The European Central Bank’s (ECB) decision to expand its quantitative easing program to include government bond purchases spurred recent fluctuations in the Swiss franc (CHF). The Swiss National Bank’s (SNB) response to the ECB was an about-face from the policy instituted in 2011 to peg the CHF to the euro. The CHF had become a popular currency in which to park funds and borrow money, but all this popularity made the peg even more expensive to sustain.
Many firms and households were impacted by the change and immediate volatility that followed in currency markets. The most severely affected firms tended to cluster in one or more overlapping categories. For our purposes, we’ll focus primarily on 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 currencies, abrupt moves can be especially disruptive, as they impact not only financial markets but also all manners of commerce in that currency. The most destructive events are often those that are widely considered to be impossible or highly unlikely.
Modern history of ‘crowded trades’
Recent trends show volatility is the latest in a long line of such trades. A trading position becomes “crowded” when it is held by enough investors that exiting the position could be difficult if the fundamentals of the situation change.
Crowded trades increase the risk of contagion, and when that trade reverses, the number of investors trying to get out of it makes the market very volatile—sometimes leaving major gaps in pricing.
This is a recognized risk in trading markets. In 2004 then-Federal Reserve (the Fed) Bank of New York President Tim Geithner reported that monitoring whether or not trades are crowded is something the Fed has done for more than a decade.
In 2009 economist Lasse Heje Pederson likened crowded trades to shouting “fire” in a packed theater: “You’re just as likely to be killed by a stampeding crowd as you are by the fire itself.” There was fateful truth to Pederson’s metaphor recently in Europe, as the markets reacted to an unexpected event, and a panicked rush for the exits ensued. The CHF has since stabilized to the euro, and had market participants waited it out, such heavy losses would not have been incurred.
CHF and euro instability
In 2014 17 countries in the euro zone experienced a bout of deflation. Switzerland had felt the pinch on and off for nearly two years, and in response, the SNB worked to keep deflation at bay by having negative yields out to the seven-year tenor. To maintain competitiveness with the euro zone, the SNB also pegged the franc to the euro. The SNB promised they would maintain this policy for the foreseeable future, and this assurance caused market participants to maintain a variety of positions, assuming the peg would remain in place.
However, two factors caused the SNB to re-evaluate this position. The peg was becoming more unpopular with the Swiss public that became so alarmed at the size of the SNB balance sheet that an attempt was made in November 2014 to pass a referendum limiting its size. When SNB officials learned that the ECB was to begin purchasing government bonds of European countries, they realized that negative yields in Europe would only put accelerated downward pressure on the euro versus other currencies in the world, especially the US dollar and the British pound.
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 than it had in the past. To prevent the balance sheet of the SNB from growing larger than its already bloated 86.6 percent of GDP, the decision was made to end the peg.
Part of the problem was that 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.
At the same time the ECB decided to purchase government bonds, the US Federal Reserve Bank reiterated its intention to raise short-term interest rates and begin to normalize monetary policy. Historically, when the major central banks of the world engage in opposing monetary-policy actions, market volatility ratchets higher. As a result, the turbulence beyond the Swiss exchange rate has been substantial, particularly with emerging-market currencies, such as the Mexican peso, which is now trading over 15.
Meanwhile, the euro had devalued 20 percent from last year’s high against the US dollar; the yen was down 50 percent versus the US dollar over 20 months; and even the Chinese yuan was allowed to sink to the very bottom of its trading range versus the US dollar in the last quarter of 2014.
Anatomy of contagion
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. Traders started raising cash by selling various assets to pay off margin. The significant move in the franc spurred dramatic selling in other asset classes. This is one potential reason why an expected pop in risk assets, such as equities immediately after the ECB announced quantitative easing, took a few days to materialize.
Further, many traders lost money—not because they couldn’t post margin, but because for about 36 hours, the market had no bid. That is to say in CHF there was no one to take the other side of the trade. 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.
Looking ahead: The risk for financial
services and how to be prepared
For financial services leaders, it is important to be proactive to stay ahead of the next crowded trade. A series of simple yet effective questions can be instructive:
Do you assess the crowdedness of a trade
as part of regular risk considerations?
Most leaders will likely say, “Yes.” But it is worth delving further to learn how they do this and how often this limits the size of their positions. Institutions should examine their portfolios to ensure that they can withstand pressure to sell, or can afford to sell at “fire sale” prices without putting undue pressure on other parts of their portfolios or holdings.
Do you identify hedges to carry trades?
Because carry trades are generally low-cost to get into, there is a temptation not to hedge against movement in the stable, low-priced security or currency. In the case of the Swiss franc, however, a little insurance would have gone a long way—because it was pegged, it would have been extremely inexpensive to bet that the SNB would end its peg. The lesson is that if a carry trade is crowded and there’s a lot of leverage, it may be prudent to put on a hedge for at least part of the position. That said, it was probably unlikely that those involved in the Swiss carry trade contemplated hedging—having reached a comfort level with several years of relatively stable trading in the currency.
Are you reading the tea leaves correctly?
Analytics tools are constantly improving. However, just because more data becomes available does not mean it is easier to analyze. Using sophisticated data mining techniques cannot just be the purview of the quant funds. All funds need to make use of this tool to remain competitive and avoid or hedge against crowded trades. One example is to compile and analyze the top holders of companies to get a sense of the crowdedness of single name equity trades.
Are you prepared for unforeseen instability?
These are volatile times. It is important to try to identify issues before they become major problems to be prepared for both the challenges and opportunities created by fluctuations in currency markets.
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. It is important to understand what you have exposure to so that you can engage in a dialogue about how best to manage that exposure.
With volatility an ever-present feature of markets that 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.
The article is written by John Budzyna and Constance Hunter of KPMG in the US.
R.G. Manabat & Co., a Philippine partnership and a member-firm of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
For more information on KPMG in the Philippines, you may visit www.kpmg.com.ph.