BoE’s Jackson: need to intervene on market function still an open question

Central banks are still investigating the evolution of market structure in recent years, and the question of whether fresh intervention will be necessary remains an open one, says the Bank of England’s Rebecca Jackson.

Markets are still in a state of flux as they adapt to the “new normal” post-crisis, and central banks are working to gain a more complete understanding of the changes. The outlook is clouded by uncertainty – in the UK, the twists of the Brexit negotiations may yet knock markets askew, so it could still be some time before firms settle into new business models.

But central banks’ understanding has improved significantly, Jackson said in an interview with Central Banking on March 9. One major initiative has been the Bank for International Settlements’ work to understand the sterling flash crash in October 2016. The BoE was heavily involved in that work.

“We are confident we have a good grasp of what transpired,” says Jackson. As head of foreign exchange and reserves management at the BoE, a big part of her job is understanding why such events have become more frequent since 2008.

Rebecca Jackson has been head of foreign exchange and reserves management at the BoE since 2015. She first joined the bank as a graduate trainee in 1998, before moving to the Financial Services Authority. She returned to the BoE when the Prudential Regulation Authority formed, undertaking a range of supervisory roles.

Her current division is responsible for four key areas: foreign currency market operations, serving customers including the UK government and other central banks; gathering market intelligence; using markets expertise to inform policy; and using influence with market participants to overcome market failure and improve functioning and practice.

Market structure has clearly changed. Market makers are less willing to hold large inventories, impairing liquidity, and the rise of high-frequency trading strategies means markets can crash very fast.

Has market function deteriorated? “The FPC [financial policy committee] characterises it as ‘uneven’, and that does chime with me,” says Jackson. “We have seen examples of market function being incredibly good despite significant events.”

“If you look at the way markets coped with the outcome of the UK referendum, liquidity was strong, volumes were high, price adjustment was orderly. There are other examples like the sterling flash crash where you can point to thinner liquidity and fragility of liquidity.”

Cable crash

The sterling flash crash occurred in cable – the pound/dollar currency pair – in early Asian trading on October 9. According to the subsequent investigation, a “confluence of factors” triggered the 9% plunge in sterling’s value.

One factor was the time of day – thinner trading means lower liquidity outside core UK and US trading hours. There were also less experienced traders working, with less expertise in the suitability of their algorithms.

There was significant demand to sell sterling and hedge options as the currency depreciated, with an additional impact from execution of stop losses and closing out of positions. The withdrawal of liquidity and cessation of trading on the futures exchange led to the exhaustion of the limited liquidity on the spot market, creating a spiral. “What you saw was a vacuum into which orders were going,” says Jackson.

Nevertheless, after the plunge the market quickly corrected itself, and resumed trading only a little below its original level. Jackson calls this “very positive”, and says it limited the impact of the event spilling over.

Questions remain, including whether there is a way to predict such events, and whether there will ever be a flash event that does have a significant impact on the real economy. The BoE and the BIS markets committee are both investigating further.

Case for intervention?

Jackson notes markets have been getting better at handling flash events, observing that many firms made improvements to their systems and controls after the sharp moves in the  Swiss franc in January 2015.

With markets self-correcting at present and with little sign of spillovers to the economy, “the case is not made” for whether the BoE should intervene, Jackson says. “The research we plan to undertake will better inform that decision-making process.”

Nevertheless, “there is clearly something going on there,” she adds. “If the problems do not self-correct, we start looking and asking: ‘Is there a role for us here?’”

Asked what form an intervention might take, Jackson points to the work on the  global FX code, which the BoE is helping to assemble along with other central banks and market participants. “The code has the potential to significantly improve practice around the world,” she says. Codes in other areas, such as sterling and bullion, are also being updated.

Looking ahead, there are plenty of developing trends to be aware of. In foreign exchange, the move from open venues to unlit ones creates a challenge for price discovery. The FX market is responding with efforts to improve transparency, such as consolidated tape and transaction cost analysis.

In bond markets, there has been growth of non-bank liquidity providers, and in repo there has been greater counterparty diversification and moves toward clearing.

“Those sorts of developments are things we watch with interest,” Jackson says. “We are always cognisant of the fact that we should consider whether there is a need for us to intervene and catalyse a change if the market seems unable to overcome a friction.”

The BoE is also looking at ways to improve its own market operations. One key change the bank is in the process of making is replacing existing foreign currency repurchase agreements with more market-standard global master repurchase agreements, including supporting a subsequent move to two-way margining of repo collateral. Jackson calls this a “natural response” to changes in balance sheet availability.

Other major events the BoE has its eye on include the market response to the forthcoming Brexit negotiations, and the completion of the global FX code. “Central banks will be leading by example,” Jackson says.

Rebecca Jackson will be speaking at Central Banking’s National Asset-Liability Management conference on March 23-24. For more information and to register, click here.