Will FX Liquidity Vanish Friday? You'll Find Out - Analysis

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FX traders this week have fretted that the price action in currency markets in the wake of Thursday's UK Referendum will resemble that seen in January 2015, when the Swiss National Bank roiled markets by removing the Chf1.2000 floor in the euro-Swiss cross.

Liquidity disappeared in a nanosecond that day. Carnage ensued, with millions of dollars in FX losses booked.

The Brexit vote may make the aftermath of the SNB floor debacle look like a cake walk, traders said.

"Everyone is planning to work through the night - if they leave - it will be messy, very messy," one U.S. trader said.

"Depending on the circumstances this could be January 2015 all over again," said one UK strategist, referring the SNB's action last year.

"No one is going to make a rate or support the market depending upon the outcome ... . Many of the banks will not watch or guarantee in any way any customer orders over the window," he said.

The strategist saw scope for nearly zero liquidity as FX traders globally pull in their horns and lie low.

"We are trying to dissuade clients from leaving orders," confirmed a U.S. corporate strategist.

"No one is guaranteeing any order limits or stops," noted another trader.

Seasoned traders have long stressed that FX liquidity is an illusion, i.e. that a handful of major players make prices for the various platforms and sub players piggyback off of these prices and are not market makers.

So, if the major banks decide not to make prices to protect themselves from post-UK Referendum losses, it is likely that spreads in currencies such as cable, the euro and dollar-yen, which are usually less than a pip, could be hundreds of points wide at some point in the next two days.

Euromoney's FX rankings survey 2016, released in late May, noted that the biggest ranking change was that the combined market share of the top five banks (Citi, JP Morgan, UBS, Deutsche Bank, BOA Merrill Lynch) accounted for only 44.7% of the total in 2016.

This compares to a peak of 61.5%, seen in 2009 and a 60%-plus ranking as recently as 2014. The top 10 FX houses has also declined, to 66% this year from 75% in 2016, with the decline driven by the performance of the top 5 banks.

The banks rankings decline comes as non-bank liquidity providers gain a greater foothold on market share.

If the major banks do not make prices Friday, the question is, what motivation is there for the non-bank liquidity providers to step up to the plate?

In April 2015, the International Monetary Fund released their Global Financial Stability report, with a section on "When Market Liquidity Vanishes."

In the report, the IMF pointed to, "Two recent price disruptions - the October 15, 2014, volatility in U.S. Treasuries and the January 15, 2015, surge in the Swiss franc" and said that these episodes "involved an initial shock that was likely amplified by market makers' withdrawal of liquidity support."

The IMF observed that, "Many of the factors responsible for lower market liquidity also appear to be exacerbating risk-on/risk-off market dynamics and increasing cross-asset correlations during times of market stress."

"These phenomena suggest that low market liquidity may act as a powerful amplifier of financial stability risks," the IMF said.

In addition, the IMF said "technological change, regulation, and the shifting composition of market participants have altered the microstructure of the Treasury market and fixed income markets more broadly."

"As a result, participants cannot always rely on dealers to provide sufficient liquidity in volatile markets, making them more vulnerable to liquidity shocks; Moreover, market safeguards may no longer be appropriately calibrated to changing market conditions," the IMF said.

Specific factors include 1) the "automation and the rise of high-frequency trading" 2) the "reduction in market making by traditional dealers" 3) "inadequate market safe-guards" 4) the "emergence of less-regulated non-bank market intermediaries" 5) "benchmarking" and 6) the "use of derivatives and exchange-traded funds."

In terms of January 2015 memories, FXCM, a leading online provider of foreign exchange trading and related services, compiled data points regarding the January 15 euro-Swiss "flash crash" and released their findings March 11, 2015.

FXCM wanted to "demonstrate the unprecedented and extreme dysfunction of the FX market" in January, after the SNB announced it was removing the Chf1.2000 floor in euro-Swiss.

At 4:30 a.m. Eastern Time, the SNB made the announcement and the cross broke below Chf1.2000 for the first time.

"Nine seconds later, the major international banks who provide liquidity to FXCM began rapidly removing liquidity as quotes go as low as 1.1659," the FXCM report said.

At 4:32 a.m. ET, the first quote from FXCM liquidity providers is seen at 0.9831. Less than a minute later, "a major international bank quotes a bid of 0.6374."

At 4:35:16, "While there are still no valid quotes on EBS, three bid quotes from FXCM liquidity provider bounce within a 6000 pip range in 2 seconds: 1.1078, 0.5696, 0.9769," the report said.

FXCM noted that Chf0.5696 was "the lowest quote received by FXCM from all its liquidity providers."

"The January 15 flash crash saw the EUR/CHF drop 40% in seconds whereas the 2010 flash crash in the equities market saw about 9% drop in the Dow Jones Industrial Average over the course of a few minutes," FXCM said.

Traders had no desire to make FX prices in a fast-moving market.

"Everyone has an excuse - no one wants to lose their career," one U.S. trader explained.

"No one wants to explain a big loss or gain on these days - welcome to regulation," offered another trader.

In the Foreign Exchange Committee's latest FX volume survey, released by the New York Fed in January, as per October 2015, average daily volume in total over-the counter (OTC) foreign exchange instruments (including spot, outright forward, foreign exchange swap, and option transactions) was $809.3 billion in October 2015.

Traders were also on the alert for FX intervention by the various global central banks.

JPMorgan strategists maintained that even in the event of Brexit, which was not JPM's base case scenario, "Unilateral FX intervention by the BOE to support the pound or by the BOJ to weaken the yen is unlikely, as convention amongst major economies obliges such actions to be coordinated through the G7."

They saw the "bar for coordinated intervention" as high and said it would likely require "USD/JPY to depreciate sharply (to below 100) and for FX volatility to rise materially (perhaps above 17% on VXY from its current 12%)."

As for other official measures, "The extension of G7 FX swap lines and emergency domestic liquidity facilities is a given, as these have become standard over the past several years due to Lehman," they said.

In terms of potential FX levels, if the UK votes to leave the EU, cable would likely move to $1.32, euro-sterling to Gbp0.8300, the euro towards $1.09 and dollar-yen towards Y101, the strategists said.

Commodities and EM currencies would likely see a 2-3% decline, JPM added.

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