Last week, I wrote about how the increased volatility in the markets was probably spurred by a new regulation called the Volker Rule.
This legislation, combined with even more restrictions from the CFTC, seems to be causing banks to retreat from market-making activities in the forex industry.
Market makers are banks and financial institutions that make moolah through spreads and by trading against their clients. Dubbed as dealing desks, these market makers also happen to absorb volatility shocks in the markets as they set the exchange rates for their clients.
However, these market makers seem to have a lot on their plates already as they have been dealing with the recent surge in volatility. It doesn’t help that new regulations in the industry are making things more difficult for banks, as they worry that taking on the additional volatility and risk might not be worth it anymore.
For one thing, the CFTC has already forbidden hedging by requiring traders to close offsetting positions. Aside from that, they reduced leverage to a maximum of 50:1 (or 2% margin requirement) on major currency pairs and 20:1 (or 5% margin requirement) on all other forex transactions in the U.S.
Of course, let’s not forget about the Dodd-Frank legislation and the Volker Rule. As I mentioned in my previous article, this regulation aims to prevent banks from drawing from their own funds in making speculative bets in the markets.
The unprecedented rise in High-Frequency Trading, or HFT, and algorithmic trading (the big brothers of the retail market’s expert advisor) has also created a lot of inexplicable and weird moves intraday. There have been instances of currency pairs rising a certain percentage one day and then fully retracing almost the exact same move the next.
When the trading risk is high, these types of traders simply turn off their machines.
This can cause significant changes in liquidity from time to time, which can result in spikes in volatility. Uncertainty is something market makers really hate.
And finally, there is the issue of central bank intervention. To subdue the rise of their respective currencies, the Swiss National Bank (SNB) and the Bank of Japan (BOJ) have bought massive amounts of euros and yens, which disrupt the overall stability of the foreign exchange market.
If the big market makers start retreating, then it is almost certain that liquidity would be reduced. This would make it harder for traders to enter and exit their positions.
Also, to compensate for the lost liquidity, transaction costs need to be increased: spreads would be widened and commission rates would be increased.