FX: Institutional trading restrictions limit risk mitigation, research suggests

Research conducted by JPMorgan Chase Institute suggests greater trading flexibility could help institutional investors navigate market-moving events.

JPMorgan Chase Institute analysed institutional investor trading behaviour before, during and after three events: the decision of the Swiss National Bank to remove its floor on the Swiss Franc/euro exchange rate; the UK EU referendum; and the 2016 US presidential election.

The think tank’s analysis of total trading volumes and net flows at sectoral and regional level, and transactions within each investor type, showed among other things that access to after-hours trading capabilities could be a useful addition for some institutional investors.

The authors suggest that company policies or regulations that limit the trading activity of institutional investors to their normal business hours or the local market of a currency may prevent these investors from accessing liquidity and mitigating their risk during market-moving events.

They based this observation on that fact that in response to the Brexit and US election events, asset managers based in the Americas and EMEA did not increase their trading volumes until the open of the US trading day, between 10 and 20 hours after the news broke and exchange rates first began to move.

Since the FX market functions 24 hours a day and market-moving events can happen at any time, it seems natural that being able to trade at times of market stress could be beneficial, says Curtis Pfeiffer, chief business officer at Pragma Securities.

“The same trading tools are available during these periods and can help clients reduce their execution risk by spreading trades out to achieve executions across multiple points in time to get an average price,” he adds.

Events like the Swiss National Bank removing its floor on CHF/EUR are not predictable, so out-of-hours operations could help with faster response times, observes Klarity FX director, Amarjit Sahota.

However, the cost of operations has to be taken into consideration, he says.

“Ease of access to trading platforms (for example, mobile trading) is continually improving, so policies are likely to become more accommodative,” he says. “I would also expect institutional investors to have reasonable risk-management strategies in place to lessen the impact of sizeable moves. For instance, they may only trigger strategies if the market moves beyond two standard deviations for given timeframes.”

The research also noted that market makers established a new equilibrium exchange rate without the benefit of net flow information from all investor sectors and regions. This conclusion is based on the fact that hedge funds traded immediately after news broke and the repricing periods began, transferring risk during episodes of high exchange-rate volatility during all three events, whereas other institutional investors transferred risk only after market prices had stabilized.

According to Pfeiffer, this is not surprising.

“Each market participant has their own criteria for the amount, type and duration of information they require in order to trade,” he says. “Participants also trade for different reasons. Corporates are trading in order to facilitate their internal business needs and alpha is generally not a consideration.”

Sahota agrees, observing that waiting for net flow information from all investor sectors and regions has the potential to widen the bid/ask spread or create greater price gaps.

It is concerning if any pertinent information is left out of a calculation on which the markets rely, suggests John Halligan, president of Global Trading Analytics.

“That said, I think the question must also be considered from the market makers’ side,” he adds.

In addition, the authors of the research suggest the role played by hedge funds and market markers in establishing a post-event equilibrium exchange rate should be taken into account when regulators and other policymakers are deliberating policies that limit their trading activity.

When asked if this was a reasonable observation, Halligan states that regulators should take all pertinent information into account when drafting market rules.

“Any role that any market participant plays which may materially affect the market at large has to be considered to protect the integrity of the market,” he says.

Sahota is more sceptical, saying that it was unlikely regulators would be overly accommodative to the role or needs of hedge funds and market makers.

“Policy makers like the Swiss National Bank are often trying to create disruption to discourage investors from taking advantage or forcing policymakers into a corner,” he concludes. “In short, policymakers – while providing greater transparency – also want a few cards up their sleeve to correct perceived market imbalances.”