Forex Trading Dynamics Around 4pm Fix

Thorough documentation of the unique dynamics surrounding the 4pm Fix in Forex trading, including discussions on dealer incentives, volatility patterns, collusions, civil suits, and regulatory actions. Insights from academics and the impact on the market landscape are detailed through charts and tables.

• Forex trading
• Market dynamics
• Volatility patterns
• Regulatory actions
• Collusions

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Presentation Transcript

1. Martin D.D. Evans Forex Trading and the WMR Fix Carol Osler, Discussant Stern Microstructure: May 8, 2015

2. London 4pm Fix? Forex doesn t close Still need benchmark prices 1993: WM Co + Reuter Fixes Most influential: 4pm London time Customers submit orders to dealers for trades @ Fix 3:45pm deadline for 4pm Fix Dealers commit to trade with customer @ Fix price Fix traders = Fund managers to avoid tracking risk Large orders Many executed simultaneously High volatility pre-Fix

3. Academics on 4pm Fix 2011: Melvin & Prins highlight high volatility @ Fix London 4pm Fix: The most important FX institution you never heard of Focus on end-month Surprisingly: Does not document volatility Just analyzes it + Provides explanation based on portfolio hedging Equity returns Hedging flows @ Fix Substantiates with regression analysis + Highlights perverse incentives of Fix trading: Maximize price move Volatility @ Fix Hedging perspective suggests Fix volatility self-reinforcing Hedge trades @ Fix Volatility @ Fix Tracking risk Could explain secular rise in Fix volatility

4. Perverse Incentives At Fix, incentive is to Maximize price move Normal Trade Incentive: S B Minimize price move Standard techniques: Split trades . S Dealer buys , Closes position Dealer quotes prices Sells to customer Fix Trade Fix S Incentive: S B Maximize price move New techniques . B B S Dealer sells Closes position Dealer learns Amount to sell Dealer Buys

5. London 4pm Fix June 2013, Bloomberg: Traders colluding to manipulate Fix prices in chat rooms Fall 2013: Many traders put on leave, fired, etc. Civil suits filed Revised version of Melvin & Prins (Nov 2013) Says nothing about dealer incentives to maximize price moves * 2014: Traders on leave are fired or resign (total 20+) Civil suits combined to class action suit Late 2014: Banks pay big fines to CFTC, FCA, others Tantalizing chat details courtesy of regulators Cartel Let s double-team them .. Future . Criminal suits against individual traders?

6. Forex Trading & WMR Fix Thoroughly documents unusual dynamics around 4pm Fix 315 Charts, 14 Tables, average entries/table = 290, 4-6 significant digits Section 3. Volatility @ Fix + How big is Fix volatility relative to long-run volatility? + How big is Fix volatility end-month vs. mid-month? + How big is daily volatility relative to returns @ macro horizons? Small Much bigger Very Big Section 4. Placebo: Volatility away from Fix + How big is volatility at normal times vs. the Fix? + Has distribution of normal returns shifted over time? Small Not much Section 5. What exactly happens pre-Fix? + Big moves beginning 3:45, especially end-month Section 6. What exactly happens post-Fix? + Less volatility than pre-Fix + Some retracement of biggest pre-Fix moves

7. Dynamics @ 4pm Fix Evidence for high volatility around 4pm Fix Frequency distribution, pre-Fix returns EUR/USD 5 Min -20 -10 0 10 20 Non-Fix Mid-month Fix End-Month Fix

8. Dynamics @ 4pm Fix Retracement tendency is remarkable 20 15 20 5 0 -5 -10 -15 -20 >75th percentile end-month End-month avg Mid-month avg Basis Points Mid-month avg End-month avg >75th percentile end-month 3pm 3:30 4:00 4:30 5:00

9. Retracement after Fix Retracement tendency provides profitable trading strategy Sell @ 4pm if price rises 3:45 4:00, vice versa For end-month, profitable & high Sharpe even after transaction costs Reliable? Assumes can always trade at prices in dataset + At month-end Fix, EUR Fix trading sometimes > $500 (FCA) + EUR 4pm limit-order-book cumulative depth averages $170-$210 million + Hmmmmm Suggestion: Examine retracement at longer horizons For end-month Fixes, major share of pre-fix returns typically reversed by noon the next day

10. Forex Trading & WMR Fix Documentation seems to be paper s primary goal Behavior of spot rates in the minutes immediately before and after 4:00 pm are [sic] quite unlike that observed at other times Paper wisely careful about collusion if indeed [collusion] took place, could [it] have materially affected the determination of the Fix to the detriment of participants in the forex and other financial markets. This paper presents statistical evidence pertinent to this issue. Also: Insights from standard models Section 2: Standard model = Portfolio Shifts (PS) Designed to capture forex market over the trading day Batch trades in sequences of 3 with specific characters + Customer (Random Investors) Dealer + Dealer Dealer + Dealer Customer (Risk-averse Investors)

11. Insights from PS Model Volatility is to be expected with portfolio rebalancing If many funds want to sell foreign currency, other agents must buy + Dealers do not hold positions overnight + Contrast with Duane s perspective rebalancing not fundamental information In PS model, other agents are other investors + Price falls to create bigger risk premium on foreign currency In reality, other agents also include firms who import/export + Price falls to make imports of foreign goods cheaper Evidence to date supports active role of import/export firms in absorbing financial rebalancing flows

12. Fix Dynamics & PS Model Is PS model consistent with observed behavior around Fix? PS model does not predict surge, 3:45-4:00, and retracement + Model implies instantaneous jump at 3:45 to end-of-day price + No retracement Is PS the only relevant model? Advantage: Incorporates market s 2 tiers But Fix price dynamics occur entirely within interdealer market Any dealing model potentially helpful Dealer Dealer Importers, Exporters Asset Mgrs

13. Fix Dynamics & Other Models Could be fruitful to examine other models PS assumes perfect competition among dealers + True in 2002 + But interdealer market now highly concentrated + Insights from models of imperfect competition? E.g. Holden & Subrahmanyam (1992) rat race Predicts smooth price approach to new equilibrium after information PS assumes dealers know ALL customer order flow when trading with other dealers + But in reality they don t (and wish they did ..) + Most existing models assume incomplete dealer information + Insights from classic Figlewski (1981)?

14. Fix Dynamics & Other Models Could be fruitful to examine other models PS dealers are combination of Seppi s informed & rebalancing traders Know customer rebalancing flows Are (essentially) doing the trading for customer Have good information about true value Because it depends on magnitude of rebalancing + Insights from Seppi s model? PS assumes batch trades in sequences of 3 with specific character + But allegations of manipulation describe attempts to exploit continuous trading process + Insights from Kyle models with many trades or from sequential- trade models?

15. Fix Dynamics & Other Models Could be fruitful to design other models PS assumes dealer incentives = Bank incentives + But in reality, alleged collusive activities violated bank policies Collusion allegations include sharing client order information Compliance offices routinely stress importance of protecting client information Dealers may have maximized own bonuses at bank expense Model with agency costs (& chat rooms = low costs of collusion?) PS assumes dealers first trade with customer, then cover their position + But sequence reversed for Fix trades + Reverse sequence creates perverse incentives (Melvin & Prins 2011) + Optimizing model of Fix trading?

16. In Sum Thorough documentation of price dynamics @ London 4pm Fix Exchange rate behavior provides great puzzles Interesting discussion of whether dynamics fit PS model Recommend examine whether dynamics fit other standard models Maybe develop new models consistent with institutional constraints and incentives unique to Fix Other suggestions Trimming tables, charts Measures more closely tailored to examining potential influence of Fix -- offline