The Impact of Collective Behaviour on FX Market Volatility

Funded by Japan Society for the Promotion of Science (JSPS): JPY 16,120,000.00

The broader objective with this research project is to develop an understanding how robots ‘behave’, or are ‘programmed to behave’ in the global foreign exchange (FX) markets – and how this might have destabilising effects on financial markets and the global financial system. Algorithmic (and high-frequency) trading makes up an increasingly large share of the $5.1 trillion-a-day turnover in the global FX market. Whereas financial market participants and academics generally see this is positive, the development is not without controversy. Critics point out that algorithmic traders, and high-frequency traders in particular, by being able to react and anticipate order flow faster, ultimately ‘crowd out’ the liquidity traditionally provided by human traders at market making banks. At the worst, algorithmic traders could engage in market manipulative practices, which would not only be harmful to investors and reduce the quality of the market but potentially also destabilise the financial system.

In particular, it appears as if markets largely populated with algorithmic traders have become susceptible to a withdrawal of liquidity at an unprecedented speed and scale. Consequently, given that the FX market is over-the-counter (OTC), largely unregulated and free from circuit breakers, it could be argued that a major ‘flash crash’ or sudden extreme price changes could pose systemic risks. Importantly, following the ‘Pound flash crash’ in October 2016, the Bank of England and the Bank for International Settlements argued that liquidity withdrawal could act as an ‘amplifying mechanism’ and, due to the inherently international nature of the FX market, have a more devastating impact on the global financial system. Thus, the aim is to contribute not only to the literature on FX market microstructure, which, due to lack of data, hitherto has featured a relatively limited number of contributions on algorithm trading and high-frequency trading but also to the on-going debates on currency interventions and the effective regulation of OTC markets.