How hedge funds keep markets trading in a crunch
Data show they supply vital liquidity while most institutions sit on their hands
Hedges Funds make convenient bogeymen for politicians when a market crisis hits. Just think about how George Soros was blamed for “breaking the pound” when sterling plunged in 1992. Or how politicians in Japan and Germany have railed against them. Emerging market governments, such as Turkey’s, are now tossing blame around, too.
But if you want to get a new glimpse into what hedge funds do during currency shocks, ponder a striking piece of data mining that the JPMorgan Chase Institute published this summer.
This analysis confirms that hedge funds do indeed trade frenetically in a crisis. No surprise there. But it also suggests that their impact on currency movements is not as simple as popular discourse might suggest. And there is another finding which matters for the financial regulatory debate: hedge funds may have become more, not less, important in the overall structure of markets during the past decade. Turkey — or Argentina and South Africa — should take note.
The researchers reached this conclusion by focusing on three moments when currencies have moved sharply: the unexpected 2015 decision by the Swiss central bank to abandon its floor for the Swiss franc; the 2016 UK Brexit vote; and Donald Trump’s US election victory later that year. Then they combed through the investment bank’s database of 400m institutional investor transactions to isolate 120,000 spot and forward foreign exchange trades conducted just before and after these events.
Investors already know what happened to prices and overall trading volumes during these shocks, since there is excellent, real-time transparency around currency prices. Moreover, regulators require groups such as Reuters to release daily data on the overall trading volumes and the Bank for International Settlements offers comprehensive data on global flows, after a time lag.
But what is intriguing about the JPMorgan data is that they offer a rare glimpse into what investors were trading during the turbulence, and when. This is revealing. In normal times, JPMorgan cuts an average of $500m in trades each day with hedge funds that involve the Mexican peso and dollar, and some $2.8bn of sterling-dollar trades and $900m for the Swiss franc and euro. Trades with other banks and asset manages are similar in size.
But just after the Swiss bank, Brexit and Trump shocks, daily trading volumes by hedge funds more than tripled. Bank trading volumes also rose sharply after the Swiss and Brexit events (but not after the Trump victory).
This might imply that it was the hedge funds that pushed the currencies around. Not entirely so. Most funds did buy francs after the Swiss bank announcement. But they bought and sold sterling after Brexit, trading on opposing sides on a massive scale. So too after the Trump shock, although there were more hedge fund dollar sales.
This is striking. But what is more important is that the volume of trades cut by pension funds, insurance companies, public investment groups and corporate treasury departments did not rise at all after the shocks. These groups only started to shift risk much later, long after prices had been reset.
That inertia might reflect judicious caution (as Andy Haldane of the Bank of England has often argued, speed does not always benefit investors). Or it might stem from bureaucratic constraints (the JPMorgan data suggest these institutions only trade during the normal business day, or when local markets are open).
Either way, this pattern has important implications. Traditionally, banks were the main providers of liquidity in foreign exchange markets. But since 2008, they have reduced this role because of post-crisis regulatory reforms.
Regulators had hoped that other long-term holdings of capital would start to fill that gap, supplying badly needed liquidity that could stabilise markets when a crunch hit. But the data suggest this is not happening. Most institutions are sitting on their hands in a crisis instead.
It is impossible to know whether this pattern is true of the whole market, since no other bank has published such data. One hopes that regulators will force them to do this one day, not just for foreign exchange but for other asset classes, too.
But in the meantime, governments should take note of the findings. The antics of hedge funds may sometimes appear unseemly. But the unpalatable truth is that it is they who often keep markets trading in a crunch.