For traders, economists, and British citizens, the morning of Friday 7th October 2016 started with a bang. As the Asian session kicked into action, the value of the pound suddenly and mysteriously dropped by an astonishing 10 per cent. This fall occurred in a matter of minutes, leaving spectators open-mouthed with shock.
The phenomenon saw the price of GDP drop to between 1.10 and 1.20 from its previous 1.26, sending shockwaves through the financial markets. The effect was felt across all sterling crosses, with major pairings like the EUR/GBP, GBP/AUD, and GBP/JPY combinations each displaying rapid movement.
Here, we look at what catalysed this strange occurrence, and whether this is a trend that we can expect to see repeating itself in the future…
What Caused the Flash Crash?
One point that has left commentators, brokers, and traders alike scratching their heads in bafflement is the cause of the flash crash. It seemed to come out of nowhere, with no identifiable catalyst to trigger such dramatic movement.
Early commentary identified three main causes: negative comments from the President of France, Francois Hollande; rogue algorithms; and a fat finger order. However, none of these seemed to account for such movements in and of themselves, leaving spectators with no satisfactory answer.
So could any of these suggestions provide a starting point when it comes to reaching a final sterling conclusion? The answer is not a simple one, and the truth is that though each of them could have contributed, not one of them could have had such an impact in isolation. Thus, they cannot be held responsible for the flash crash.
How Did the Flash Crash Happen?
According to experts FxPro, flash crashes are caused by a number of factors working in tandem with each other. They require a perfect storm of events to catalyse them: a trigger, exceptionally low liquidity, market making algorithms, and large stop orders. If any one of these is absent, the bomb will not explode.
Liquidity is arguably the key component in these situations. Should the trigger arise under ordinary market conditions, there might be a correlating market move, but the depth of liquidity and behaviour of market participants would typically absorb any extreme adverse effects.
Where such liquidity is absent, problems begin to arise, and this is what we saw on Friday 7th October. Largely, this was down to sheer ill luck, with the lack of liquidity attributable to the early hour.
The result was catastrophic for sterling. The initial reaction triggered orders that could not be matched at contemporary market prices. This meant that they had to begin matching with bids or offers that were further and further from their real market value.
The phenomena witnessed quickly spiralled. Algorithms kicked into action, directly responding to these dramatic market movements. They attempted to utilise the rapidly gathering momentum in order to take a few pips out of the move for themselves, and in doing so moved the market in an ever more drastic direction.
The effects of this were exacerbated once again when large stop orders began to be triggered. When hit, these sent further large market orders, snowballing until numerous orders had been wiped out.
Could a Second Flash Crash Occur?
The flash crash we saw was catastrophic for the value of sterling, yet it was not necessarily an isolated event. As much as we would like to be able to say that it was a one off, it was a symptom of a flawed system – a system that could easily misfire a second time.
The only way to entirely prevent a repeat would be by fundamentally amending the rules of trading. Working within the current framework, it does not matter whether brokers or liquidity providers claim to have developed solutions: they have not, because they cannot.
Unfortunately, replicating futures exchanges does not seem to offer a viable remedy either. Although many of these have successfully implemented circuit breakers, the currency markets trade from too many separate venues to make such an approach successful.
How Can You Prepare for Flash Crashes?
The flash crash involving the British pound helped to demonstrate a significant flaw in the currency trading system; one that we all must go to pains to combat.
For brokers, this means developing systems capable of keeping time with rapid market movements. These must be able to trigger all orders correctly irrespective of the speed of market happenings. As an additional measure, a capital buffer to absorb the most extreme scenarios is also advisable.
For traders, the main way to guard against disaster is by adopting a long-term view on low leverage. You must ensure that your long position puts you at no risk of being stopped out should a second flash crash occur, so that your success on the currency markets is not jeopardised by a simple and almost impossible to predict twist of fate.