Matt Levine explains how FXCM, Alpari, et. al. screwed up.

[randomness]

Matt Levine has an entertaining piece in Bloomberg View on how all those brokers lost all that money when their retail speculators were losing their shirts:

Imagine being a retail foreign-exchange broker and letting your customers day-trade Swiss francs with lots of leverage. How much leverage would you feel comfortable giving them? Well, if daily moves are typically less than 0.1 percent, then that means that 95 percent of the time their positions will move by less than 0.2 percent in a day. So if you required 2 percent margin -- that is, you demand $2 of cash from them for every $100 worth of Swiss francs that they trade -- you'd feel pretty safe. That would mean that, 95 percent of the time, customers couldn't lose more than one-tenth of their equity in a day -- so if they lost money and skipped out on you, you'd be able to liquidate their positions without getting close to losing any of the money you'd lent them.

On the other hand when the euro/franc moves by 19 percent in a day, they're gonna get utterly smoked, and so are you. This is roughly the boat in which FXCM Inc. finds itself.

...

It's good to occasionally remember that a margin loan is a put: If you let your customer buy something for $100, and you lend them $98 of the purchase price, and then the price of the thing falls to $81, then guess what, you own the thing! Also you've lost $17. I mean, you can call the customer and ask for more money, it can't hurt. But you're not going to, like, feel full of joy and confidence while you're making that phone call.

Comments

[r-ness.livejournal.com]

this is like the titanic hitting an iceberg, a classic black swan.

I entirely disagree. It was inevitable that the Swiss National Bank was going to be forced to end its euro peg. The only question was when, in the same way the Bank of England being forced to withdraw from the European Exchange Rate Mechanism was inevitable.

It seems pretty clear that the European Central Bank gave the Swiss National Bank an early heads-up about their QE announcement Thursday morning and that precipitated the Swiss action. In short, Mario Draghi told Thomas Jordan that a tsunami of over a trillion euros was coming, and Jordan made sure to move the Swiss National Bank out of the way.

That said, it's an extremely good example of why Bitcoin isn't going to find itself on a lot of FX venues anytime soon.

So true, and so overdetermined. :)

[drwex]

We may be splitting hairs here, but I think the claim that the Euro peg was going to end is both trivially true (nothing lasts forever) and unhelpful. Likewise I'm sure that mortgage interest rates are going to rise - once that happens it'll seem inevitable, but if you look at the past year even 30-year-fixed rates continue to tumble.

The probability of the peg ending on any specific day is nearly zero or nearly impossible to predict depending on how you look at it. I would also argue that the choice to make a flat-out end to the peg rather than a gradual increase in the exchange rate float amount was also hard/impossible to predict. SNB could just as easily have said something like "starting next month we will allow up to a 5% float, increasing by five percent per month for the subsequent three months after which time restrictions will be removed altogether."

Had they said that and exchanges continued to allow low-margin positions to continue then that'd be a screw-up. But instead they yanked the plug all at once and the ship hit the iceberg.

[r-ness.livejournal.com]

We may be splitting hairs here, but I think the claim that the Euro peg was going to end is both trivially true (nothing lasts forever) and unhelpful.

I think we're going to have to agree to disagree here because while it's true that nothing lasts forever it was fairly obvious to many observers that the peg wasn't going to last. The political pressures on the SNB were building and would not survive ECB quantitative easing. And QE in the eurozone was clearly coming.

(Disclaimer: I was long CHF, so I made a little money on this move. I did it in actual physical banknotes--Switzerland has some pretty cool-looking ones--so it hardly counts as "investment" as opposed to "holding onto some Swiss francs so I can get out of the airport without hitting a price-gouging cash machine on my next visit to Zurich".)

In any case, this isn't the only possible fx move that would blow them up, and they still allow low-margin positions, even now. Their business model doesn't make sense unless they give punters lots of leverage, because no one will play in their casino without it. The NFA just tightened it down to "only" 20:1 for CHF and 33:1 for SEK and NOK (and only in the States). But all other currencies? Unchanged.

Shorter answer is that their business model doesn't make sense without gamblers. So maybe it isn't so much as a "screw-up" as that the whole model is prone to occasional volatility events, and therefore needs much more capital than they planned for.

[achinhibitor.livejournal.com]

There's more to it than that. At this time, the SNB was trying to prevent the CHF from rising against the Euro, despite that all the fundamentals were driving the CHF up. The problem with such pressures is that they often follow the pattern of increasing pressure from the fundamentals being met with increasing pressure from whoever is intervening... Eventually the pressure becomes too much to resist, either because the costs to the intervenor become higher than the intervenor is willing to bear, or the intervenor runs out of power to intervene with enough force. At that point, the market very quickly snaps to approximately where it would have been on that date if the intervention had not been done at all, i.e., a huge making-up of change. Worse, as the situation develops, all the smart money starts betting on the ending of the intervention, which tends to increase the pressure on the intervenor, causing the end of intervention to come earlier than the fundamentals would lead you to expect.

This is the typical pattern for the breaking of currency pegs.

The subtlety in this case seems to be that in the early phases of the intervention, the CHF was being driven by panicked flow of money from the eurozone, and so the SNB could expect that after a few months the money flows would naturally reverse, and the CHF/EUR exchange would go back to what it was. But the pressure transitioned from being panic-driven to being driven by the fundamentals (the continuing weakness of the eurozone economies), which moved the intervention into the long-term-unsustainable category.

Of course, it's still hard to make money on this unless you have a few billion that you can invest for a few years, and go short on EUR and long on CHF.