Thursday, May 21, 2015

How Barclay's took advantage of its client's stop-loss orders

The FT had a nice article on the efforts to rig foreign currency titled "If you ain't cheating, you ain't trying."  Here is one way the banks tried to make money:
In the FCA settlement, the regulator details an exchange between traders at Barclays and three other firms, refered to as X, Y and Z. Barclays was trying to trigger a client stop-loss order to buy £77m at a rate of 95 against another currency.  
If it could trigger the order, it would result in Barclays selling £77m to its client and the bank would profit it the average rate at which the bank had bought sterling in the market was below the rate at which the client had agreed to buy it.

The key to understanding the strategy is understanding how a stop-loss order works.

Before going to this example, let me give you a simpler example. Mr. Dumbass buys a stock without much conviction at $40 per share. He tells his broker, “I don’t mind if this thing goes down a little, but if it does down to $32.00 or less, sell it at market, regardless of where the market is.” 

This should make the hair on back of your neck stand up because what Mr. Dumbass is saying is that the LOWER the price goes, the MORE HE WANTS TO SELL. In fact, if the price goes down to $32.00 or even less, he wants to sell “at market,” no matter how low the price is. Pretty nuts, but there are people who think this way. That’s why I gave this character the name I gave him. And to be fair, there are LIMITED circumstances in which such an order makes sense (e.g. someone who is highly leveraged and would be bankrupted by a margin call).

In Barclay's case, Mr. Dumbass is short the stock – well, it’s currency here, not a stock -- to begin with. So he’s not worried that the currency will go down and wipe him out. Rather, he’s worried that it will go UP and wipe him out. Remember, he shorted it.

According to the complaint, Barclays is presumably trying to jam the price up so that Mr. Dumbass’s stop loss BUY order kicks in, pushing the price even higher. By “investing” a little in buying, which pushes the price up slightly (or as much as it can manage to push it up…because that is Barclay’s intent, to push up), Barclays hopes to trigger Dumbass's stop-loss buy order and make the price go up yet further still. And at that higher price, Barclays will sell.

In theory people like Mr Dumbass should not exist, because they will have lost all their money.  But I guess it takes time for them to lose money.  


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