Monday, September 24, 2018

Hedge Funds and Currency Volatility

Gillian Tett points to this JP Morgan Chase research that appears to point to hedge funds being a major contributor to currency market volatility.

The Bank researchers used JP Morgan's database of 400 m institutional investor transactions to isolate 120,000 spot and forward forex trades conducted just before and after the unexpected 2015 Swiss central bank decision to abandon its floor for the Swiss franc, the 2016 Brexit vote outcome, and Donald Trump's US election victory. She writes,
In normal times, JPMorgan cuts an average of $500m in trades each day with hedge funds that involve the Mexican peso and dollar, and some $2.8bn of sterling-dollar trades and $900m for the Swiss franc and euro. Trades with other banks and asset manages are similar in size. But just after the Swiss bank, Brexit and Trump shocks, daily trading volumes by hedge funds more than tripled. Bank trading volumes also rose sharply after the Swiss and Brexit events (but not after the Trump victory). This might imply that it was the hedge funds that pushed the currencies around. Not entirely so. Most funds did buy francs after the Swiss bank announcement. But they bought and sold sterling after Brexit, trading on opposing sides on a massive scale. So too after the Trump shock, although there were more hedge fund dollar sales. This is striking. But what is more important is that the volume of trades cut by pension funds, insurance companies, public investment groups and corporate treasury departments did not rise at all after the shocks. These groups only started to shift risk much later, long after prices had been reset... this pattern has important implications. Traditionally, banks were the main providers of liquidity in foreign exchange markets. But since 2008, they have reduced this role because of post-crisis regulatory reforms. Regulators had hoped that other long-term holdings of capital would start to fill that gap, supplying badly needed liquidity that could stabilise markets when a crunch hit. But the data suggest this is not happening. Most institutions are sitting on their hands in a crisis instead... the unpalatable truth is that it is they (hedge funds) who often keep markets trading in a crunch.
Talk about efficient financial markets, the belief that markets take care of themselves, and that market regulation should be minimal!

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