* Bankers put 10-cent fall in sterling down to algorithmic
* Traders have warned for month of gaps in global FX market
* Big new electronic players not filling void left by banks
(Updates to give full name of Citadel Securities in paragraph
By Patrick Graham
LONDON, Oct 7 Sterling's short-lived 10-percent
fall on Friday could not have happened without the
lightning-fast computer-driven trading that now dominates the
$5-trillion a day foreign exchange market. But a person, not a
machine, was probably ultimately the cause.
The Bank of England is still investigating the cause of the
sudden price move.
But traders and senior managers at some of the main non-bank
market makers said Friday's crash probably stemmed from an error
in the parameters of one of the algorithms that more
sophisticated players routinely use to execute larger orders.
Electronic platforms developed over years of a technological
arms race among banks and other players now account for 95
percent of trading and run on algorithms that can buy or sell a
currency, often without human intervention. But people set the
parameters for the algorithms.
"If it was an execution algo and someone was working
something in it and it winds up being on a best efforts basis in
a thin market, then this would be the result," said the head of
hedge fund sales at one of the top five currency trading banks.
"What that adds up to is human error," he said. "But once
you have a largish volume going through on that basis, it will
trigger other computer-driven orders."
Algorithms can trigger buy or sell orders when certain
levels are reached, meaning a fall can rapidly accelerate, as
happened in January 2015, when the Swiss franc dropped 40
percent against the euro in a matter of minutes.
But that fall was triggered by the announcement of a major
change in Swiss central bank policy, whereas Friday's flash
crash in sterling had no apparent similar cause.
Those in the industry say the impact of algorithms has been
exacerbated by other changes to the FX industry, following huge
market-rigging fines levied on banks and a raft of new
Bankers say such changes have left the market dangerously
short of liquidity: when a bank or an asset manager seeks to
sell large orders, there could be too few buyers to absorb that
order without it moving the market substantially.
Many see that as a hazard of the slow death of risk-taking
by people-led voice trading desks at banks, which historically
would take and if need be hold millions worth of orders until
they could get what they judged was the best price.
The biggest of the "algo" players are a handful of
businesses which have emerged from the hedge fund world to rival
the banks essentially by working far more efficiently and with
far less regulatory baggage and backroom staff.
New York-based Virtu, Citadel Securities and Tower Research
Capital along with new European player XTX Markets, London's GSA
or Chicago-based Jump Trading, have become both rivals to and
partners of banks. There was no indication that any of these
firms played any specific role in Friday's price moves.
Where historically voice desks might hold the risk of open
currency positions overnight if they had taken orders but could
not fulfil them at a good price, new players will now sit on an
order for no more than minutes or seconds.
Banks have followed suit and removed the sort of instinctive
decision-making by more experienced traders that in the past
would have prevented large-scale trading at off-market prices.
That means the bank may be less exposed to the risk of holding
an open trade, but its clients may potentially face more risk
from sudden volatility.
"In the post-GFC (global financial crisis) world we are
making individual institutions more resilient, but systemically
instability still persists," said Nick Parsons, a currency
strategist with National Australia Bank in London.
"We're seeing a very rapid game of pass-the-parcel and
machines playing pass-the-parcel can do it much more quickly
than 10-year olds at a birthday party."
The programmes run by the big new algorithmic foreign
exchange trading houses tend not to take a directional view of
currencies. Rather they are seeking to make a profit through
arbitrage off the relationship in prices of, say, sterling and
other assets that trade in some kind of correlation with it.
That might mean working through past data on the link
between sterling and certain share prices, and when sterling
rises or falls, quickly buying or selling the shares before
their prices have had time to catch up.
Crucially, however, such algorithms are all dependent on the
reference prices created in trading venues like ICAP-owned EBS
or Reuters News owner Thomson Reuters, meaning
a run on those prices may trigger a series of responses.
"All the HFTs try to do is find price discrepancies," said
another senior sales executive.
"You typically don't make it worse. But if there happen to
be two or three execution algos out there with interest to sell
the currency, then that will drive it. I absolutely think that
this is down to some sort of human error."
(writing by Patrick Graham; editing by Peter Graff)