In the world of economists, there is a dearly-held view that a country’s exchange rate is the best barometer/thermometer/all-out-gauge for how that country is doing*.
*Always assuming that there is a free-floating exchange rate. If not, you need to look at the black market exchange rate.
As I’ve said elsewhere – I can’t help but wonder whether that particular belief shouldn’t be changing.
Here is an infographic from 2010:
In 2010, 45% of all forex trading was algorithmic, with daily foreign exchange turnovers of around $4 trillion (in April 2010).
Here are some more recent figures from the Bank of International Settlements:
- Daily trade volumes were up to $5.3 trillion (in April 2013)
- And algorithmic trading made up 68% of all trades.
That was over two years ago. We’ll only get an update on the current position in the next triennial survey (meaning sometime toward the end of 2016).
But in the interim, think of what that means: virtually 70% of all forex trades are done by formula. And the formula is only as good as the programmer that invented it. AND the formula is only as good as the measurability of the underlying variables.
So, for example, how do you formulaically measure political risk? Number of anti-vs-pro government tweets? Perhaps the number of negative news stories, measured as articles using the term “disaster” in the header?
You have to rely on proxies, or discount those risks altogether.
And that’s just for the algorithms that try to take a forward-looking view of the valuation of the currency. What of the other algorithmic traders that look to momentum and ignore the economics? The algorithms that simply look at the trade flows, and the volume of buy and sell orders in the market, and trade with the trend?
I’m not saying that all algorithmic trade is bad. The bulk of those trades will almost certainly be arbitrage and order-spreading strategies – which act to make the market more efficient.
But it’s the momentum and economic-data-based traders that worry me. If you have enough dumb money being shifted around by automated trading strategies, then I suspect that there is a point of critical mass against which the contrarian/fundamental investors will struggle to make an impact.
In particular, I worry about what happens when those trading strategies want to trade on China’s figures. Only the yuan isn’t freely tradeable – so what happens when the South African rand becomes the proxy for China’s currency trades?
Just a Monday morning thought.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.