The calm after the storm…
Last week’s global markets were peppered with precautionary and reactionary measures from electronic trading companies, executing venues and liquidity providers alike, in the wake of one of Russia’s most dramatic liquidity crises since the nation emerged from the Soviet era.
As Friday’s trading concluded, many companies which had temporary suspended ruble trading had not thus far reinstated it, indeed all of those which did so, with the exception of Alpari and FXPro, still remained cautious with regard to allowing trading on ruble pairs, electing to continue the suspension.
Other companies had chosen to continue providing trading in ruble pairs, but with either adapted margin parameters or extremely low maximum leverage, which in the case of GAIN Capital, was reduced to 1:5 for USD/RUB pairs.
Following a week of swift action by many firms across all industry sectors, it is now a poignant time to take stock and view the different methods by which different categories of companies took action.
Indeed, institutional ECN EBS, ICAP’s venerable electronic brokerage division, provides liquidity to professional outfits, and closely rivals Thomson Reuters, placing it firmly in the sole institutional business camp. The company operates a model in which the risk management transfers all trades to the liquidity providers, which in this case are a series of banks.
The matter to look closely at here is that EBS did not suspend any trading on ruble pairs, despite the high potential risk of what many companies considered to be potential negative equity due to low liquidity which could cause exposure to companies who could easily catch a cold should the highly volatile ruble’s price change dramatically during a trading session, or even worse have a dry liquidity spell resulting in orders not being filled at the anticipated price.
This modus operandi was relatively common throughout the course of last week, in that firms operating an A book model continued to process ruble pair orders.
Whilst many retail companies had suspended trading, Russia’s prominent executing venue Moscow Exchange, whose senior management could quite easily have decided to close the doors for a week, continued trading but made several very regular changes to the parameters on many pairs.
Thus, it appears that the decisions taken across the entire FX industry fall into two camps: Firms which operate a direct market access model, which kept trading facilities open for ruble pairs, and market makers, many of which suspended ruble trading.
At first glance, this may appear contrary to expectations. At times of low liquidity and volatile sovereign currency, it is often the market maker which is the savior of the situation, stepping in to provide a bid and ask price, thus creating a market which in turn increases liquidity. Within exchange-based stock market trading, the revival of liquidity in past periods of low confidence or low interest in certain instruments, the market makers have often revived the market in question successfully.
In this case, however, it is important to consider that liquidity can affect asset prices, too, thus creating a risk for market makers in particular. For example, investors may demand higher rates of return as compensation for holding illiquid assets and assets that are particularly sensitive to fluctuations in liquidity. Despite the interest in aggregate liquidity from both of these angles, we know relatively little about exactly why market liquidity varies over time.
Recent theoretical work by Gromb and Vayanos (2002) and Brunnermeier and Pedersen for Princeton University and the US National Bureau of Economic Research in 2008, among others, postulates that limited market-maker capital can explain empirical features of asset market liquidity. Up to now, data limitations have hampered efforts to test the broad implications of these models and demonstrate direct links between liquidity supplier behavior, capital limitations, and liquidity.
Under this circumstance, the potential exposure to a medium-sized FX market maker would be exponential and not worth the risk.
When dissecting the three distinct types of specialist institutions whose business provides access to capital, companies which are part of a much larger firm (such as Goldman Sachs, HSBC, Citi, Barclays or Merrill Lynch) deal with the parent in obtaining capital. Most free-standing specialist firms clear through other member firms and therefore deal asymmetries can make it hard to raise capital quickly or cheaply.
In turn, this means that market makers face short-run limits on the amount of risk they can bear. As their inventory positions grow larger (in either direction, long or short), market makers become increasingly hesitant to take on more inventory, and may quote smaller quantities at less attractive prices. Similarly, losses from trading reduce market makers’ equity capital. If leverage ratios remain relatively constant, as suggested by the evidence in research at Princeton University by Adrian and Shin (2008), market makers’ position limits decrease proportionately, which should similarly reduce market makers’ willingness to provide liquidity.
The action taken by companies which allowed close-only orders to be filled on ruble pairs by market makers last week reflects this line of thinking. This provided companies which operate a dealing desk with the knowledge of the current open positions on their books, and what they could expect should a closed order go awry, without exposing them to new orders that may jeopardize their capital position.
Indeed, there were also certain announcements that open orders would be closed by the company if not closed by traders by a certain date, creating further risk management control for the company, as well as a fair warning period for traders.
This theoretical position can be applied to all manner of asset classes in any situation where low liquidity occurs, however Russia faces a greater and deeper rooted difficulty which may take some time to resolve, and that is the potentially crippling interest rates, which are up to 17%.
Interest rates set at such a high level are potentially unsustainable and in the short term will relieve retail investors of disposable income that they may otherwise use to trade the retail markets, as they will need to use it to fund increased mortgage payments or business loan payments whilst not receiving the same 17% interest from the bank on their savings, thus causing the Russian market, which has become very important to many global companies recently, becoming less of a region with great earnings potential.
Additionally, if the ruble’s rapid decline, economic uncertainty and high interest rates continue for a prolonged period, low liquidity will become the least of any concern, as those who are watching the value of their capital assets decline whilst servicing vast interest rates with money that they no longer have, could result in widespread repossessions, nationalization of banks and companies, and a return to public housing for many who are unable to maintain payments.
By proxy, that would result in a return to a state ownership model for Russian business and housing stock, as occurred in Great Britain in the early 1990s when interest was 15% and widespread negative equity in mortgaged homes exposed banks to repossessed housing which did not clear the outstanding mortgage when sold at auction, whilst residents which numbered thousands walked away and handed the keys back to the bank as they saw it not worthwhile to continue fueling a negative equity mortgage with 15% interest rates on a depreciating asset.
The vast difference was that the British pound retained its value, and most banks eventually recovered by adopting emergency measures, which delayed their nationalization until the credit crisis of 2008, to which unserviceable retail debt contributed greatly. Indeed, despite that, the British pound remained a major currency throughout the entire period and liquidity constantly remained in demand, with no disruption whatsoever to currency markets.