What caused the pound to flash crash?
With only 24 days before Halloween, the markets were spooked in the early hours of Friday (7 Oct.) morning—the witching hour, BST—when a so called “fat finger” error by a trader entering or omitting a number by mistake, or a computer-triggered sell order, in Asia made the pound crash.
The pound dropped to $1.1841 in a “flash crash” and no one really knows what happened. At one point, a transaction was made when the pound was bleeding at $1.1378. Traders chose to remain anonymous. The pound has recovered and is trading at $1.236. The BoE is investigating the crash.
A Bloomberg article said that “the extent and speed of the drop add to signs that bouts of extreme volatility are becoming more commonplace in the global currency market as the volume of transactions dwindle and algorithmic traders pick up market share.”
Analysts identified three possible explanations: Algorithmic trading, an accidental “fat finger,” and the French president’s comments on Brexit. The Financial Times also mentioned the possibility of a build-up of stop-loss orders below the level of $1.26 or that someone was trying to move the market sharply by taking advantage of low liquidity: at the time, only the markets in Asia, Australia and New Zealand were open and trading was quiet; due also to the release of US job data on Friday afternoon.
What is algorithmic trading?
This is when computers are pre-programmed with a specific set of instructions in order to place trades and generate profit at a speed and frequency beyond a person’s ability. Such instructions might be based on time, price or quantity. Algo-trading can execute trades at the best price, is instant and accurate, and reduces human mistakes based on emotion or manual errors. But automation can also create unexpected trades that can affect the market. Some algorithms trade according to social media and news headlines, which adds a human touch to the trades.
City Index analysts said: “Apparently it was a rogue algorithm that triggered the sell off after it picked up comments made by the French president, François Hollande, who said if Theresa May and company want ‘hard Brexit’, they will get hard Brexit.”
Kathleen Brooks, research director at City Index, said: This highlights the drawback of machines making trading decisions, however, it is the reality, and it is only getting more popular. Thus, another flash crash is possible.”
Hard Brexit Hauntings
There is speculation that an algorithm-driven flash crash was sparked by a Financial Times article in which the French president, François Hollande, said that Britain would have to “suffer” for leaving the EU in order to keep unity within the EU. The idea is, if computers detect anything negative on Brexit, they are programmed to sell the pound.
Since some algorithms are designed to respond to news headlines and social media, this might have been the culprit behind the ghostly hand that pushed the ENTER key on their keyboard.
HSBC is warning that the pound will drop to $1.10 by the end of 2017.
David Bloom, HSBC’s global head of FX, said that because of Brexit, the pound has become a political currency:
“Brexit, whether one likes it or not, is a political decision, one we have to respect. The currency is now the de facto official opposition to the government’s policies. The argument which is still presented to us, that the UK and EU will resolve their difference and come to an amicable deal, appears a little surreal. It is becoming clear that many European countries will come to the negotiation table looking for political damage limitation rather than economic damage limitation. A lose-lose situation is the inevitable outcome. The pound used to be a relatively simple currency that used to trade on cyclical events and data, but now it has become a political and structural currency. This is a recipe for weakness given its twin deficits.”
HSBC’s dark forecast and the fact that manufacturing and industrial production readings were lower than expected at 0.2% and -0.4% respectively, have made things worse since the pound on Friday has been slowly worsening. The flash crash didn’t help the situation either. But it appears that from now on the pound will continue heading lower. Even more, it might be particularly vulnerable every time the UK and the European Union face each other.