The Butterfly Effect
The Butterfly Effect was something that I never heard of until yesterday. I had heard and discussed the concept before, but never put the two together. The Butterfly Effect is when small instances over an extended period of time produces a large change in long term behaviour. The subject came up when I was discussing with a salesperson the recent events in Emerging Market FX. Spreads are contracting, Volatility is coming off and Risk is being put on across the board. This person felt that markets were in for a dramatic shake up, mainly because liquidity was being taken for granted. This really struck me. I totally agree the liquidity is taken for granted. Start with a major current, The Major Currency, The Euro. It is traded over one major electronic platform called EBS. All of the others in one way or another feed from this system. Bank electronic platforms, retail platforms, Algorithmic Trading all feed in one way or another from this system.
I know in our office that we use a number of systems which feed from basically this source. If if “crashes” then what? Bank platform are turned off, spreads widen out and traders rush to the phones hoping and praying that a broker is there in an attempt to get a market going. Luckily this does not happen often (almost never) but during those time there is much less trading (dramatically so).
Now lets look at Brazil. All of the liquidity comes from the BMF exchange. This is the local futures exchange which provides an FX contract. This contract is extremely liquid and all major market participants use it to access liquidity. There is also a smaller (but not insignificant ) group of institutions which use a secondary market to access this same liquidity. Off-Shore brokers have set up a system whereby a bank provides them (the broker) with a spread around the BMF contract from which they would accept a deal. Lets say the Front BMF contract is trading 1.7205/10, they would say to the broker that they were -3/+2. If a bank came into the broker shop and bought 10 mio usd, the broker would go to the floor and pay the 1.7210 offer. He would then fill the bank at 1.7212. The bank which provided the on/off shore price would be left with an onshore purchase at 1.7210 against an offshore sale at 1.7212. This spread will change according to the banks position. -5/00 or 00/+5 are very common occurrences. During the height of the crisis this spread moved out to 50/100!
For a few weeks the banks providing the on/off execution even moved the price to “par choice” to gather market information and see who the “fringe” players are. Now the price has moved to -5/+5. “Surprisingly” all the banks providing the on/off execution decided on the same day to widen out this spread (hhmmm… collusion anyone?). Honestly I think this is the correct spread to provide the execution. Running a cross border book is complicated (depending on the systems used very complicated) and costly (taxes, collateral, potential restrictions). But what does this do for liquidity. Right away nothing, but down the road I think there is real potential for an adjustment. Lets remember that liquidity is a self fulfilling prophecy. Put prices into a market and prices come back. Fringe players were putting prices in and adding depth. Couple this with end of year pressures, possibly extended markets and you have the possible beginnings of the “Butterfly Effect”. Just a thought and I would like to hear yours.
Good Luck and Good Forex Trading.
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