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Monday, 24 July 2017

DERIVATIVES: Dramatic FX moves feared on low liquidity

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Low liquidity in foreign exchange markets has left some dealers fearing there could be some explosive moves coming into year-end.

Euro-dollar has come under consistent pressure over the past few months as politicians have failed to draw a line under the euro zone crisis, tumbling from 1.4247 on October 27 to 1.2944 earlier today.

Traders noted that while volatility has remained elevated, it had not yet spiralled out of control. However, with liquidity likely to drop off over year-end anyway, the general nervousness of markets could lead to some dramatic moves.

“My concern is the year-end lack of liquidity could lead to some fairly sizeable and volatile moves if there is no definitive resolution of the sovereign debt issue,” said Kevin Rodgers, global head of FX spot, e-trading and derivatives at Deutsche Bank.

Rodgers highlighted there have previously been big moves in foreign exchange markets around year-end as end-users have needed to execute trades while liquidity has been scarce. With hedge funds generally having a dire year, it also means these players would be unlikely to commit risk capital to stand against a one-way market.

“We’re definitely watching our traders’ holiday calendars carefully to ensure we have good coverage on the desk. With massive uncertainties and the lack of liquidity, we all need to be prepared in case there’s a sudden burst of activity,” added Rodgers.

Volatility in the major currency pairs has remained relatively muted despite the ongoing uncertainty stemming from the euro zone crisis, with one-year euro-dollar volatility currently trading at 15.7 volatility points. While elevated in historical terms, it is still below the highs of around 17 points it reached in late November. Similarly, euro-dollar risk reversals — the difference between three-month 25-delta puts and calls — are currently at 3.5, compared to 4.5 in November.

“There is no panic — vols are not exploding. Usually you have fast money that are short euros trying to push it lower, but that doesn’t seem to be the case at the moment,” said Hubert de Lambilly, deputy global head of FX trading at BNP Paribas, who also played down the potential for violent swings in FX markets going into year end.

“There is very little bond issuance over that period,” he noted, alluding to the fact that stress over issuances is usually a big driver of FX moves. “We should have an illiquid, but smooth year-end.”

The low rate environment fostered by the European Central Bank is one of the reasons put forward for the orderly depreciation of the euro. While the ECB has refrained from quantitative easing, it has kept front-end rates low and eased liquidity conditions in the euro zone area by extending liquidity operations and relaxing its collateral framework. This easing of pressure on euro funding could partly explain the depreciation of the euro, said de Lambilly.

Meanwhile, Rodgers noted major currency pairs have not actually shown huge deviations from their levels against the euro at the beginning of 2011 despite the sustained levels of high volatility. The biggest mover against the euro year-to-date has been the yen, which has gained 6.8%. Euro-Swiss has only dropped 1.2% (albeit after two central bank interventions), while euro-dollar has fallen just 2.6%.

“There has been a huge amount of tension this year in volatilities being elevated and whippy moves caused by headlines, but actually the fundamental spot levels have been pretty stable. The market has been worried about the potential for a calamity, but in reality has not moved that much,” said Rodgers.

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