TWO notable events roiled global currency markets in 2015. The first was the Swiss National Bank’s scrapping of the peg on the Swiss francs to euro in January. The abandonment of the peg, which had essentially pinned the currency at 1.20 francs per euro for the past 3½ years, prompted a collapse of as much as 30% in the euro versus the franc, the biggest single-day move in a developed market that traders could recall.
The other, in the emerging market space, the Peoples’ Bank of China devalued the Chinese yuan by almost 2% in August, prompting the yuan suffered its biggest one day decline in more than two decades. Both events were driven by Central Bank action in an unexpected manner and markets being caught off guard. While these events can be explained, certain exchange rate movements are totally unexplainable, unless one looks into the microstructure of currency markets.
Dramatic exchange rate moves are as puzzling to economists as they are disruptive to market participants. Exchange rates often make huge, abrupt moves and it is all the more startling especially when it does not appear to have been triggered by any fundamental factor, though at times it’s rather fanciful by market practitioners to pin it down to economic indicators or news flow for sudden large swings.
Large intra-day move in certain currencies that are under stress is driven by patterns in the placement and execution of price contingent orders. These form of trading orders include stop-loss orders and take-profit orders.
Stop-loss orders instruct dealers to buy (sell) when the price is rising (falling) while take-profit orders instruct dealers to buy (sell) when the price is falling (rising). Any exchange rate move would trigger both stop-loss and take-profit orders, and one of these order types will require purchases while the other requires sales. Currency dealers manage these orders for customers and for others within their own bank. When liquidity is rather thin, prices would reflect a cascading pattern and discontinuous gapping, and for no apparent reason currency prices move abruptly and wildly.
Information about stop-loss and take-profit orders is held fairly closely by currency dealers for good strategic reasons since it is part and parcel of their profit and loss targets. Giving out information on stop-loss and take-profit orders to the public at large or even to counterparties in the dealing rooms would not be in the best interest of any currency dealer.
The ringgit’s recent swing to the firm side, gaining by almost 17 sen in a single trading session on Wednesday is a classic case study of how prices cascade very quickly. The gains on the currency perhaps caught many off guard, for the sheer size of the move, but the triggering of stop-loss and take-profit order at certain levels tends to amplify the ringgit’s cascading pattern.
When there are many stop-loss buy orders there will likewise be many take-profit sell orders, so the average of order flow is likely to be small. However, in the case of the ringgit, since the orders cluster differently, there will be occasions when one order type clusters strongly while the other does not, which could generate large bursts of net order flow and extreme swings on the currency, which typically describes the recent gains on the ringgit.
These form of pattern in ringgit currency trading is likely to prevail in the near term, given the fact that the market is highly skewed towards long foreign currency positions, since foreign currency deposits held by business enterprises have ballooned to RM71.5bil as at July from RM60bil in January 2015.
Further gains on the ringgit should open the valve of foreign currency inflow into the local financial system, but the big question being what would the ringgit trigger level be for businesses to do so.
The US dollar-ringgit level of RM4.00 to the dollar is a key psychological level to be eyed, and it is at this very level that some of the conversions would eventually be made since currency option strikes and foreign exchange forward contracts at this price level played a very prominent role in the valuation of contracts when the ringgit was on a weakening path.
The next big level being the RM3.80 level, a prominent rate that has played a vital role during the Asian financial crisis of 1997/1998. A breach below this level would truly signify normalcy is back into the ringgit currency market, but to do so for that final push it would eventually need a strong dosage of currency intervention, an intervention that is “with the wind” and giving more bang for every “sell order” of the US dollar and “buy order” for the ringgit.-TheStar
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