Publication - Market Functioning - speech by Chris Salmon
It is a pleasure to be here this evening. The economic and political events of the past twelve months raise many questions. From my vantage point as the head of the Bank of England’s Markets Directorate, they reemphasise the need for central banks to understand the structure and functioning of core financial markets.
That matters both for our role as guardians of financial stability, and to ensure the effectiveness of our own operations to implement monetary policy. Let me illustrate this with reference to developments in two very different markets.
i) The first – the sterling FX market – a large, global, highly liquid, and almost continuously traded, market, with a constantly evolving structure. Here, the challenge is to understand how those developments affect the functioning of the market. My focus will be on the lessons about market functioning from two particular episodes last year: the period immediately following the EU referendum and its ‘flash crash’ a few months later.
ii) The second market – the sterling corporate bond market – is small, local, and thinly traded, with heterogeneous underlying assets. Here I will explain how our analysis of market structure shaped the design of the Bank’s corporate bond purchase scheme, and how the scheme may have affected the functioning of the market.
In both cases our understanding of these markets, informed by market intelligence, analysis and our own experience in previous operations, has been both tested and improved as the Bank has responded to events.
Section 1 – Sterling’s headline days during 2016
The foreign exchange markets are core to the broader financial system, processing enormous volumes of transactions and relied upon by a broad range of economic participants from corporates to individuals. The structure of these markets has evolved markedly in recent years, with electronic trading playing an ever greater role, while the amount of balance sheet devoted to this activity by intermediaries has fallen. Benefits of the broader trend towards greater speed and electronification, common across a range of markets, include a reduced cost of transacting – and hence better value for end-users – but these structural changes as a whole have also led some to question whether markets are now less resilient in periods of stress.1
The value of sterling fell by 17% against the US dollar over 2016 , largely as market participants digested the impact of the EU referendum decision on its long-term sustainable level. Although sterling was in the spotlight for much of the year, two key episodes stand out: the sharp adjustment in the exchange rate immediately after the referendum result, and the so-called flash event in the early (UK) hours of 7 October (Chart 1).
Markets displayed resilience in the immediate aftermath of the referendum: the record 11% depreciation of sterling against the US dollar that took place over the succeeding two trading days was accompanied by exceptionally high trading volumes (Chart 2). The market facilitated an orderly correction in the sterling exchange rate, while enabling individual participants to adjust their portfolios in response to the news, and can therefore be reasonably judged to have functioned effectively. This was aided in no small part by the well-telegraphed nature of the event. Informed by the lesson of the CHF de-peg a year and a half earlier, our market intelligence was that dealers engaged in extensive planning and preparation to cater for the possibility of sharp movements in sterling, including by reducing trading positions, pre-defining trading strategies and risk appetites for a range of scenarios, recalibrating algorithms and engaging in conversation with their clients to manage their expectations.
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