The European Central Bank’s (ECB’s) decision to expand its quantitative easing program to include government bond purchases spurred recent currency volatility in the Swiss franc (CHF). The response by the Swiss National Bank (SNB) was an about-face from the policy instituted in 2011 to peg the CHF to the euro.
Currency trading risk was in the spotlight, as many firms were impacted by the change and immediate currency market volatility that followed, particularly in currency trading, hedging and funding. Carry trades are defined as borrowing in a low-rate currency and investing an asset that is likely to provide a higher return.
When any market experiences a large spike in volatility there is fallout. In the case of currency trading risk, abrupt moves can be especially disruptive, to both financial markets and all manner of commerce in that currency, requiring careful currency market hedging.
In 2014, 17 countries in the euro zone experienced a bout of deflation. Switzerland’s SNB worked to keep deflation at bay by having negative yields out to the 7-year tenor and also decided to peg the franc to the euro. The SNB’s assurance that they would maintain this policy for the foreseeable future caused market participants to maintain a variety of positions.
However, the Swiss National Bank decided to re-evaluate this position when SNB officials learned that the ECB was to begin purchasing government bonds of European countries, and they realized that negative yields in Europe would only put accelerated downward pressure on the euro versus other world currencies. Meanwhile, the market wanted to be long CHF, putting upward pressure on it versus the euro. Thus, maintaining a peg of the Swiss franc to the euro would cost even more to sustain. To prevent the balance sheet of the SNB from growing larger, the decision was made to end the peg.
Adding to the problem, with interest rates so low, the Swiss franc was used as a funding currency for carry trades. Some carry trades were versus emerging markets and focused in high-yield corporate debt, but many were versus developed markets, including government debt and high-grade fixed income. As a result, the turbulence beyond the Swiss exchange rate has been ubstantial, particularly with emerging market currencies.
In the carry trade arena, if your original currency trade goes south, you must post margin. Without cash on hand, the most logical place to raise money is to sell liquid items in your portfolio that are performing well and that have low bid/ ask spread. This is how contagion infects other asset classes.
Such was the case with the Swiss franc, where traders raising cash by selling various assets to pay off margin. The significant move in the franc spurred dramatic selling in other asset classes.
Further, many traders lost money – not because they couldn’t post margin, but because for about 36 hours, the market had no bid. In turn this caused the market price, which reflects the mid-market between bid and ask, to gap lower. This highlights the limitations of stop-loss orders and their ineffectiveness in certain circumstances.
For financial services leaders, it is important to be proactive to stay ahead of the next crowded trade. These simple yet effective questions can be instructive:
Crowded trades and the reversal of crowded trades can happen in any instrument or any asset class. The best advice is to stay vigilant and always have controls in place to assess investments and determine the extent to which a position is held in a crowded trade.
Since market volatility can pop up seemingly out of nowhere, financial services leaders need to prepare, hedge, and potentially gain a competitive advantage during periods of volatility in the currency markets.
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