, she is also a second-generation West London Pole (who likes mushroom picking, bigos and pierogi).
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