As a twist on a biblical saying, “What Man has wrought, let Markets put asunder.” The simple lesson is that mankind cannot control markets with artificial constructs of any kind. There will be consequences, and their degree of harshness will relate to how complex the associated market forces happen to be. There are countless examples of this maxim, but last week, the global forex community took a major broadside hit when Swiss banking authorities eliminated the forced linkage between the Swiss Franc and the Euro. The announcement caused an immediate and drastic adjustment in all “CHF” currency pairings. In some markets the move against the Euro was nearly 40% or more.
Their action was also unexpected, since one official earlier in the week had confirmed publicly that the so-called “peg” of 1.20 would “remain the pillar of our monetary policy.” Forex brokers soon became meek deer, frozen in the headlights of a financial tsunami. The brokers that suffered the most were the ones with highly leveraged customer positions with insufficient capital to cover such a hit. In these instances, the broker must sustain the losses, and these losses were off the charts. FXCM, a large and well-capitalized broker, gulped hard on $225 million in overnight losses. Their shares were halted on Wall Street, but, to the firm’s credit, they quickly raised an additional $300 million in capital support to withstand the avalanche.
Smaller brokers were not so lucky. As the tsunami spread from distant shores, several bankruptcies were the immediate consequences. The first casualty to hit the news wires was Excel Markets, a New Zealand regulated broker-dealer, that had to halt operations when it could not cover its client losses held at its STP liquidity providers. Their written statement, dripping with blood, explained it all:
“The dramatic move on the Swiss franc fueled by the Swiss National Bank’s unexpected policy reversal of capping the Swiss franc against the euro has resulted in rare volatility and il-liquidity. Both our primary and backup liquidity providers became unresponsive or illiquid for hours after the event. The majority of clients in a franc position were on the losing side and sustained losses amounting to far greater than their account equity. When a client cannot cover their losses it is passed onto us.”
What market artifice had Swiss authorities crafted that wreaked such havoc?
When the European debt crisis hit with full force in mid-2010, the flight of capital to safe havens was swift and predictable. U.S. Treasuries and Gold were the likely targets, but the Swiss Franc was also a member of this revered triumvirate of safe places to hide. But Switzerland is by no means a large country. Even though it may seem to be a banking center for global wealth, there are still limits within which the SNB (Swiss National Bank) has to operate. Costs are already high, due to import taxes assessed by surrounding countries, a type of fiscal punishment for having been neutral during the war, but a high valuation for the Franc puts enormous pressure on the export trade.
If the CHF had been allowed to seek a market equilibrium, then exports would have plunged. Exports of goods and services tally over 70% of Swiss GDP on an annual basis. The SNB had to act. Three years ago, they instituted a “peg” of 1.20 to the Euro to artificially halt market forces in their tracks. In its announcement, the SNB stated, “The value of the franc is a threat to the economy”, and that it was “prepared to buy foreign currency in unlimited quantities.” SNB intervention was required at times, but intervention has its limits, too. One analyst noted that, “The SNB spent billions defending the currency cap after introducing it in September 2011,” amassing as much as $480 billion-worth of foreign currency, an amount sum equate to roughly 70% of Swiss GDP.
Political tensions have been running high in Switzerland after this run up in foreign currency reserves. The highly anticipated quantitative easing program by the ECB would only add more fuel to the fire. The fear of hyperinflation, said to be unfounded by economists, gripped the populace, leading to referendums to force a change. None of these public attempts were successful, but Swiss bankers are a conservative lot. If they deserve criticism, it is for implementing the cap in the first place, and, subsequently, they could have eased the cap gradually over time. When central bankers attempt to manipulate exchange rates, it always results in disaster in some form, and the ripples of this change will be felt in currency, stock, bond, and commodity markets for months.
What happened when the cap removal was announced?
Central bankers typically move in small steps, but the Swiss policy change took the market by surprise, causing “exceptional volatility and extreme lack of liquidity.” The conventional wisdom in the forex world is to go long on the Swiss France. Clients would generally show sentiment ratings as high as 90% in expectation of a rise, especially against the Euro. These sentiments had recently undergone a temporary change, according to one observer, “Many clients were following the confirmed longstanding strategy from the SNB and were anticipating a weakening of the Swiss franc against the euro.” Short positions were the rage, as unsuspecting investors awaited depreciation.
Exactly the opposite situation occurred. Highly leveraged positions suffered the largest losses, and traders that utilized automated trading robots or EAs were casualties, as well. The global problem was that, “The majority of clients in a franc position were on the losing side and sustained losses amounting to far greater than their account equity.” In cases where the broker had segregated client account deposits in Tier-1 bank accounts, customer deposits were protected from broker insolvency issues, but the jury is still out until all the pieces of this tragedy are sorted out.
What types of broker were impacted?
There were winners and losers in all sectors of the industry. FXCM was noted above, but they have raised additional capital, an easier thing to do when you are traded on a major stock exchange. As also noted, Excel Markets went down, as did Alpari UK. IG Group, a company traded on the London stock exchange, sustained losses of up to £30 Million, but many are stating that this may only be the tip of the iceberg. Major banks like Citicorp, Deutsche Bank, and HSBC, all known for their dependence on trading room profits, are licking their wounds, too. Citicorp losses are said to be over $150 million.
Mutual funds were not immune either. Shares for the $1.9 billion John Hancock Absolute Return Currency Fund tumbles 8.9%, said to be the largest loser in the U.S. The largest losers, however, appear to be in the hedge fund sector, where fund managers typically make highly leveraged bets. Marko Dimitrijevic, the manager for the $830 million Everest Capital Global Fund, had already won a huge bet on the Swiss Franc in December when the local referendum was defeated, but in one 24-hour period after the cap was removed, the entire fund met its doom. Everest Capital will survive, but only with about $2.2 billion in seven other funds. They are known for their comebacks.
There have been winners or at least firms that have not been severely impacted by the carnage. These firms are releasing positive press releases to alert their customers that all is well in their respective necks of the woods. AvaTrade, Markets.com, XM, FXPro, ForexTime, and Orbex and others have all notified us that they are well capitalized and operating as if business were usual.
Is the current system likely to reach equilibrium quickly?
Reverberations from this market turmoil will be felt for some time. The biggest question at the moment is how will the Swiss economy be impacted. As for the forex brokerage community, the onslaught hit smaller firms more heavily, but size did not seem to play a part as to determining winners and losers. FXCM, a public company that must disclose pertinent details in public documents, is a case in point. They have over 230,000 retail forex clients that average nearly 600,000 trades a day worth $439 billion in currency trades for the month of December alone. Even highly-computerized controls for this firm could not prevent $225 million in losses.
The nightmare is also not over for another quirky reason. Re-quotes, a poor business practice for many unsavory brokers, has now been reversed. Liquidity providers are going back on a number of trades and requiring that a different rate be used for settlement, as per their contracts. It is being called the biggest reconciliation nightmare in the industry’s history. Back offices will be sorting out the details for months, but, hopefully, brokers will absorb the damage and not their clients. The re-quotes are between them and their banking partners, but some may elect to pass them on.
Risk in the investment world can come in many forms. Systemic risk, the kind that affects all parties in an industry, instead of being confined to a specific area that can be hedged, is extremely difficult to predict, much less protect against. In the forex world, many brokers are still reeling from the crash of the Russian Ruble in December, but those crosses were not as significant as the Swiss Franc and its Euro “crutch”. History has shown that any attempt to manipulate market forces will eventually meet with chaos. The Euro, another “human” experiment to regulate markets, as well, along with OTC swaps and mortgage-backed securities, have already shown signs that market destruction could be just over the horizon. Liquidity issues may be lurking, as in 2008.
As for the Swiss, Beat Siegenthaler, a currency strategist at UBS, stated, “Around parity the Swiss franc appears more overvalued versus the euro than at any other time in the last 30 years, and the strength of the Swiss franc is likely to put significant strain on the Swiss economy and will fluctuate around parity for the coming months.” As for everyone else, Nick Parsons, the London-based head of research for the U.K. and Europe at National Australia Bank Ltd., summed it up this way, “I would be astonished if we did not see more casualties. This was a 180-degree about turn by the SNB. People feel hurt and betrayed.” And the beat goes on…