What precisely occurred last Thursday? Within just a few seconds, the euro/Swiss franc exchange rate fell from 1.2020 to 1.2000. Despite SNB offers placed in the trading systems, a few isolated transactions occurred below CHF 1.20 per euro. However, at no time did the best available euro exchange rate in the market fall below the minimum exchange rate of CHF 1.20. Thus, for a short time, what is known as a segmented market could be observed, in which transactions below the best price were concluded. This situation was remedied within very few seconds, however, by means of arbitrage.
In other words, the CHF/EUR exchange rate market experienced what is sometimes referred to in equity markets as a “crossed” phenomenon. Despite there being a perfectly good bid at CHF1.20, the counterparty failed to transact at the best “global” bid available in the market place, because the market, as Jordan explains, became “segmented”.
Why did this happen? As Jordan goes on to explain:
How could transactions take place on the foreign exchange market for below CHF 1.20 per euro despite the fact that the SNB was at all times present in the market? The foreign exchange market is a decentralised market. Rather than foreign exchange being traded on a bourse, forex transactions are made directly between market participants.
Each bank has its own individual group of counterparties, and, in particular, banks with lower ratings only have a small number of counterparties. The exchange rates below CHF 1.20 per euro were concluded by banks that do not have an agreement relating to limits with the SNB, in other words, by banks that cannot or do not wish to trade with the SNB.
The SNB was at all times prepared to buy unlimited quantities of euros at CHF 1.20 per euro. All market participants were at all times aware of this SNB purchase offer, including the banks without an agreement relating to limits. Consequently, banks which sold euros for less than CHF 1.20 did not receive the best market price and had – relatively speaking – to accept losses.
Since there is no compulsion to make business transactions at the best prices, such anomalies cannot always be excluded. However, they can only be maintained for a very short period.
To sum up: Market structure fail, not attack.
(And kinda what goes on in fragmented and increasingly decentralised equity markets all the time.)
Of course, one other theory doing the rounds is that an option play might have been in place. In which case, those counterparties that Jordan says accepted losses because they transacted below 1.20 might have actually have offset them with healthy options payouts.
Floored, but not unfloored – FT Alphaville