The algorithms of automatic trading have rules embedded in their code such that quotes are immediately pulled if there is a severe market liquidity event. Moreover, the algorithms often have automatic rules that activate circuit breakers or socalled “kill switches” should the aggregate notional risk on a firm’s book exceed programmed limits. On 15 January, the algorithms acted quickly to pull the so-called “streaming prices” when liquidity in the reference market for these prices dried up. Where this did not happen simultaneously, it resulted in large open positions being accumulated by the banks, quite literally within seconds, as an overwhelming balance of client sell orders were automatically executed. Once pre-determined risk accumulation limits had been breached the algorithms instantaneously shut down. Whilst each algorithm, operating independently, may well have been quite prudently calibrated to protect the bank from building an exposure that exceeded its risk appetite, collectively, the impact on market liquidity was akin, albeit temporarily, to a cascading failure across a power grid. As a consequence, the foreign exchange market reverted to human voice orders as the substitute for automated trading. There were therefore outcomes that appear not to have been expected. So, at the risk of quoting Shakespeare inappropriately, all was well that ended (reasonably) well, but the risk that this would not be the outcome is too great to ignore. In summary, there is good evidence that financial market conditions have evolved in ways that reduce the likelihood of continuous market liquidity in all states.
The fifth area concerns the risk of asset managers offering short-term redemptions to investors against potentially illiquid securities. The proportion of assets held in such structures has increased over the past decade. Given more fragile underlying market liquidity, for the reasons I have described, stressed disposals of assets might be harder to accommodate in an orderly fashion. The international securities regulatory body IOSCO, issued recommendations in 2012 that provide a basis for Common Standards for Money Market Funds (MMFs) across jurisdictions, in particular seeking to ensure that MMFs are not susceptible to the risk of runs (in the way that banks can be). More broadly, work continues on putting into practice appropriate policies and standards to prevent the risk of disorderly sales of assets in the face of investor withdrawals. Potential responses (and at this stage we are looking at options in an open way) are to require funds to hold larger liquid asset buffers to facilitate orderly redemption payments to investors, to apply more stringent leverage limits where appropriate, and to require that the redemption terms offered to investors take sufficient account of the risk that secondary market liquidity in the assets they hold could become impaired. These are possibilities, but at this stage very much not policies for the reason that a lot more work is need to properly assess them. Last, central banks can back-stop market liquidity by acting as market makers of the last resort.