On the 3rd of Jan 2019, in the early hours of 6.30am Singapore time, a flash crash occurred in the FX market. In a couple of minutes, USD/JPY dropped from 108.85 to a low of 102.35 and recovered just as fast as it had declined. In that couple of minutes, millions of dollars was lost for clients, whose positions were liquidated due to insufficient margin requirement.
The event that triggered the flash crash
Apple triggered the flash crash when it issued a profit warning after the New York stock market closed. The reason for Apple profit warning was a sharp contraction of iPhone sales in China. This profit warning raised concerns over a slowing Chinese economy coming just one day after China PMI contraction. The day before, China reported its PMI at 49.7 raising concerns of a hard landing in China. As investors and traders in the FX market moved their capital into safe haven Japanese Yen, USD/JPY rate declined rapidly. AUD/USD, which is a proxy for the Chinese economy and currency, also declined. AUD/JPY was badly hit with both USD/JPY and AUD/USD declining rapidly. These falling rates were exuberated as a result of decreased liquidity with Japan on holiday. The twilight zone, the time when New York market closed for the day at 6am and the time before Tokyo is opened at 7am (Singapore time), has the least liquidity in the global cycle even when Tokyo is not on holiday.
Liquidity risk
Investor will usually consider market directional risk when they take on a position. Example; bullish or bearish. They will place a stop order to protect themselves against adverse price movement. They do not give adequate consideration to liquidity risk. In a flash crash, especially when liquidity is low, the spread will widen. For USD/JPY, where its spread is usually less than 2 pips, in a flash crash, the spread can widen to 200 pips. In the British Pound flash crash of 2016, the spread reached 600 pips at the peak of the flash crash. Below is a study of the spread by the BIS in the aftermath of the Sterling flash crash.
Effect of liquidity risk
When the spread widened, stop loss order placed by clients in the system as well as valuation of open positions will be affected. Even fully hedged positions can be affected by a wider spread. When the spread widened, stop further away can be hit. Real time valuation of open position will be revalued at a wider bid or offer price. This could affect margin level and if there is insufficient margin, it could even lead to auto liquidation of position. Fully hedged positions will be affected by a wider spread as well just like a single open position. Insufficient margin will lead to an auto liquidation of one leg of the hedged positions, exposing the other leg to great risk.
Managing Risk
It is always advisable to trade with sensible margin. A broker that offers 500x leverage, sound good but your risk is greater. You are likely to deposit insufficient capital since you are going to take advantage of the high leverage. When spread widens even your fully hedged positions can come into great risk. Avoid using more than 20X leverage on your open position so as to have sufficient margin in your account. Risk should be the most important consideration in your trading decision.