Let’s start with some numbers. Sterling fell 9% overnight on the Brexit vote; the yen rallied nearly 5%. Barclays was down 30% at the open on June 24; RBS down 24%, Lloyds down 29%. Additional tier one was off five points. Eurostoxx vol hit its highest level since September 2011. The Nikkei, with no obvious connection to the UK, was down 8%.
Many of these measures bounced back quickly, leaving sterling-dollar rates the remaining carrier of bad Brexit news. But by any measure, the market was a mess on June 24, with scarcely an asset class in global markets where prices were not lurching wildly.
The turbulence was repeated early on November 9, with Donald Trump’s victory in the US presidential election. This time it was the Mexican peso’s dollar rate which did the heavy lifting, with other EM assets sent spinning — a rally in Russia, a sell-off in Ukraine, widening across the Gulf. But Trump’s victory prompted a faster bounce back, and set off a sustained rally in equities, as market players learned their lesson from the Brexit results.
Template for Trump
“The Brexit vote provided a template for other macro events, for example how we set up on November 8 and 9 for the US election, and potentially other political situations such as the Italian referendum, and elections across Europe in 2017,” says Tarun Mather, head of European rates sales at Barclays.
But again, the night’s disturbances to the conspiracy of Wall Street elites did not actually do any immediate damage. High volumes went through, but prices did not gap downwards, and markets remained orderly and two-sided.
The obvious advantage banks had for both events was the chance to prepare. Unlike the Leave campaign, financial institutions put a lot of work into figuring out how different scenarios would affect the markets — and unlike the Remain campaign, they did not get complacent. In Donald Rumsfeld-speak, both Brexit and Donald Trump were known unknowns.
“We started off well in advance of the event itself, thinking about the impact on all aspects of the system,” says Lisa Francis, head of corporate FX sales Europe at Barclays in London. “Processes, collateral calls, cut-off times, when clients would want to come to the market, and how we’d be able to facilitate their trades.”
In that respect, these two political shocks differ from other market upsets. The Swiss National Bank’s abandonment of its currency peg to the euro in January 2015 came as a complete surprise. It was announced in European market hours, and left banks nursing hundreds of millions of losses. Currency broker FXCM needed an emergency rescue from Leucadia, the parent of Jefferies.
No doubt plenty of funds positioned themselves the wrong way for both Brexit and Trump, but currency funds are supposed to have capital at risk — trading desks at banks, meanwhile, are just supposed to be intermediaries, in the new regulatory environments.
There were not any noticeable wobbles, either. The SNB move saw trades reviewed, and some of them torn up, as with other “flash crash” events where fat fingers or rogue algorithms pushed markets around.
One investment bank chief executive said that a couple of funds were late meeting their margin calls — but only by a couple of days, and with their counterparty’s consent.
Actually, as intermediaries, both political upsets were great news. Volumes boomed, not just on June 24, but for weeks afterwards. Most of the Street reported FICC revenues up 30%-40% for the third quarter.
But this did not come easy.
Long hard night
For one thing, it meant being willing to trade all night. Foreign exchange trades continuously, even if listed equities do not, but most institutions appeared to have kept their whole London trading operation live through the night, and through the day following.
“We decided to rest our people on a staggered basis, having teams in and out for five to six hour stints,” says Francis at Barclays. “We wanted to avoid a situation where everyone was excited through the night and just came in early when the polls were turning because you can end up with a tired trading floor by late afternoon.”
This, in turn, meant all the support functions staying live as well.
Francis continues: “We had teams of people to support the trading businesses here through the night. We had credit teams, legal, compliance, people serving the troops coffee. The whole infrastructure was geared for us to best serve our clients.”
In other time zones, the Brexit vote may have slotted into the trading day a little better — but some UK-based desks warned their colleagues based in the US not to give too much credence to early poll numbers or declarations.
Most important, however, for all the institutions trading that night, was risk, given the magnitude of the moves involved. One US investment bank said it had $19bn of collective margin calls to deal with.
Figures from the Commodity Futures and Trading Commission stress tests, published in late November, show an extra $27bn in collateral calls across the five largest clearing houses on June 24. With movements of this magnitude, the most senior officers in the bank need to be on hand if needed.
Collateral calls, however, are only a problem when you don’t have enough collateral.
Shrinking repo
But that’s exactly what worries many regulators in normal times, as margin rules for derivatives, the shift of interbank markets from unsecured to secured, bank rating downgrades and the rise of clearing houses all tend to need more top quality bonds to back trades.
Meanwhile, repo markets are tightening. Government bond repo is a leverage-intensive business, while the ECB’s public sector purchase programme has sucked a huge volume of European govvies out of the market. Repo market participants hold an increased proportion of bonds quoted at levels which are “special”, and fewer executable prices.
Whatever the longer term trend of the market, however, it was alright on the night.
Most institutions had been running very flat positions into the vote, and ensuring they had plenty of liquidity on hand — enough high quality liquid bonds, as well as cash and money market instruments. This meant enough risk appetite to move fast, and enough resources to meet cash calls.
Even if banks hadn’t done this for themselves, regulators would have forced their hand, since the vote didn’t come as a surprise for them either.
“The regulators, central banks and banks were in regular communication to ensure the industry was prepared for volatility and thinner liquidity,” says Patrick George, head of EMEA markets at HSBC in London.
“Risk management metrics are solid given the regulatory environment of the last few years. Inventories are at their lowest level, while banks have more liquidity buffers and reduced leverage.”
The Bank of England hit the screens on Friday morning, offering an extra £250bn in liquidity to UK institutions, as well as foreign currencies through its swap lines with other central banks.
The Bank had already announced measures, cutting capital buffers, extending term repos, and buying corporate bonds.
The announcement helped to calm the panic in UK bank shares, but no institution seemed to take advantage of the facility, according to subsequent Bank statistics.
Thinner markets, but still markets
The Bank of England’s Financial Stability Report, published in July, noted thinner rates markets in the run up to the vote, with sharp declines in volumes for Bund futures, Gilt futures and cash US Treasuries. It also noted wider bid-offer spreads in cash Gilts — running up from around 0.7bp at beginning of May to over 1.2bp.
But, overall, the Bank’s assessment was positive.
“Electronically traded markets (such as foreign exchange and equity markets) proved resilient to volumes of transactions much higher than their normal levels,” said the report. “The volume of transactions in short-term Gilt repo markets was below, but close to, its average daily level since 2016. At the same time, activity in some dealer-intermediated markets, including corporate and UK government bond markets, was subdued, but appeared to be largely orderly.”
The pattern of trading through the Brexit vote was, of course, different to normal. While FX and equities might have remained firmly electronic, more trades were done by voice, and more liquidity gravitated to the most traded instruments.
“In rapidly moving markets, there’s a tendency to want to transact business via voice, which contrasts with the overall pattern of recent times,” says Mathur at Barclays.
HSBC’s George says: “Liquidity, in these more stressed or volatile moments, gets concentrated into the most liquid instruments of any asset class — on-the-run government bond, on-the-run credit indices, ETFs of major stock indices, futures. As the market calms, the stock-picking, single name story approach starts to return.”
Regulatory strength
Longer term, it seems regulation can take much of the credit for the resilience of the capital markets. While plenty of industry groups and banks themselves have argued regulation hurts market liquidity, and may discourage banks taking the other side of trades as principals, it seems it has made the industry better able to handle the largest market moves.
“My view is that a lot of the regulatory initiatives, and the conduct changes that banks have made created a far more professional and resilient outcome than might have been the case in previous years,” says Mathur. “There was a large and rapid move in sterling, but markets showed a strong degree of leadership by remaining orderly throughout and continuing to facilitate all aspects of client flow.”
That bodes well for another year full of political risk. Even if the world ends up in big geopolitical trouble, its banking and markets seem strong enough to stand up.