The CHF blood bath, explained
http://blog.darwinex.com/chf-bloodbath-explained/
January 17, 2015/7 Comments/in Darwinex /by Juan Colon
48 hours into the CHF debacle, it’s always healthy to carry out some post-mortem analysis to learn the lessons of why it happened, and what we could have been done to weather it better.
Since we’ve done it, why not share it?
The macro-story: Black-Wednesday, redux
What happened is crystal-clear with the benefit of hindsight (as it always is).
The CHF is a currency safe-haven, albeit a rather illiquid one, since it’s only backed by a tiny and financially hypertrophic economy. Ever since the EUR crisis, everyone and their mother placed some of their safety net in CHF – so much so that the Swiss National Bank was forced to ¨intervene¨ to keep the level at 1.20 to the EUR.
The intervention mechanism was: whoever bought CHF close to 1.20 sold to one counterparty, and one counterparty alone – the SNB. In broker parlance, the SNB became the daddy of all market makers by being the only player in the market with “unlimited” access to CHF close to the 1.20 EUR/CHF cliff. This filled the balance sheet of the SNB with foreign currency reserves… above all with a boatload of EUR, for EUR area is the Swiss’ primary commercial partner and the home currency of nervous europeans who by now trust neither their “unbreakable” currency, nor their tax-agency (the latter being food for another post).
With the EUR crisis on its way back (it has never really left…), the EUR has gone on free-fall, and EUR reserves were drilling the daddy of all P&L hits in the SNB balance sheet. That was before Herr Jordan got Mario’s phone call kindly announcing QE. Herr Jordan’s press conference is (financial) history being written as we speak.
Black Wednesday on September 16th, 1992, George Soros hit the headlines. Actually, he didn’t until after the dust had settled.
On the January 15th Donnerstagsdebakel (made this up, but it’s fitting for Thursday is the day of Thor and Thunder, depending on the language you choose), someone else hit the Jackpot.
We don’t know the name of the winner yet: journalists are still chasing around for a name and a photo to head their scoop… but if you want an outline of his likely background, read on.
We (traders, brokers, broker-dealers, and dealers) went about our business, nonplussed.
Traders saw juicy price-action dynamics at that level, and brokers readily offered (leveraged!) trading access to the CHF. Again with hindsight, everyone was dancing on a cliff… not wondering too much what would happen if (actually, when) Hoover Dam fell.
So far, all pretty standard, really.
The interesting (and sad) bit, and the one that has received the least early attention is that the Fall affected brokers (A-Book) and dealers (B-Book) in tragically different ways – just as you’d expect it, for brokers trade with customers and dealers trade against them.
This effect IS news, because what went belly up on Thursday is the capillary over-the-counter (OTC) system of broker-dealers that makes currencies flow world-wide.
a-book, aka involuntary (unprepared!) contingent market makers
The moment the previous market maker (the SNB) went on strike, Hover Dam fell and sent the EUR on free-fall against the CHF – which called the next market makers to action: customers short the CHF and their collateral posted with their agency-only brokers and Prime Brokers (we’re pure A-Book).
Once that was exhausted (the higher the leverage offered, the quicker), brokers’s and Prime Brokers’ stop-losses triggered, but there was no market, so the margin we had posted with our Prime Brokers was the market. We, a-book brokers became involuntary (and ill equipped) market makers of last resort, not against our retail customers, but our wholesale counterparties.
Technically we ran no risk since actually it was our customers shorting the CHF who got smacked. In practice, FXCM (and others!) now know better: you can’t hire an army of lawyers to track thousands of micro-debts because each debt is smaller than 30 min of lawyer fees.
So there you go.
If you’re looking for victims, you’ll find more than your fair share in the lines of pure agency Brokers and Prime-Brokers who catalysed spot foreign exchange flows between macro (Tier 1 Banks and Central Banks)market makers and micro (Hedge-Funds, retail traders, Tier 2 institutions) price takers.
b-book, unregulated retail bucket shops
The retail spot forex trading arena contains close to 1000 unregulated, undercapitalised, over-levered retail dealers (= bucket shops) who make markets against FX punters.
(How or why they are allowed to invest massive amounts into advertising to earn business in regulated markets escapes our understanding, but that’s for another blog post.)
More to the point, how did they fare? Just fine, thank you.
They kept the deposits of those short the CHF, as they always do – and they didn’t have any losses with wholesale counterparties to match (all they do is trade against customers, remember?).
So how about the winners? You can bet that many of those outfits will keep the P&L of winning customers (there was no market, re-quotes, blah-blah), as they always do. That’s when operating an unregulated casino comes in particularly handy.
So there you go.
If you’re looking for more victims, go find would have been genius… who discovered a tad too late that trading with an unregulated bucket shop is a variation on the age old “heads I win, tails, you lose” coin toss.
They could have been George Soros, but learnt the concept of counterparty risk instead.......