19 January 2015

This Does not Bode Well for the Euro or the Eu

As you are no doubt aware if you follow the financial papers, the Swiss Central Bank abruptly ended its peg to the Euro, and then all hell broke loose:
One does not normally see sharp right angles in financial charts, but you could pretty much cut yourself on this chart of the volatility of the Swiss franc against the euro:

One straightforward takeaway is: Whoa, that volatility is super high! But perhaps a more useful takeaway is: Whoa, it was super low for a really long time! This is of course because the Swiss National Bank capped the franc's value against the euro: The SNB wanted a price of no less than CHF 1.20 per euro, and the euro itself wanted a price of no higher than CHF 1.20 for reasons of its own, so the result was pretty much a peg at slightly above 1.20. In the 12 months ending on Wednesday, the euro traded in a range of 1.20095 to 1.23640 francs:


That chart looks more jagged than it is, because you're standing too close to it. Here, I've zoomed out by two days:


On the other hand! Imagine being a retail foreign-exchange broker and letting your customers day-trade Swiss francs with lots of leverage. How much leverage would you feel comfortable giving them? Well, if daily moves are typically less than 0.1 percent, then that means that 95 percent of the time their positions will move by less than 0.2 percent in a day. So if you required 2 percent margin -- that is, you demand $2 of cash from them for every $100 worth of Swiss francs that they trade -- you'd feel pretty safe. That would mean that, 95 percent of the time, customers couldn't lose more than one-tenth of their equity in a day -- so if they lost money and skipped out on you, you'd be able to liquidate their positions without getting close to losing any of the money you'd lent them.

On the other hand when the euro/franc moves by 19 percent in a day, they're gonna get utterly smoked, and so are you. This is roughly the boat in which FXCM Inc. finds itself. Like many other retail foreign exchange brokers, it offered 50:1 leverage on FX trades. And yesterday its "clients experienced significant losses" on the Swiss franc move, and "generated negative equity balances owed to FXCM of approximately $225 million." id="footnote-1421429157415-ref">  And now it's in talks with Jefferies Group for a large cash infusion to fix the problem. FXCM is also distinguished by just an unbelievable sense of irony:
FXCM Chief Executive Officer Drew Niv, in remarks published in Bloomberg Markets magazine’s December issue, said individual currency traders are enticed by the chance to control large positions with little money down.

“Currencies don’t move that much,” he said. “So if you had no leverage, nobody would trade.”
Famous last word words. FXCM is basically insolvent now, and is relying on a loan from a "white knight", in exchange for who knows what concessions.

Here is the scary quote about this:
As realized volatility gets lower, estimates of future volatility -- and so estimates of future losses -- get lower. And so position limits get higher, as banks feel safer with the risks they're taking, because, on a historical basis, they don't look that risky. And then the risk that didn't look risky becomes the one that gets you.
So, what we have just had a major case of "It's different this time" contagion because a non-EU member dropped a peg following months (years?) of denials.

We have another player, and one who is one of the EU's  "stronger" members who is not on the Euro, but is on a peg, Denmark, which retains the Krone.

And Denmark is promising to do whatever it takes to keep their peg:
Denmark moved to quash speculation it may follow Switzerland and abandon its euro peg, delivering a surprise interest-rate cut to prevent the krone gaining further.

“We have the necessary tools to defend the peg,”Karsten Biltoft, head of communications at the Copenhagen-based central bank, said by phone. Asked whether Denmark could ever consider abandoning its currency peg, he said, “Of course not.”

Since the Swiss National Bank shocked markets on Jan. 15 by jettisoning its three-year-old euro peg, Scandinavia’s biggest banks have fielded calls from hedge funds and other offshore investors asking whether Denmark could be next. Danske Bank A/S (DANSKE) has sought to dispel the speculation, noting Denmark’s three-decades-old currency regime is backed by the European Central Bank, unlike the SNB’s former system.


The Danish bank today cut its deposit rate to minus 0.2 percent, matching a record low, from minus 0.05 percent and lowered its lending rate to a record 0.05 percent from 0.2 percent. While the bank can adjust rates at any time, it traditionally announces changes on Thursdays and mostly in connection with ECB moves.
Is it just me, or do the assurances of the bankers at Copenhagen not sound particularly credible right now?

If Denmark is forced to drop its peg, all hell breaks loose, because it opens a Pandora's box of asymmetries that have been growing in the Euro zone, and the EU over the past 3 decades.

It will not be pretty.


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