Why did sterling “flash crash”?
By IG Index Market analysts
Numerous theories have emerged about why GBP fell from about $1.26 against the US dollar to about $1.18 in no more than two minutes on Friday morning, but the precise reason may not be discovered, despite the Bank of England looking into the root cause.
Foreign exchange markets are complex. There are a huge range of trading systems at work in the market, across many time zones, and there is no single market or provider of information.
The GBP crash happened shortly after midnight GMT, when liquidity in forex markets is normally low. Forex trading in Asia spreads across many important markets like
- Sydney
- Tokyo
- Hong Kong
- Singapore
However, low liquidity in itself is not a cause for this “flash crash”.
Was the GBP crash a Computer error?
It could be down to a simple slip of the finger – where a person types in a wrong number in an order. In a market dominated more and more by algorithmic trading via computer – it could also have been caused by a glitch in a programme or ‘algo’.
These glitches have happened before, notably in 2010 on the US stock market. If it was this type or error – by a person at a bank – we should have found out quickly as counterparties acknowledge the error and wipe the trades out. An computer or programming glitch however, may never be found.
There are other potential reasons that are often repeated when market moves cannot be easily explained, including a build up of stop loss orders at a certain price level and when those are triggered together, they can cause a large subsequent move – or hit further stop loss levels further down.
How can traders mitigate risk?
There is not a lot traders can do about flash crashes. They are not easily predicted, and are fortunately rare. But sterling markets have been highly volatile since the UK voted for Brexit, and traders need to be familiar with mechanisms like guaranteed stops.
Common sense also applies – the pound is now at risk to the kind of surprise headlines (‘tape bombs’ to use the industry jargon) that can cause swift movements in prices either way.
As well as using guaranteed stops, to manage risk further, traders can move to using smaller position sizes. FX markets are volatile at the best of times, but now news events are combining with low liquidity – relative to previous years – to make this asset class an even more volatile area.
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