Cash Crash

Oct 17, 2016 | by Franck Cushner, CFP®

On October 6, around 7pm New York time, the British Pound lost 6.3% value in three minutes (though recovered to being only down 4.8%). While the direct spark is uncertain, the resulting damage is likely due to the low liquidity of early morning Asian trading hours. 

How often does this happen?

While infrequent, it is not unlikely (a significant difference).  These types of events have been occurring more and more in recent times, especially in the more than $5 trillion a day currency markets.  In January, the South African Rand (ZAR) plummeted 9% in 15 minutes and last August, the New Zealand Dollar (NZD) fell roughly 5% in 10 minutes.  Neither of these are particularly exotic currencies.  The NZD, in fact, is part of the G10,  the traditionally most liquid currencies traded.

How is this time different?

This time it happened to the oldest currency in use.  The Sterling has been around since the days of King Offa, about 760 AD, #MakeMerciaGreatAgain.  This sends a signal to the markets that the issue is not idiosyncratic, but rather systemic.  It isn’t the amount lost in the Sterling that is key, rather the rapidity of destruction.

Who is hurt by this?

Everyone involved.  There is less and less liquidity (reflected by greater bid-offer spreads), though still high amounts of values being exchanged. Retail traders, particularly, with highly levered accounts (50:1 being max at FXCM) are forced to cash out quickly – basically handing money over to brokers the day they open their accounts.

Wait, leverage?

Let’s say you invest $1,000. With 50 to 1 leverage, you have market exposure of $50,000. If you were long the Pound against the US Dollar for $50,000 at $1.25, then for your $50,000 you are given £40,000. Now, while you are sitting down for a sandwich and Coke, the exchange rate falls 4% to $1.20.  You still have your £40,000, but your account has a USD value of $48,000.  You have lost twice as much as your initial investment of $1,000 in the span of a few bites.  If your broker is lucky or smart, they would have liquidated your entire position before you hit an account value of $0 and collected whatever fees they charge. This liquidation, however, reinforces the decline, and, in times of low liquidity, passes it on the next trader, who then hits their account limit, passes their pain on, and so on and so forth. The buck doesn’t stop.

What should I do?

Don’t chase reward.  Manage risk.  If you’d like to trade on the side, have at it.  Just don’t put up what you’re not willing to lose – such as your lunch.

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