Inflows into exchange-traded products tracking long sterling exposures were the largest in over two years last week as the pound had a “flash crash” while ETPs tracking short sterling exposures recorded the highest outflows in two months.
On October 7, at 7.07 in the morning in Hong Kong, sterling fell more than 8% to 31-year lows against the dollar in just eight minutes.
Issuer ETF Securities said in a report that inflows into ETPs tracking long GBP exposures last week were more than $3m, the largest since June 2014, while ETPs tracking short sterling exposures had outflows of $12m, the highest withdrawals in two months.
Martin Arnold, global FX & commodity strategist at ETF Securities, told Markets Media: “Investors in the ETP space have started to believe that GBP was making a floor, based on fund flows. There have been eight straight weeks of inflows into ETPs with long sterling exposure and investors have been reducing short GBP positions.”
Townsend Lansing, head of ETCs at ETF Securities, told Markets Media that ETPs provide easy access for investors who have not previously considered currency risk and do not have direct access to trade foreign exchange.
“We had our largest ever foreign exchange trade around the Brexit vote when an asset manager put on a $150m position over four days,” Lansing added. “Investors will continue to make event-driven trades.”
The UK voted to leave the European Union in June. ETF Securities said that while investors remain bearish on sterling, the prior 15% move down since the EU Referendum had fully priced in the bad economic news to come. “Additionally, we have not seen any large bearish changes in ETP flows, something that usually occurs when fundamental information is behind the currency moves,” added ETF Securities.
The UK vote to leave the EU has also led to surge in flows into gold ETPs. ETF Securities said ETPs tracking long gold have had inflows in 11 of the past 12 weeks, with cumulative inflows over the past three months of $1.1bn. This indicates investors remain cautious about the global economic outlook and the impact that monetary policy is having on global fiat currencies.
Lansing said: “The major trend for us since the beginning of this year has been the growth in assets of the gold ETPs. Investors are also using currency ETPs as hedges as they want to hold commodities exposure but without the FX volatility.”
ETF Securities said in a blog that the overnight flash crash in Asia for sterling may have been caused by thin liquidity and computerised trading algorithms as trading in the Asian session is typically lighter than in European or the US.
“While the trigger for the GBP plunge remains uncertain, we can, with a good degree of certainty, rule out that fundamental information was the cause,” added the blog.
Other potential causes of the crash are large derivative positions being triggered or human error.
Marshall Bailey, president of ACI Financial Markets Association International, said in an email that the organisation would not speculate on the causes and drivers of the rapid price movement in sterling last week.
“What this incident reveals, however, is that the changing nature of the global FX market brings some uncertainties,” Bailey added. “It is the responsibility of all industry participants to understand the risks of market disruption – which can range from technology to individual behaviour – and work together to find solutions.”
The Bank of England has asked the Bank for International Settlements to investigate the causes of the sterling sell-off last week.
Bailey continued that the the ACI FMA believes that the best way to resolve disputes on rates and order fills in volatile markets is through bilateral discussions.
“The ACI Dispute Resolution mechanism was successfully deployed after the SNB event for similar reasons, and it shows that the market can achieve its own solutions to difficult issues,” said Bailey.
In January last year the Swiss National Bank abruptly announced that it was removing its policy of maintaining an upper limit in the EUR/CHF exchange rate. The unexpected news caused the Swiss franc to experience one of the fastest appreciations in recent history leading to losses and disputes over the rate at which orders had been transacted.
Jeremy Schwartz, director of research at ETF issuer WisdomTree said in a blog today, that currency markets volatility this year shows the strategic importance of currency hedging.
For example, while sterling dropped, UK stocks outperformed European markets on the premise that a weaker currency would support their company profits.
Schwartz said: “Having UK stock market exposure – to diversify risk of US equities being an expensive equity market – was quite valuable thus far this year. Having GBP risk, not so valuable.”
He added that the only real reason to to add developed world currency risk is if investors believe in those currencies appreciating more tactically.
At the beginning of this year WisdomTree launched a suite of ETFs that incorporate a dynamic element to managing currency risk and Schwartz analysed their performance over the past nine months.
“In a year when being unhedged has often outperformed hedged strategies, the broad dynamic hedged strategy from WisdomTree, which has consistently averaged over a 50% hedge ratio in aggregate positioning throughout 2016, has outperformed the unhedged strategies through October 7th,” he said.
Schwartz attributed this to having larger hedges on the right currencies and lower hedge ratios on currencies that appreciated. For example, the hedge ratio on GBP has been 83.3% since December 28 last year and this helped protect returns following the GBP collapse.
He added: “In WisdomTree’s view, developed world currencies offer higher expected risk levels with no expected return enhancement. Why should you desire these higher risk levels, unless you are good at timing when you want currency risk to be unhedged?”
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