James Ducker charts the startling rise and fall of foreign exchange rates during the EU referendum, and what can be learned from the way the markets moved.
As was widely reported at the time, there was a shock to the FX market overnight on 23 June 2016, as the EU referendum result became apparent. Looking at GBP/EUR from mid-afternoon on 23 June to midday 24 June, as the afternoon progressed the market was fairly steady.
At 22:00 when the voting closed, there was a poll stating the Remain campaign had won a narrow victory – receiving around 52% of the votes. GBP/EUR climbed slightly. Just after midnight we got the first few results and there was a drop – from 1.3100 to 1.2800 in 10 minutes. The market steadied while more results arrived. The next drop at 02:00 was when a constant flurry of votes were counted. By 05:00 on 24 June, we were at 1.2000.
In the space of seven hours we had moved from 1.3159 to 1.2027, an 8.60% drop in the value of the pound against the euro.
There was exactly the same movement in GBP/USD. The pound against the dollar reached the high at exactly the same time, at 1.5018, and the low seven hours later at 1.3229 – an 11.91% drop.
What these moves show us in a very short period, and due to a very specific issue (the EU vote), is what the market is doing constantly with all sorts of data and profit-taking or positioning from traders. Combining all these factors drives the market.
Understanding the market is the vital starting point for any business that needs to buy or sell any currency. It is deeply misunderstood and myths are often peddled by those in positions of trust – salespeople who simply want you to deal with them and will say almost anything to get the deals done.
In 2014 the Bank for International Settlements (BIS) released a figure that the FX markets trade $5.3trn a day. Of that, the best guess is that 97% of the trades are for purely speculative reasons. The remaining 3% is where businesses (and individuals) require currency for a purpose – to purchase goods or services. But it can easily be seen that the activity is minute compared to speculation.
So what is the driver behind speculation? That will offer the answer as to how the market moves and why the market moves, leading closer to understanding the market and understanding future moves. Once that is understood, we can examine what a business can do about it.
The driver behind speculation is simple – profit. If a trader is looking at GBP/USD before Brexit, the market was at 1.4900. If they knew, or predicted, or felt that the market would move lower, then they would sell sterling and buy dollars. Then when the market moved lower – the trader would pick a time to reverse his trade by buying sterling and selling dollars. Using £1m, that would mean buying $1.49m. Then the trader would have to pick where to take his profit. At 02:00 the market had moved to 1.4000 and then bounced back above 1.4500.
I would suggest that was some profit-taking. On this trade, selling $1.49m at 1.4000 would equate to £1,064,285. Not a bad profit for three hours’ work. Upon the bounce to 1.4500 the same trader could do the same again – in at 1.4500 and then out again at, perhaps 1.3500 this time. The choice of when to enter and when to exit is of course key, along with deciding if the market will go lower or higher before it does it! Rarely can you access a market late, as the move has already happened. Perhaps the early morning of 24 June was a slight exception.
So, in short, the market moves when speculators buy or sell a currency as they expect it to move in their favour – then they exit the trades to make profit. Importantly they don’t care if GBP/USD is at 1.5000 or 1.3000, just which side of the market they are and thus which way it moves. There seems little point in old myths that, for example, say GBP/USD is “about right at 1.6000”. It may be an historical fact that 1.6000 seems to be a pivot, or that the UK and US economies seem to operate well at those levels. But speculators do not care. They just need the market to move (the right way) to make money. This is a zero-sum game. For every £1 made, someone else loses that £1.
So what is the truth as to why the pound collapsed on the night of the 23 June? There were more speculators selling sterling than buying it. Why? To make money. If you think back to the disgraceful campaigns on both sides of the argument, there was almost an agreement that a Leave vote would result in a 10% to 15% drop in GBP. So when the result began to become clear, it was almost a self-fulfilling prophecy.
I hope that examining these trades, looking at speculator’s thought processes and the true market movers, shows that the currency markets are extremely difficult to predict, as traders make decisions based on profit and nothing else. There are those who use Technical Analysis (studying charts) to predict moves in all sorts of markets, especially currency. There are those who believe in Fundamental Analysis – that the moves are due to traders looking at events and acting accordingly (the EU vote being such an example).
As with most things in life, there is a combination required. Analysing charts does work sometimes, again due to the self-fulfilling nature – if all traders use that theory and therefore predict the lows and highs, then of course it will become truth, as they are all doing the same thing to a large degree. Then events such as the EU referendum or important economic releases cause other traders to break away, to try to make money where others are not.
Having seen these moves, and historic movements, for example in GBP/USD from 2.0000 to 1.3800 (31%) in the space of six months, we know the market can shift in a short space of time. Equally we know it can remain fairly calm for long periods. So if you are part of the 3%, a business who buys or sells currency for a purpose, and it affects the business profits, what can be done to minimise or mitigate the risks posed by the 97% – the $5.14trn per day?
As much as I like to try to break this down to simple levels, saying the way to mitigate risk is to hedge is of little use. Hedging can take the form of thousands of simple to more complex structures. Even those that are viewed as basic have to be understood for their pricing (both how they are priced and what is fair), and for their risks – including opportunity cost especially in a competitive business market.
The basic structures are Spot and Forward. As much as they are called basic, they carry as much if not more risk than alternatives that are seen as complex and require more regulation from the Financial Conduct Authority (FCA).
A company may have six months to buy currency for a particular transaction. If they buy spot in the six months when they need the currency, they are at risk for that period. As can be seen in extreme circumstances, that could mean huge profit or loss depending on which way the market moves.
If a company buys the currency on a “forward contract” on day one, they are locking in the rate and many believe that is risk averse. However, that means they may be locking in at a rate that is less advantageous than waiting.
Many say that doesn’t matter as they lock in above budget and therefore still make money with no risk of loss, the opportunity cost of a favourable market move is not the only risk. Competitive advantage and competitor costs can rarely be ignored. If one company has locked in on forward contracts, but another hasn’t, with a favourable market move they can show a cheaper price for their goods.
Even if that contract is lost, they could win the next based on a current cheaper rate. I see no owner of a company happy with losing the opportunity cost in the first place, but I further see no owner wishing to look expensive compared to competitors, even for one contract that doesn’t matter. There is also now the issue of FRS 102 – a balance sheet adjustment at year-end for any forward contract in place. How much does a balance sheet P&L adjustment matter, to credit, to financial covenants?
We have a risk with both the basic structures – risk of market, risk of profits, risk of competitors, balance sheet risk – so what can be done? It is important to realise that as we don’t know where the market will move, and I dispute any company that either says it does, or which puts in place strategies based purely on market moves.
We don’t know what the best strategy will be until the end of the deal. Hedging strategies for businesses should be focused on the business, the business risk, the business attitude, competitive issues, and contractual issues. As simple as that sounds – and I hear the rhetoric from many – actually understanding all of those and then putting in place an appropriate strategy is very difficult. Businesses are complex in themselves, before adding the FX Market.
But what should not be overlooked is that the right strategy on day one doesn’t necessarily produce the “best” economic outcome, as strange as that sounds. If a client needs dollars in six months, on day one I would look at hedging – that could involve forwards, options or a combination of them with some spot risk.
What it would not be, I can say confidently, is leaving 100% to spot. However, in the event that GBP/USD moved substantially higher, then in six months it could be seen that in fact doing nothing, and then buying spot at the end, was the most economical decision. That is not hedging, that is not risk management, that is not corporate governance, but it does produce the most profit.
As you can see, the right decision in my opinion is to cover risk but allow for some upside. Again there are many different strategies, especially around options that could be utilised and dictated and structured around specific requirements. What is needed is for a business to understand the FX market; understand how even spot and forward contracts are priced; understand the true risks being taken in each structure; understand that options are a positive tool if used correctly; understand that most (if not all) FX providers are salespeople who don’t mind what structure you do as long as you do it with them; and understand that this arena is a complex minefield.
In the same way businesses hire lawyers for legal work and accountants for their books, they should look at FCA-regulated advisers in this relatively new arena of hedging.
James Ducker is director of Benchmark Standard Ltd
This article was published by ICAS. You can visit the original page here.