Black Thursday flash crash GBP: What really happened?

Dear Traders,

As we could see it on the night of 7 October, the GBP currency suddenly fell across the basket of currencies and no one knows why.

It was the collapse of sterling.

Unfortunately, the event was bad for many Forex brokers who reported different lows.

What could have possibly happened

The fears most likely associated with Brexit hit the extreme levels in the early hours of the Asian session on Friday, 7 October 2016, as the GBP plummeted to new interim lows.

During those early trading hours of the Asian session, the charts showed a massive drop in the GBP/USD pair – from 1.261 to (for some brokers) 1.118.

That's some 700 pips in the space of a minute or two while pound to euro exchange rate dropped like a stone.

Within the next 45 minutes that followed, the GBP had partly recovered, but it exceeded the 76.4% Fibonacci.

Fat finger

The reasons for the massive drop in the GBP's value are yet to be leaked.

However, it was likely due to fat finger error by one of the larger financial institutions…

...followed by aggressive algorithmic trading systems triggering sell orders while liquidity was thin.

Fat finger happens when you place an error on trade size or trade direction, usually resulting in a loss.

More commonly, it happens during late night trading.

Banks often make this mistake.

Central banks

An alternative, less likely scenario is that it could have been one of the larger Central Banks in the Asian region liquidating their GBP reserves.

Whichever scenario caused the massive drop in the GBP, most Central Banks across the globe were envious of it.

Many of these banks are currently trying to devalue their currencies to make their domestic economies more competitive.

Rogue algorithm

Algorithms, or algos, are programmes which trade on major news events or specific trading price action.

They usually follow a defined set of instructions for placing a trade in order to generate profits at a speed and frequency that is impossible for a human trader.

According to The Guardian, Kathleen Brooks, the research director at the financial betting firm City Index, said: "Apparently, it was a rogue algorithm that triggered the sell off … These days, some algos trade on the back of news sites and even what is trending on social media sites such as Twitter – so a deluge of negative Brexit headlines could have led to an algo taking that as a major sell signal for the pound."

Around that time, the Financial Times reported the French President, François Hollande's warning that Britain should suffer for Brexit, to deter the others from leaving the EU.

I do question whether it was algos or not, as algos usually move the price slower.

They sell or buy off the shorter-term SMAs, but with the sudden move, it is quite possible that the algos were triggered.

Whether they were triggered in the right direction is another question and depends on how they are set up.

Market trading in banking in a nutshell

To better understand fat finger errors, I am going to explain in a few words how banks trade.

Banks manage client and bank positions in the open market.

Banks have market functions which are split into sales teams and trading teams:

...while sales teams execute the client orders...

...trading teams executes the bank risk positions relative to the client orders.

Above them is the market risk function which oversees the trading team, making sure that bank positions are not too exposed.

Market risk uses a number of statistical measures to oversee trading positions, the most common measure for bank capital is the Value At Risk calculation (VaR).

Regulators are very interested in knowing how banks calculate VaR and making sure they have adequate capital for Black Swan and flash crash events.

Don't forget that thinly traded currency exchange markets can be manipulated.

GBP flash crash happened between the New York session and the beginning of the Asian session when the liquidity was the thinnest.

Even the smallest out of all major market participants can move the markets.

What is the future of GBP trading

Pound forecast remains unchanged. Sterling has since recovered but remains under significant pressure, as moves like this significantly dent the sentiment.

GBP/USD pair has already respected my analysis of 7 October and I still think that the pair will be sold on rallies.

Trading is back in normal mode and the downtrend should exert in a more stable fashion going forward.

This is one more reason why I always state how important it is to trade within a normal risk boundary.

If you do it, you should be good.

Cheers and safe trading,

Nenad