2015 will live long in the memory of foreign exchange traders because of big moves in a variety of currencies, from the Chinese renminbi to the Brazilian real, but one stands out for its savagery: the 18% appreciation of the Swiss franc against the euro on January 15.
The day went better for some than others: various clients blamed their brokers; Barclays demanded the cancellation of a number of trades it had transacted with customers; and Citi ended up suing a former prime brokerage client for $25 million.
For those who rode out the storm successfully, the decisive factor in what happened from 9:30am UK time was the risk management decisions taken in the preceding months. At BNP Paribas, those decisions produced a very good year for the bank's Swiss franc book and have helped it to a second-successive Risk award in our currency derivatives category.
"We had kept a very clean euro/Swiss franc position because we understood the limitations of the mathematical models to describe pegged currencies. We had always been very reluctant to put downside euro/Swiss franc structures in the book," says Asa Attwell, head of G10 forex trading at BNP Paribas in London.
"In fact, US dollar/Swiss franc was the more dangerous pair for banks because a year earlier the market had previously been around the levels the pair ended up going to, so it was possible banks could have had residual strike positions down there," he continues.
Instead of hedging the big demand for US dollar call positions being placed by the bank's institutional clients against the euro, yen and Swiss franc, BNP Paribas' forex options traders built a risk-reversal position of long dollar puts and short dollar calls as a hedge against the Swiss National Bank (SNB) deciding to remove the floor it had imposed on the franc's value against the euro in 2011, which had ensured the exchange rate stayed above 1.20.
At the start of the move we didn't have a directional position, but we had these insurance options where we had fears about the potential move
Asa Attwell, BNP Paribas
The SNB's position – maintained for more than three years by selling its own currency and buying euros – became more dangerous as the European Central Bank edged towards a fresh round of quantitative easing in early 2015. But the timing of the floor's removal still took the market by surprise, sending the rate to lows of 0.85 in a matter of minutes – a 30% swing – before eventually closing the day at 0.98. The US dollar/Swiss franc rate went beyond its 2014 lows, falling from 1.0187 to 0.8392, according to Bloomberg data.
"We didn't think it would go on the day quite as quickly and quite as fast. The SNB could have also done more to intervene and could have tried harder, so our position entering was flattish, but we had still left ourselves long some US dollar calls. At the start of the move we didn't have a directional position, but we had these insurance options where we had fears about the potential move," says Attwell.
Some dealers had seen the SNB policy as a chance to make easy money. Many firms traded Swiss franc products containing barriers, digitals and one-touch options that were close to or below the implied floor of 1.20; the conviction being that the floor would remain in place.
BNP Paribas refused to quote those products: "We stopped quoting downside euro/Swiss franc, but not all banks had that policy. The impact on clients was minimal because they realised there were certain positions the bank couldn't re-hedge and there wasn't much liquidity," says Attwell.
This prudent approach, which the bank employs for other pegged currencies, meant BNP Paribas was not left searching for nonexistent liquidity as it tried to close out positions.
"The market disappeared until the afternoon when people were resetting their positions and re-hedging. There wasn't a volatility market for a while and on some of the exchanges where Swiss options are quoted there wasn't any liquidity either. The moment the floor went we had all our risk scenarios at the limit to what we tend to model, and it took us an hour or two to be happy that our hedging and models of our scenarios worked out. Liquidity returned, but it was still fairly thin for a couple of weeks," says Joe Nash, head of flow forex sales for Europe, the Middle East and Africa at BNP Paribas in London.
BNP Paribas' performance on January 15 was very good, and we were able to trade forex options and forwards by phone relatively comfortably
Chief financial officer at a European corporate
The bank was also in a better decision to deal with customer requests from corporate clients looking to re-hedge their own positions.
"BNP Paribas' performance on January 15 was very good, and we were able to trade forex options and forwards by phone relatively comfortably," says the chief financial officer at one European corporate.
Traders say the Swiss franc move resulted in thinner forex liquidity for weeks afterwards, contributing to seemingly random daily bouts of volatility, even in some of the world's most-traded pairs, such as euro/US dollar.
However, there was nothing random about the two-day 3% change in the value of the renminbi against the US dollar on August 11 and 12, which saw the Chinese currency depreciate from 6.21 to 6.33 on the first day before falling further to 6.39 on the second.
The move may have been sudden, but it was deliberate, with the People's Bank of China (PBoC) bringing the currency's value against the dollar down to four-year lows, following a string of poor economic data.
It was also not the first time the PBoC had interrupted the steady appreciation of the renminbi. In the first quarter of 2014, participants in the big target redemption forwards (Tarf) market linked to the renminbi/US dollar rate suffered stinging losses as the Chinese currency saw a steady, sustained slide. Last year's move in August was more violent, but hit Tarf books in a similar way. This time, BNP Paribas was ready, but it claims other banks were slower to act.
"After 2014, you'd think everyone would understand very quickly the impact of such a move, yet the market seemed to take a day to react to it and re-hedge," says Jon Spriggs, head of local market options at BNP Paribas in London.
In fact, the market reaction was so slow that Spriggs and his team were able to roll their forward positions on the first day of the renminbi's slide – a crucial move that helped to protect the bank.
Tarfs are used by local corporates to hedge or speculate, typically selling a set amount of US dollars for renminbi at a fixed level for the life of the trade – generally two years. The target redemption feature means the product knocks out as soon as a certain level of profit has been earned, which shortened the duration of the trades to around six months during the period in which the renminbi was steadily appreciating. A weaker Chinese currency, however, spelled trouble for dealers as the duration of the trade – and the hedges required – suddenly extended.
We incurred some losses rolling our forward position, but we have clear risk reporting of this cross-gamma effect, and were therefore quick and efficient in re-hedging
Jon Spriggs, BNP Paribas
"On that first day we did a lot of re-hedging of our forwards book at decent levels and there was a day before anyone realised. Then there was a huge move in the other direction in the forwards," Spriggs says. "Spreads on volatility went much wider and spreads on forwards went wider, so re-hedging costs were quite big, which is why it was good to square most of our vega positions with clients and that helped us reduce the position at very little cost."
"The whole market was looking to roll out their forward hedges from six months to around two years, so the swap points got squeezed. We incurred some losses rolling our forward position, but we have clear risk reporting of this cross-gamma effect, and were therefore quick and efficient in re-hedging. This meant the cost was limited, and because of our efficiency in recycling the vega overall, the renminbi portfolio is currently having a record year too," adds Spriggs, who was speaking to Risk in December.
With BNP Paribas' Tarf book under control, the bank was better able to help clients who were looking to hedge but finding dealer liquidity in short supply.
"In renminbi, BNP Paribas was one of the only banks involved in the forex options market following the depreciation in August and continued to win the majority of business for a few days after the event," says one derivatives strategist at a London-based asset manager.
The net result of the bank's Tarf positions and vanilla hedges left BNP Paribas with a significant long vega position, which it recycled with real-money and hedge fund clients who wanted long US dollar positions to protect against any further devaluation. The bank also sold call spreads to insulate itself against steeper drops in the renminbi.
"Unfortunately, the rates position wasn't as easy to manage," says Spriggs. "Usually, the correlation, certainly in emerging markets, is for spot higher, swap points higher, but this isn't always the case in renminbi and it wasn't during this event. However, over the following month we were close to flat, even with some big profit-and-loss (P&L) swings in that period."
The unpredictability of central bank action in China and Switzerland in 2015 could be seen as a vindication of BNP Paribas' policy on managed currencies.
"We have similar policies around all of the pegged currencies when it comes to barriers. A pegged currency has a very low volatility, so you wouldn't normally look at it, but we are always modelling potential gap risk and spot across a range of scenarios. For the Saudi Arabian riyal, for example, we're more interested in what the P&L scenario is if it doesn't move or if it moves to 15–25%, rather than 3%, which for us is not a realistic scenario," says Nash.