The bots of FX

See the latest Australian dollar analysis here:

Macro Afternoon

High Frequency traders (HFT) have been around for a long time. What else were the locals on the SFE back in the floor days and at the establishment of many contracts except HFT? But we never thought of them in the way that many, myself included, think of the HFT guys theses days. No, we thought of these locals as important providors of liquidity and a defence against markets gapping.

Sure you knew if you worked at a big bank that could move the market from time to time they would get in front of you sometimes or snipe away to take a point or two but equally you knew that some of the big guys, Rambo for example, would often take on big opposing positions to you.

But much has changed since those niave days when it was a local’s skill and cunning around the pit that made him or her an integral part of the market, loathed by some but respected by most, as just trying to make a quid.

Since the “flash crash” on May 6th 2010 the spectre of HFT rampaging with their computers around the financial landscape sniping points in nano-seconds has raised not the respect of market players but their ire.

But once again even this new computer generated version of locals is not new. For many years traders have been trying to build algorithms that could wander through markets making money. A large FX fund in Melbourne has been doing something along these lines for well over a decade now, and has built a successful track record.

But still high frequency traders are vilified. Recently I called them the Velociraptors of finance roaming the financial jungle devouring all in their wake. It’s a bit over the top as one of our readers pointed out and even changed his Avatar to Velociraptor to remind me I think, which is hilarious by the way.

My view on HFT hasn’t really changed though, I still think they need to be regulated but in a manner that doesn’t ban them from markets but seeks to regulate their size and influence in the markets. Some markets are just too small for these guys when they are in, but particulalry if for some reason, they are suddenly out.

But not FX it seems.

The BIS released a report this week on the impact of HFT in FX markets. The BIS says that the study group was chaired by Guy Debelle from the RBA so we know there will have been a lassiez faire hand on the tiller but still this is an important study.

In the Exec Summary the report says,

Having come to prominence in equity markets, high-frequency trading (HFT) has increased its presence in the foreign exchange (FX) market in recent years. This development is one aspect of a broader trend facilitated by the wider use of electronic trading in foreign exchange, not only in the broker-dealer market, but also at the customer level. HFT in FX operates on high volume but small order sizes, low margins, low latency (with trade execution times measured in milliseconds) and short risk holding periods (typically well under five seconds). As such, it occurs mainly in the most liquid currencies. While, to date, HFT has been most prevalent among the major currency pairs, it has the potential to spread to other relatively actively traded currencies, including some emerging market currencies.

In equities, where HFT accounts for a significant share of turnover in some markets,1 the rapid growth of HFT and the perception of predatory practices have generated heightened scrutiny and debate about the benefits and risks posed by this type of trading activity. A number of regulatory initiatives are being considered. A similar discussion is now emerging about the role of HFT in FX.

If you’d asked my what impact I thought HFT traders would have had on FX I would have said negligible because it is such a big, deep market. Although I have been chatting with mates on the desks in FX recently and heard the phrase “the robots are buying” more than once. But that of itself is not a bad thing. 

The key findings of the report are essentially that although HFT in FX is something new it doesn’t look evil in “normal times”:

HFT has had a marked impact on the functioning of the FX market in ways that could be seen as beneficial in normal times. HFT helps to distribute liquidity across the decentralised market, improving efficiency, and has narrowed spreads. But the introduction of HFT to the market has affected the ecology of the FX market in ways that are not yet fully understood.


Questions remain about HFT participants’ willingness to provide liquidity on a sustained basis under different market conditions. While HFT generates increased activity and narrower spreads in normal times, it may have reduced the resilience of the system as a whole in stressed times by reducing the activity of traditional market participants (eg major market-maker banks) who may have otherwise been an important stabilising presence in volatile environments.

Importantly it also says:

…recent experience suggests that HFT participants are not necessarily flightier than traditional participants in times of market stress and may be quicker to re-enter the market as it stabilises.

This is superb news but while this is only the thinest of slices of the report there is a sting in the tail that I must point out.

First, let me say I am excited that the BIS is talking about the “ecology”  of FX markets. This is an important step in the evolution of market theory and economics – those of us  who belong to the school of economics that believe markets and economies are complex adaptive systems will be excited by this recognition. The BIS is evolving and with it so will economics.

But I digress, the sting in the tail is clearly about how the market evolves and what impact these traders have on the ultimate providors of liquidity in FX – the banks. The BIS says:

Many of the “predatory” or “unfair” practices attributed to HFT participants, in the light of their technology-driven ability to detect orders and take advantage of latencies, are in fact not new. HFT is but the latest high-tech, high-speed manifestation of them. A key question is whether other market participants are able to adapt to the presence of HFT, and how the market environment will be affected when those failing to keep up change their trading behaviour or exit the market completely.

Bank traders have a tough job. You can sit there all day trading your 5’s and 10’s and then a client can in at the end of the day and ask for a price in a couple of hundred million or more. I did it to a bank about 2 minutes before an important figure one morning. The guy read me wrong. He thought I was a buyer when I was a seller, got caught with a position, had no chance of clearing it and would have lost a heap and had a bad day. I’m not so rude now by the way.

These HFT guys roaming through the landscape will complicate what is already a complex and difficult job. So we might actually see a retreat from the market by these guys as they ask a reasonable question of why they should put their job at risk and their bank’s capital on the table for the “robots” to attack?

The BIS says:

In sum, HFT in FX is a rapidly evolving phenomenon. It is having a notable effect on the structure and functioning of the FX market, and is prompting behavioural changes in other market participants. All these influence the resilience of the system as a whole, although the impact will continue to change as various participants – including major FX dealers, prime brokers and trading platform operators as well as HFT firms themselves – adapt to the new ecology. Policymakers should continue to keep abreast of this development by maintaining contact and dialogue with the evolving set of relevant market participants.

Amen to that last bit.

So HFT has in some way or form been around for a long time. I still believe that with the curent level of trade in FX markets daily and the current structure FX is one market that can accomodate the HFT guys and girls. But evolution is a strange thing and as the BIS says their presence will change the behaviour of other participants. It may have already – the volatility of the Australian dollar, amongst others, over the past week suggests the market is not functioning as it once did.

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  1. Tks DFM I always learn when you write.
    The problems with HFT traders in equity markets are, I believe, substantial. I just speak as one who has watched share prices pushed around on a long-term basis by consistent HFT. However that is beside the point here.
    HFT, it seems to me, are a bit like our Banks. When the maths produces a ‘black swan’ event and the HFT participant is in the can for lots, the exchanges set in and cancel all the trades for them. How can they lose? So how can anyone else win in what is now acknowledged as a veritable casino?

  2. Greg this just further reinforces my view (admitted bias) that forex is a casino. The point of floating currencies is surely to enable country’s economies to function better, smooth out trade imbalances etc.

    What is the point of floating a currency if doing so returns levels that don’t reflect underlying economic conditions. Can’t you currency traders just go to your nearest casino to get your thrills and let the worlds companies and industries make plans based on stable currencies that reflect national economies (no offence)?

    ps. you have worked at banks right? was the forex desk part of the risk management division or was it viewed as a revenue stream/profit centre?

    • Deus Forex Machina

      Hi Lenny…

      I cant agree that FX markets are casinos or are even like casino’s…

      I know a lot of internet marketing of platforms to naive traders makes it look that way and I know that the blogsphere is polluted with ads to “get online and start trading” but FX rates are probably the most important transfer rate in an economy…

      EG: China is getting a massive leg up by slowly letting CNY appreciate and become a more widely traded currency…in the process China remains more competitive…in the US part of the Fed’s QE policy was to debase the USD as far as it would go without blowing up markets, when they found the level earlier this year they and the US Treasury backed off…

      In Australia we use the free floating currency all the time to balance out economic growth…its not just the prescient RBA or government that has got us 22 years without a recession its as much the AUD floating high and low when required

      FX markets are deep and liquid and they go up AND down so they naturally attract traders – but the fact that some companies marketing plans make them look like casinos doesn’t mean they are casinos

      they are simply actively traded very important global markets which trade around the clock from 5am Monday Sydney to 5pm New York Friday.

      As for the floating currency thing, the RBA would suggest that the currency does reflect the fundamentals in terms of the terms of trade…and they would be right in that respect

      the fact that there are other things in the mix is also taken into account and while the AUD did get very high in terms of “fair value” it didnt get over cooked ridiculous…

      so while the dutch disease thing did look like it was/is emerging because of the high AUD the currency wasnt completly misaligned as you imply…indeed it saved us from a couple of rate hikes in my view…imagine where U/e would be now if we’d got them.

      With regard to risk management and currency there is a few things here…bank dealing rooms are broken into differenet parts…

      1) Treasury – this looks after the funding and liquidity and balance sheet risk management function. In the sense of your question FX in this part can be seen as an “RM” function within acceptable risk tolerances

      2)Financial Markets – this is where the sales and traders. in this section they actively take risk within certain risk tolerances. There job is to attract customer flow which supplements the traders own flow to generate profits. Its a a business for sure but a business wit limits.

      3)Risk Management – all banks have trader limits and risk limits for positions both individually and in aggregate. These are overseen at a desk level by management but with ultimate authority and monitoring and reporting by a seperate “RM” department.

      So what you have is an amalgam all of the above at all banks big and small. Obviously sometimes there are control failures like UBS recently and obviously the first round of the GFC showed some flaws in the model, big ones that a 5 year old could have spotted, but that was a failure of intellect not necessarily the culture of RM


      • Greg,

        let me clarify:

        forex trading is a zero sum game, as is roulette. Negative sum game after transaction costs (as are derivatives but we’ll save that for another day) as is roulette once you take into account the casino edge (transaction cost). So the point is that unless you are using forex to actively hedge risk you are basically playing a casino game. It is gambling regardless of how you view your level of skill.

        I assert that those whose trades are tied to underlying economic activity (i.e. hedging) are small relative to casino players. Therefore currency movements are primarily (directly) determined by things other than underlying economic transactions/fundamentals. These things have an indirect effect for sure because they impact sentiment but for me the point of floating currencies is for the currency to directly effect underlying economics and was away trade imbalances (I acknowledge that even without casino trades there are pegged currencies and CB interventions that make it difficult to achieve this).

        Can you explain to me how having a bank employ someone as a forex trader is any different to them employing someone to play roulette? One banks trader set his wits against others. Ones banks algorithms go up against others. What underlying social good does that provide?

        I’m sure shareholders would be outraged if a bank bankrolled a poker player (despite it being a game of skill) yet banks “bankroll forex punting. So why don’t banks hire people to play poker or bet on horses etc. (two “games” where the right person could have an edge)?


        • Deus Forex Machina

          Hi Mate…

          we are going to have to agree to disagree on this one in terms of the casino nature of the game…the house idea is the first place it breaks down as is the zero sum game idea…

          perhaps if your ever in Newcastle we could have a lively debate over a beer 🙂

          as for the share of trade attributed to companies hedging in the market you are right…it is a market dominated by trading

          that’s why i use “investment” fundamentals rather than “economic” fundamentals when framing my views for FX…

          As for the poker player – trader analogy I also think this is different too.

          For example I don’t gamble – no horse, dogs or trots, no footy or cricket bets no two up on ANZAC Day. Why? I have no control, I don’t have a framework for analysing the outcome and crucially if I place a bet and recognise the error I cant get out (although I believe you can actually trade odds in some spheres these days…so i don’t bet.

          But when it comes to markets I do have an analytical framework, i do have control (think of me at least as the jockey if the market is the horse) and I can get out if things change mid race or mid spin of the roulette wheel…

          the big difference in your analogy between poker and markets is that in poker you sit at the table and deal with the hand you are dealt…in markets you sit at the table and deal with the hand you want…you go through the cards and you pick the ones you want…no one cares if you fold 12 times in a row and the pot is not fixed by the players at the table…you may still not know what others are holding but your framework for analysis and your experience will help you get a feel for where the market is going and the market is much bigger than the deck on just your table…imagine a deck of 52 million cards rather than 52 (I think that’s how many are in a deck) with everyone playing at once.

          its a ham fisted way of explaining the difference by reference to your analogy but FX is not poker or roulette or a casino…

          maybe time for that beer 😀

          • Greg fair enough to agree to disagree over 99% of this but w.r.t. zero sum game, this is just simple arithmetic. Forex, derivatives and so on are all zero sum games (negative sum games after transaction costs). That is not a statement of opinion that is just a mathematical fact.

            If I am ever in newcastle I’d be happy to debate the rest of it over a beer 🙂

          • Deus Forex Machina

            I still don’t buy the zero sum thing lenny…in practical terms at least

            FX is not a cake and there is no fixed time or pot over which we must take our winnings or pay our losses…

            Over infinite time perhaps but at discrete time intervals no way…

          • Greg the fact that participants are “forced” to realize losses or profits are predetermined times doesn’t alter the zero sum game nature of the process.

            Think of an american option in which the participant can choose to exercise with some degree of flexibility. If you think of it as an accounting exercise you have a zero sum game at any point in time after the contract is struck. The values on each side of the ledger may change with time but they still sum to zero. Likewise with forex markets. At any point in time you have zero sum. The fact that you are unconstrained about when you realize profits and losses is irrelevant.

          • Deus Forex Machina

            Yeah Lenny I know what you are saying but in terms of why would a bank or a trader play an zero sum game then i think the analogy breaks down a little…

            Mainly because different players are playing in different time frames…

            A short term trader is selling to medium term buyer and boooks a profit then the medium term buyer sells to a long term buyer and also books a profit and then the long term guys can make money as well by selling to a short term trader who is playing the noise.

            So they are all accumulating greater than zero in that chain. Its not zero sum even if over the very long term you might argue it is.

            that’s why i say FX is not a cake…but it could be a multilayered wedding cake 🙂


        • Without forex traders, there will be no currency hedge. Even though currency trading is a ‘zero sum game’, there are economic benefits to make currency hedging available for exporters and importers.

          • no disagreement Ronin. you need these instruments to hedge risk. I a speaking solely about instances in which participants have not hedging but trading/gambling.

  3. HFT started off as a kind of ‘front running’. It can sniff out a buy order and buy up all sell orders at a lower price faster than a human trader. Since then, it evolved into something far more sophicated.

    There are two problem as I see it. First, the HFT programs are written to trade very aggresively, in the assumption that if something goes wrong (like the ‘flash crash’), it’ll be reversed. Secondly, as the HFT volume grew, the program has evolved to target what other HFT programs are doing. This is what BIS is warning us about. The human trader is increasingly being disillusioned, and when they see market trends that are illogical (like a stock market rally based on Europe not having a plan), they will blame everything on the ‘bots’ and sit on the sideline.

    A market with no human player can exist, however it’ll become useless to the society.

    • in addition to front running the game plan for HFT is to take advantage of structure at the e.g. microsecond timescale. At small timescales returns are structured in a way that in theory enables you to determine price movements. This structure “washes away” as the timescale expands so that by the time you get to e.g. per second ticks, you are left with the pseudo log normal distribution of returns, i.e. pseudo random walk.

    • Deus Forex Machina

      Amen to that…I couldn’t agree more.

      That’s the interesting thing here at present HFT in FX is not big enough to distort or destabilise FX but its a bit like a new freeway…provide the conduit and the volume of traffic will follow…so I’d expect HFT to get big enough to change the “ecology” of the market in a negative manner.

  4. Deus Forex Machina

    Bloomy reporting its being bought cause someone figured out that there is a German vote tonight…quality analysis!!!

    Short term EUR is hitting an old uptrend line on these 30 min charts so this 1.3640 region might hold it for a bit…

    but its 6am in London time for “early doors” move…

  5. So why are high frequency traders actually worse than slow frequency traders? Why should someone who speculates in the time frame of days be preferenced to someone who does so only intra-day?

    In equities a bank’s trading desk is surely no worse than a HFT desk – they don’t provide capital to companies any more than the HFT guys, they operate solely as a secondary market participant. A bank’s IPO or capital raising dept’s might, but don’t pretend they are the same. In fact they probably have chinese walls up between the depts because of regulatory requirements. If they don’t then a bank may be involved in insider trading.

    So what’s the difference? Both have speculated, neither have helped a company raise capital, or have traded goods and need to take a currency position or have done anything else economically useful. HFT firms have RM overseeing their activities, at a desk and organisational level so a lot of the reasons you cite above in your post to Lenny could easily describe an HFT organisation

    And if anyone can front run it’s a broker, not someone who has only public market data. A broker will know about a large client’s order before it’s public info. HFT guys might get the data before a “normal” trader, but only in ways that all direct market participants have access to. If slow frequency traders wanted to spent the money on the same systems and access there’s nothing stopping them. Some banks and clearers will even sponsor direct access to the market for non-participants, so it’s not really that exclusive.