PART 1:  The “Colossal Seller of Gold", the potential culprit behind “The British Pound flash crash”, and the “Silent Market Maker for the Japanese Yen”.

Does any name come to mind? Well the team here at EssenceFX might have some vague evidence pointing towards the International Monetary Fund (IMF).  That’s right; we think the IMF potentially disrupts the markets from time to time. Nonetheless as a disclaimer, this is merely an EssenceFX economic team VIEW and MIGHT NOT be any bit reflective of the actual picture. Now that we have clarified that and also before we get to the fun part, let us first briefly introduce the IMF and they role they play in our financial system. 

The IMF and their role in global financial markets:

The International Monetary Fund (IMF) is an international organization formed initially in 1944, at the Bretton Woods Conference, primarily driven by the ideas of Harry White and John Keynes. The IMF's reach covers 189 countries and is headquartered in Washington, D.C. The THREE major roles of the IMF are:

  1. Surveillance and monitoring of economic and financial developments and provision of policy advice, aimed especially at crisis-prevention.
  2. Lend to countries with balance of payment difficulties, to provide temporary financing and to support policies aimed at correcting the underlying problems
  3. Provide countries with technical assistance and training in its areas of expertise.

The focus of our discussion will mostly be on point number two and in particular, on their 'special drawing rights' (SDR). In facilitating temporary financing to countries, the IMF somewhat operates its own currency (via a basket of currencies). This currency is called ‘special drawing rights’ or more commonly known as the SDR.  The SDR was created by the IMF in 1969 as a supplementary international reserve asset, in the context of the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves (i.e government or central bank holdings of gold and widely accepted foreign currencies) which can be used to purchase its domestic currency in foreign exchange markets, as and when required to maintain its exchange rate

As of March 2016, 204.1 billion SDRs (equivalent to about $285 billion) had been created and allocated to members. SDRs can be exchanged for freely usable currencies. The value of the SDR before the 30th of September 2016 was based on a basket of four major currencies namely, the U.S. Dollar, Euro, the Japanese Yen, and the Pound Sterling. However, effective 1st October 2016, the SDR basket saw the inclusion of one more currency into it's basket - the Chinese Renminbi:

                                                                                                                               Source: The IMF

 

This now leads us to our first observation:

The coincidental steep fall in the price of gold on the 3rd of October 2016:

 

As well as……

The coincidental steep rise in the SDR / Renminbi index during the same timeframe:

The IMF has been long criticised for its lack of transparency on the sale of gold (read more HERE). In addition, the IMF being the third largest holder of gold (ranking only behind the United States and Germany) has been reportedly selling off their gold reserves over the years. The IMF claims that their ongoing decision to sell “was to ensure that the fund remained on a sound long-term footing and also help to boost the institution’s capacity to provide loans to low income countries” (read more HERE)

The part which really piques the EssenceFX team's curiosity is; the IMF's capability of being allowed to engage in the sales and purchase of both physical and paper gold in the open market as they please. Couple this thought with the idea that (with the exclusion of pre-existing currencies in the SDR basket), on what terms of exchange did the Renminbi make, prior to it's inclusion into the SDR basket? You can’t possibly have a whopping 10.92% weightage appearing into the IMF's SDR basket out of thin air (read more about the inclusion HERE). Moreover, at a level of inclusion far greater than the Sterling’s 8.09% and the Yen’s 8.33%? 

 

This leads us to our second observation:

The coincidental flash crash of the Sterling on the 6th of October 2016:

The Bank of England (BoE) Governor Mark Carney has asked the Bank for International Settlements to look into the pound’s sharp drop in trading during early Asian hours, which sent the currency plunging to a 31-year low in mere seconds (click HERE for more info). 

                                                                                                                                                                                                                              Source: Bloomberg

 

The inquisition however, holds no solid ‘result’ until today. EssenceFX fully rejects Carney’s narrative which seems to put the spotlight on ‘inexperience traders’. The economic team is somewhat confident that the causing party should be a ‘colossal’ with ample firepower; our views and deductions as to what we think caused the flash crash will be further explained in our Part 2 below. Meanwhile, let us bring your attention back to the SDR.

As earlier indicated, the IMF has recently re-weighted its Special Drawing Rights (SDRs). The body’s international reserve currency was formerly made up of the US Dollar (42%), the Euro (37%), the Sterling (11%), and the Yen (9%). On 30th September 2016, the Sterling saw a cut in weight down to 8% from its former 11% with the addition of the Renminbi. The new weightings for the SDRs are as follows: US Dollar (42%); Euro (31%); Chinese renminbi (11%); the Yen (8%); and the Sterling (8%). 

Do you notice the significant drop in the Euro and the Sterling?

Now moving on to our consideration. I’m certain as traders, everyone should be well informed about the worlds most liquid currency pair. Hence, phasing off would be an easy for the Euro. However post the BREXIT shock, do you know of any facilitating financial entity which would have been willing to buy up such an ample quantity of Pound Sterling while it was still on a heavy downtrend?  In addition, the BoE was in favour of weakening the Pound Sterling even further to make exports more competitive post BREXIT and hence, reduced their interest rates from 0.50pct to 0.25pct on August 2016; exactly a month before the Renminbi's inclusion. Cross analyze this fact with Carney’s narrative which stated exactly as follows: “The report finds that there were no material losses incurred by systemic financial institutions, large volumes were transacted around the event window despite the illiquid time of day, and spillovers to other markets were very limited”.  Once again, take note of some of IMF’s governing regulations between members such as:

  1. In regards to obligations regarding exchange arrangements, the Fund shall consult with the respective member’s on their exchange rate policies.                                     – clearly the BoE has already given the green light for this one.
  2. Each member shall deal with the Fund only through its Treasury, central bank, stabilization fund, or other similar fiscal agency, and the Fund shall deal only with or through the same agencies – given this green light, there surely had to be some hard phasing off of the GBP prior to 30th September 2016 to accommodate the Renminbi.

Coincidentally after these additions were done and over with, behold the:

 

New SDR interest rate which is to be published during the 7th of October 2016:

                                                                                                                           Source: The IMF

 

As well as……

The addition of the Renminbi’s interest rate on the 10th (first Monday) of October 2016:

                                                                                                                                            Source: The IMF

 

Imagine a colossal market player dumping the Pound Sterling at such a staggering amount onto the open market. Could this be the ‘fat finger’ we are all looking for? =)

 

Part 2: “Theories behind “The British Pound flash crash”.

The ever mysterious first Friday of October’s one-tick move which crashed the Pound Sterling (herein referred to as ‘Sterling’) during early Asian hours, instantly taking the GBP/USD down to a 31-year low, could easily strike out as a major market theme which would probably last for years to come.

There were numerous reports as to what the low was for the GBP/USD during the time but the majority of the market seems to be reporting in the figure of GBP/USD  $1.18. The difference or more accurately, the spread a broker can offer to contain price to remain close within the large market consensus somewhat shows its strength to handle such volatility; the closer the better while the farther away, the worse off (we state this because we hear of reports of slippages extending as far as GBP/USD $1.10). Minutes later, the GBP/USD posted a mild recovery back to $1.23.

In light of this, the EssenceFX team would like to take some pride in our call of maintaining a downside bias on the GBP/USD since the beginning of our analysis (pre-Brexit ) this year in line with our ‘currency wars’ perspective; our call for GBP/USD parity seems to be gaining more and more traction moving forward.

With that said, we have received a series of questions asking us why and what led the Sterling to instantly (one-tick move) crash so low. In response to these queries, we wish to enlighten our readers and share our take on the matter as well as rule out some market wide assumptions which we think do not make much sense.  Enclosed below is a brief analysis on our findings which we hope can assist our readers to attain some trading directive for GBP related pairs for the weeks to come.

 

Assumption 1: The fat finger

Verdict: Highly unlikely

In this day and age, taking the use of google for example, just by logging into a Google related service via your internet connected device, your exact whereabouts can be known and detected by Google’s servers. Likewise, the anonymity of such a fat finger during a non-volatile trading hour at such a colossal amount makes no sense at all to pass through the market undetected. Nonetheless, we did not hear of any case of any financial institutions going bust, neither was any responsible culprit named. Strange? We think not. This suggests that there is high likelihood that the Sterling’s ‘flash crash’ could have been a result of a well-coordinated event. In addition, an even  better rebuttal against this view would be the fact that modern day financial institutions are well equipped with various automated “risk control limits”, be it dealer specific limits,  single exposure limits, or maximum lot size limits to disable such transactions from going through. Therefore with these two points in mind, we think this assumption holds little weight.

 

Assumption 2: Statement made by French president, Francois Hollande

Verdict: Rather unlikely

The market does indeed come up with a series of amusing possibilities. This we think, is perhaps the most amusing. French president Francois Hollande made a remark which stated that ‘Britain would have to suffer for the Brexit vote in order to ensure EU unity’. This was then reported as a breaking story in the Financial Times at about approximately 7:00AM Asian time.  The belief here is that fundamental keyword discovering ‘robot trading systems’ picked up this bit of information and started a selloff which triggered a domino effect downwards. There are two reasons we think this assumption is unlikely so. The first reason is, colossal entities (i.e financial institutions, hedge funds, investment banks) need not rely on robots to initiate trades; they are more than capable of moving the market on their own and at the best of our knowledge, seem to always chose to initiate trades manually. Their positions are usually one to manage and cater to ‘on demand’ corporate client flow, and fall within assigned risk limits. The second reason would be, neither you nor me employ the use of such robots or at least. The larger portion of the market does not rely on such automation. Although algorithm trading is gaining popularity, they still make up for a minimal amount of the total market. Therefore with these two points, we think Francois Hollande is clear from accusation. What makes thing’s more amusing is he is not the first one to make such a statement, Theresa May likely said it first. Furthermore, we would like to point out that the market’s reaction this time around towards a delayed news story mirrors how the market reacted to a particular backdated recording in regards to the potential use of employing ‘helicopter money’ to support the Japanese economy; to conclude, we think this just goes to further prove that in an era of colossal flow, there are larger market moving forces at work here.

 

Assumption 3: Chain trigger of computer driven algorithmic systems

Verdict: Rather unlikely

Somewhat similar to the assumption which states that remarks made by French president, Francois Hollande triggered the crash; the view on computer driven algorithmic systems or also known as ‘robo traders’ follows a rather similar narrative. The initial huge sell-off might have been triggered by a single or multiple colossal players however, the continuous sell down later was said to be a chain effect of robo traders spotting sell signals and hence, joining in the move. Different that the former scenario which blames a fundamental news cue as a sell trigger, these robots were said to be at work due to technical factors alone. In order to give a more laymans overview on this matter, picture this: There are 10 apple wholesalers with 100 apples each (yes the fruit, not the phone). These apples are obtained with little cost via self-plucking them off a tree from a ranch; the apples will go bad in a week. The average consumption of apples in a day is let’s say, 10. Therefore to be the most successful seller or in this case of brutal timeliness, off-loader, one needs to sell at a lower ideal price fast enough to outdo competition (before getting ‘price matched’) while also taking into account that there is a daily consumption threshold. Therefore in the end, this would ultimately lead to multiple parties initiating brutal price cutting in order to out beat competition while keeping in mind the maximum daily market supportable amount (based on a lower price, good buy psychological bias); the price of apples would free fall downwards until all apples are taken up or at least, until the market is just unable to take up any more apples for the day. Similarly, ‘sell’ orders in the context of foreign currency arguably comes with little cost; it just takes a click of a button to initiate an exchange for something else (often times of a perceived higher value). All it took was for one large order to give up on the Sterling and pushed for it to be exchanged for something else, which then triggered the signal receptive robo traders to hop on the bandwagon. It sure does make a nice story. However as formerly mentioned, the larger portion of the market does not rely on robo traders. Although algorithm trading is gaining popularity, they still make up for a minimal daily traded amount of the total market, hence making this a rather unlikely assumption in our view.

 

Assumption 4: Expiry of foreign exchange options contract

Verdict: Unlikely

Friday is the market chosen expiry day for forex options. As the rumour goes, colossal X was holding an exotic FX option, likely a GBP put option with a down-and-out barrier at we’d say GBP/USD $1.25. Colossal Y on the other hand, likely being the financial institution counterparty has in its best interest, to have the option swoop past the barrier level, rendering it as worthless. To note, there is no directive which states that market manipulation in the trillion US Dollar foreign exchange market is illegal. At early Asian hours and at a period of thin liquidity guess what colossal Y can do? Well it’s clearly a no brainer.  Noting that GBP/USD is at $1.26, colossal Y gets orders filled for a sell right up to GPP/USD $1.25. However, this move got them more than they bargained for; whether it was a stream of stop-loss orders triggered around that level, or whether robo traders picked up a signal to further sell, the Sterling engaged in a heavy down sell which crashed it to the $1.18 level. On the other hand, the same argument can also hold for a put option with a down-and-in barrier. By tweaking the scenario in a slight reverse perspective, it would now be in the best interest of option writers to sell the Sterling (enacting somewhat a hedge) past this level to protect themselves from any losses or further losses from the triggered option. The technicalities in this narrative does indeed make a good story. However, our basis for deeming this as unlikely is that this was a ‘one-tick move’ all the way down way past the supposed $1.25 options barrier level. If you’d put it on replay, you’d clearly see this.  Therefore, this leads us to believe that all orders were deliberately filled by potentially, a single large order.

 

Assumption 5: Large hedge fund unwinding / sell down

Verdict: Plausible

No names mentioned. This probably makes a terrible start for this plausible assumption, or not. For one, the team prefers to not pinpoint any entities to avoid any unnecessary attention. Therefore, if you’re alright with reading in-between the lines, then perhaps we have something for you. Hedge funds and other speculators are said to hold more short positions against the Sterling ever since 1992; we hear news of a particular large fund selling off their Sterling-linked assets from their £2.5 billion portfolio taking them down by almost half from 47% to 25%. They do this regardless of overall improving data out of the UK, be it better manufacturing, construction, or services data signaling their conviction for a potential move to parity. Next, even the Bank Of England (BoE) has indicated that they favour cutting rates to weaken the currency; the BoE cut interest rate by 25 basis points bringing them down to 0.25% from the former 0.50% on the 4th of August this year; no change has taken place since March 2009. Therefore by combining these two possibilities, and unlike Japan, you now have an implied government approval for allowing the Sterling to fall farther below. There is reason to believe that the one-tick move was caused by a single large sell by any of these hedge funds. However, once again we do not think this is the case as we think we already have identified the main culprit via our research J

 

Will they do anything this 2017? Stay tuned with us to find out more! =))

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