The Bank of England has warned the financial community against complacency in the wake of a series of “short sharp shocks” in markets over recent months that it said could happen more frequently.
Chris Salmon, the Bank’s executive director for markets, said uncertainty surrounding the global economy following the collapse in the oil price had heightened anxiety in the major currency and bond markets.
He argued that the growing unease combined with a shift to computer-generated trading platforms, some of which froze amid serious market volatility related to US Treasury yields and the Swiss franc over the past year, had triggered panic trading.
Salmon said another “flash crash” in one market could spill over into other markets and cause widespread panic.
The warning followed an unusually calm period last year when the Greek crisis and other major events failed to move markets. But in October, concerns about the global economy triggered a flash crash in US Treasury yields, and in January this year there was a sharp rise in the Swiss franc after it was detached from tracking the euro.
In both cases, markets stabilised over the following weeks to avoid contagion to other markets, but this may not be the case every time, Salmon said.
“Financial markets may not have been truly tested for the ability to absorb price moves or flows that persist for a prolonged period, or for a wider spillover between markets,” Salmon said in a speech in London.
“And that is why it is only fit and proper for me to finish on a cautionary note: market participants take heed.”
He said the spikes in volatility in recent months have coincided with periods when trading firms were reluctant to buy and sell financial instruments in the frenzied period during a major event.
Increasing reliance on computer-based trading was reason to believe that the severity of the two events was accentuated by structural change in the bond, commodity and currency markets, he said.
“There must be a risk that future shocks could have more persistent and more widespread impacts across financial markets than has been the case in the recent past.”
He said markets were more liquid before the banking crash of 2008, but warned that this was an unusual period when the cost of participating in markets was “under-priced”.
Regulators have encouraged banks to direct their currency trades via electronic trading platforms to make them more transparent. Currency markets dwarf stock and bond markets with trillions of dollars traded every day.
But the algorithms used by the trading firms can lead to the platforms shutting down in periods of stress that occur when lots of participants want to buy, without any traders willing to sell. The mismatch, which regulators have attempted to eliminate, can send prices spiralling upwards or downwards.
Regulators are braced for a series of shocks over the next few months as the US central bank prepares to increase interest rates from 0.25%. Salmon points out that 24 central banks have cut rates this year in response to slowing global growth. But the US is heading in the opposite direction. The US economy has surged over the last year and many politicians have called on the Federal Reserve head, Janet Yellen, to raise rates.
When it happens, cash is expected to pour into the US, pushing up the value of the dollar and the cost of US debt. Several countries have borrowed heavily in dollars to benefit from low interest rates. It is not known how heavily indebted governments and corporations will pay the higher interest rates and what disruption it will cause in the markets.
Salmon said: “if we accept the hypothesis that the market’s ability to digest significant news has changed such that sudden increases in volatility and loss of liquidity are more likely, then the concern is that the stabilising factors which dampened the impact of such events in recent months may not always kick in.
“In those circumstances the period of market dislocation could become more persistent, increasing the scope of spillovers across financial markets, with potentially more significant impacts for financial stability,” he added.
This article was written by Phillip Inman Economics correspondent, for theguardian.com on Friday 13th March 2015 14.18 Europe/Londonguardian.co.uk © Guardian News and Media Limited 2010