Barometer of Fear

by Alexis; Stenfors

  Market making is not only about quoting prices to others, it also involves asking others for prices. Thus, market makers are both goalkeepers and strikers at the same time. As in sports, it is easier to win a contest if your opponent is weak. By the same token, if you are weak, or perceived to be weak, you opponent is more likely to launch an attack. Market makers are therefore good at spotting each other’s weaknesses, and will sometimes use (or abuse) those weaknesses if and when the opportunity arises. In other words, just as market makers can learn how to detect and avoid their own habitual mistakes, they can learn to exploit the psychological flaws of others.

  Market making does not come without its drawbacks, one of which is visibility. Other players know that market makers are able to suck up information and sentiment from the market by quoting prices throughout the day. This is one of the reasons why, when I was a trader, clients and sales people often tended to ask market makers for ‘market colour’ – a string of intangible factors that gave a feeling for the direction of the market. Sometimes this feeling was underpinned by real or potential trading activity. Sometimes it was just a gut instinct. Whatever its basis, market colour was a sought-after form of expert judgement that predominantly came from the market makers.

  However, the existence of such market colour (regardless of whether it is revealed to others or not) can also lead to unwanted copycat behaviour. The logic goes like this. Because of fear or greed, other players try to imitate the actions of a market maker, who is presumed to have unique information. If the market maker buys, others try to buy. If the market maker sells, others sell. Consequently, executing a large amount can be difficult, as others figure out the market maker’s intentions and jump the queue before the mission has been completed. What is more, competing market makers who have snapped up some information might warn others of an incoming attack. Brokers might be told that ‘the Big German Guy is selling!’ or that ‘the Oil Tanker is out spraying the market in size!’ Even without mentioning real names, market moving information spreads like wildfire in an environment where everyone knows everyone else. The market maker might therefore want to divert unwanted followers. Rather than attempting to execute a very large amount, which is immediately spotted and ultimately proves to be loss making, the market maker can turn copycat behaviour to their advantage. Instead of trying to sell a large amount, the market maker might buy a smaller amount via a broker. The broker, unaware of the market maker’s true intentions, whispers to his best clients that ‘the Big German Guy is out buying!’ or just shout ‘Taken!’ down the speaker boxes to a number of dealing rooms around the world. Now, knowing that other traders have been warned of the opposite, the market maker begins to sell frenetically, taking advantage of the fact that other traders have read the market maker the wrong way: as a buyer rather than a seller. Trading techniques have also been refined to exploit the fact that human beings tend to be psychologically affected by real, observable and recent events – such as a fear of flying after a recent and widely reported plane crash. Traders have similar biases. If something special happens for real in the financial markets, players often adjust or anchor their perception of reality around that event. If a market maker puts in a ridiculously low bid – let’s say ‘83’ – with a broker, nobody takes any notice. A price at which nobody in his right mind would be prepared to sell is of little interest. However, if another trader (perhaps conspiring with the market maker) suddenly decides to sell at that price, everyone is immediately alerted to the fact that the market has been ‘given at 83!’ The instinctive knowledge that the market has suddenly collapsed often has more impact than the knowledge of why this has happened. A similar logic applies to ‘spoofing’ and ‘layering’, which involves placing fictitious orders in the market with the purpose of influencing other traders’ perception of the prevailing market. These could be seen as either clever trading tactics or outright deceptive behaviour.

  When my ex-colleague pondered what might happen should regulators shift their investigations from LIBOR to FX, he was referring to an open secret – that numerous forms of bluffing (or double-bluffing) had been regarded more as ‘trading techniques’ than as ‘deceptive and market abusive practices’ in the FX market for as long as both of us could remember. There was no textbook, manual or crash course on the subject. Instead, poker tricks such as these were taught on the job, passed down from one generation of market makers to the next – informally, of course. Put differently, behaviour that would be unacceptable in, say, stock markets had long been cynically regarded as ‘part of the game’ in the global FX market. Although the culture was not considered criminal, it was not always considered ethical.

  ***

  Recently, without thinking too much about it, I sent a LinkedIn request to my psychotherapist – not to book a session, but simply to add her as a ‘friend’ on social media. She declined, and wrote me a personal email instead. ‘I saw your invitation on LinkedIn and just wanted to say thank you, but unfortunately it is leaning towards being unethical.’ Having embarrassingly completely forgotten about the obvious patient–therapist relationship issue, I apologised. The boundary was clear – rather more so than has sometimes been the case in banking.

  One of the banks’ ‘criminal activities’, to paraphrase the FBI, related to how they had exploited some of their clients. In particular, banks had tried to trigger so-called ‘stop-loss orders’ to profit from them.

  I still remember my first ever stop-loss order. I was a junior trader and my manager asked me to watch his position of 5 million deutschmarks against Swedish kronor during the day, and then to pass it on to another bank overnight. I cannot recall the prevailing exchange rate at the time or whether he was ‘long’ (betting that the market price would rise) or ‘short’ (betting that the market price would fall), but for the sake of simplicity let us assume that he was long 5 million deutschmarks and that the market exchange rate was trading at 5.0000. Thus, if the exchange rate appreciated by 1 per cent to 5.0500, he would make 50,000 worth of deutschmarks (250,000 Swedish kronor) and if the exchange rate depreciated by 1 per cent to 4.9500, he would lose the same amount. By leaving me a stop-loss order at, say, 4.9500, he instructed me to ‘close the position’ (do an opposite trade to eliminate the risk) should the market exchange rate fall to 4.9500. He could be assured that no matter how much the market moved against him, his maximum loss was capped at 250,000 Swedish kronor.

  Nothing happened during my watch. It was nerve-racking, though, to stare at the flickering market prices that changed every second, perhaps dropping as low as 4.9580 but nevertheless not quite reaching the predefined level at which the ejector seat was to be activated. I sweated a lot, I couldn’t leave the desk for a second, and I almost felt relieved when I could call the trader at the other bank and leave it all up to him. As we were not market makers in the specific currency pair at the time, I was treated more like a client (a patient) than a competitor (another clinic offering therapy sessions). However, nothing happened during New York trading hours either, and the stop-loss order was passed to Hong Kong. In the morning, the trader called me up to say that nothing had happened overnight, and that the order could therefore be cancelled and passed back to me. I started watching again.

  Leaving a stop-loss order overnight should have enabled me to relax, as the worst-case scenario was limited. In all honesty, though, I don’t think I slept at all that night. I was way too nervous that the stop-loss might be triggered and that I would have to deliver the sad news to my manager that he had lost money. However, the downside was limited. The trader at the other bank had guaranteed that if the market moved to 4.9500 (the predefined level), he would do a trade with me at that price before the market had time to move even further. If so, the hot potato became his problem. If he then believed that the market would drop further – to 4.9200, say – he would sell the 5 million to someone else. If he believed the market would rebound, he would keep it, hoping to make a profit at some later stage.

  B
anks receive numerous stop-loss orders from clients, but also ‘take-profit orders’ (assume that my manager wanted to close his position at a profit should the exchange rate move to 5.0500). They offer this service free of charge.

  Why would a market maker voluntarily absorb the fear and anxiety of customers and other traders for free? An important factor is information. Being able to (almost secretly) read the cards of customers and other traders is a valuable asset: for example, a Swedish car company’s position in US dollars against Swedish kronor or a mobile phone manufacturer’s position in British pounds against South Korean won. Such orders add up to information about the supply and demand of the market. If nine clients leave stop-loss orders to protect them from lower prices and only one client the opposite, it appears as if the client base (and perhaps the whole market) is ‘long’: in other words, they are betting that the market will rise. In that case, an unexpected collapse in the price would trigger a string of stop-loss sales, causing the market to plummet. Similarly, if many orders (or large orders) are given within a certain price range – 4.9000 to 5.1000, for instance – they indicate that such price levels are particularly sensitive. If these levels, for whatever reason, are reached, sharp market movements will follow.

  Generally, we tend to think about markets being driven by the buying and selling of products. Prices then fluctuate according to the ‘real’ buying and selling. Stop-loss and take-profit orders are somewhat different, because they are not actual trades until they are executed – and most of them never are. They are, however, very important in revealing what clients want to do if something happens in the future: ‘If the euro falls below 1.10 against the US dollar, I want to buy €10 million’ or ‘If the Swiss franc rises to 3.30 against the Brazilian real, I want to sell 15 million francs.’

  The problem is that a market maker with a substantial client order book could, technically, ensure that the ‘if’ happens. This is where the unethical part comes in. Let us return to my own stop-loss order above. If the market had been trading at, say, 4.9520 in Asia (when I was desperately trying to get some sleep in Europe), a bit of selling might have been enough to push it down to 4.9500, at which stage the bank with which I had left my order would automatically have executed my order to sell 5 million to them. It would not matter if the market then immediately bounced back to 4.9520. The bank would already have booked a profit by having sold to someone else at 4.9520 and having bought them from me at 4.9500. Triggering a stop-loss is a manipulative technique to ensure that the ‘if’ happens, even if it is just for a very brief moment in time.

  ‘Love them … free money … we love the orders … always make money on them,’ an HSBC trader had told a colleague according to transcripts released by the UK financial regulator, following a string of fines imposed upon a handful of major banks. To traders at other banks, an HSBC trader had said: ‘Going to go for broke at this stop … it is either going to end in massive glory or tears’ and ‘Just about to slam some stops.’8

  Not all orders in the FX market relate to if something happens. Orders can also reveal what clients want to do when something happens in the future: for instance, ‘When it is 4 o’clock in London, I want to buy £20 million against euros.’ In other words, clients not only give take-profit or stop-loss orders to banks, but also specific orders to buy and sell various currencies at a particular moment during the day.

  This type of order is widely used in the global FX market. The so-called WM/Reuters 4 p.m. fix is the world’s most widely referenced FX benchmark. In contrast to LIBOR, where banks argue about the level of a price, the 4 p.m. fix is based on actual FX trading by market participants just before and just after 4 p.m. London time. This foreign exchange benchmark, like LIBOR, has become increasingly important over the years. From having mainly been used for valuation purposes, it is now used not only in a range of derivative instruments and other contracts, but also by clients as a trustworthy and ‘official’ closing rate for a range of currency pairs. The market continues to trade after the fixing. However, given that around 40 per cent of the global foreign exchange turnover takes place in London, and that the FX market conventionally ‘closes’ at 4 p.m. (i.e. it then shifts to New York), it appears to be a cleverly chosen snapshot in order to capture the market when it is very liquid. Bundling as much buying and selling as possible into one minute gives clients time to focus on other important matters during the rest of the day.

  ‘Banging the close’ is a technique to try to influence a benchmark, such as the 4 p.m. fix. Rather than trying to buy or sell in order to push the exchange rate to a level at which a stop-loss order gets triggered, it involves trying to buy or sell in order to push the exchange rate as far as possible in one direction or the other at a specific time during the day.

  This might, or might not, involve collaboration between several market makers. Assume that three fictitious traders, Andy, Bruce and Charlie, despite working for three banks in fierce competition with each other, happen to be good friends. A pension fund has placed an order to buy €200 million against US dollars from Andy at 4 p.m. A life insurance company has placed an order to buy €20 million from Bruce, also at 4 p.m. And a dishwasher manufacturer has placed an order to sell €50 million to Charlie. Looking at the order books, it is clear that Andy would prefer a very high 4 p.m. fix as he will sell €200 million to the client at whatever the closing rate will be. Bruce has the same interest, although he will sell only €20 million. Charlie, however, would prefer a low 4 p.m. fix, as he will buy €50 million from the dishwasher manufacturer. Andy and Bruce, in other words, have the same incentive, whereas Charlie has the opposite incentive. Andy and Bruce will do whatever it takes to achieve a high exchange rate at 4 p.m. Charlie, however, will try to push it lower. But all three are friends, and they don’t want to deliberately cause each other losses or missed opportunities in order to make money.

  Given Charlie’s limited amount of ammunition (€50 million versus Andy and Bruce’s combined €220 million), he would be the likely loser. Therefore, he could give a €50 million buy order to Andy that perfectly offsets the one he has received from the dishwasher manufacturer. Andy would then have sell orders worth €150 million, Bruce would still have sell orders worth €20 million, but Charlie would effectively have nothing left. Instead, he can sit back and watch the action from a comfortable armchair.

  It could also be that David, a fourth market maker, has the opposite interest. If that is the case, Andy might wish to reduce his exposure further (from €150 million to, say, €90 million) to ‘clear the decks’ or to ‘take out the filth’ from the market – in other words, to prevent other market makers from working against him and Bruce.

  ‘Hopefully taking all the filth out for you … hopefully decks bit cleaner,’ a Barclays trader told a UBS trader, having matched €196 million worth of orders to help his friend ahead of a benchmark fixing on 15 February 2012.9

  Ultimately, the large banks get the vast majority of orders and are therefore able to benefit from superior information. Moreover, the larger the orders, the greater the potential there is to make more money. Another tactic would therefore be to ‘build ammo’, where orders are actively increased to create an even stronger desire to make the ‘if’ or ‘when’ happen. Bruce, with orders worth €20 million in the example above, might transfer his orders to give Andy even more ammunition ahead of the fixing battle.

  ***

  One afternoon, the following scenario was played out on the FX spot desk at HSBC (with spelling mistakes as they were typed in the chatroom forum), according to transcripts released by the FCA.10

  3.25 p.m.: HSBC has orders to sell £400 million against US dollars, and Bank A has sell orders worth £150 million. ‘Let’s go,’ HSBC tells Bank A. ‘Yeah baby.’

  3.28 p.m.: ‘Hopefulyl a few more get same way and we can team whack it,’ Bank A says. HSBC asks Bank C to do some ‘digging’ to see if anyone else has orders in the same direction.

  3.34 p.m.: Bank C h
as sell orders worth £83 million.

  3.36 p.m.: Bank A now has sell orders worth £170 million and Bank B has £40 million in the same direction. Bank D steps into the conversation and exclaims: ‘Bash the fck out of it.’

  3.42 p.m.: Bank A warns HSBC that Bank E is ‘building’ in the opposite direction to them and will be buying at the fix.

  3.43 p.m.: Bank A tells HSBC, ‘[I have] taken him [Bank E] out … so shud have giot rid of main buyer for u … im stilla seller of 90 [million] … gives us a chance.’

  Between 3.32.00 p.m. and 3.59.00 p.m. that day, HSBC sold £70 million against US dollars, and the exchange rate fell from 1.6044 to 1.6009.

  Between 3.59.01 p.m. and 3.59.05 p.m., HSBC sold a further £101 million, and the exchange rate fell to 1.6000.

  Between 3.59.06 p.m. and 4.01.00 p.m., HSBC sold £210 million.