Trading at London 4pm: The illusory benefits of maximum liquidity
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This paper explores why trading at the London 4pm WM/Refinitiv benchmark fix (Fix) brings Australian institutional investors only the illusory benefits of maximum liquidity.

The conclusion is that investors need to challenge the use of the Fix for execution purposes, and instead pursue strategies that meet with their objectives. It will require more rigour, but the reward is the conversion of very material and unobserved execution costs evolving into visible implementation 'profits' relative to the industry benchmark fix.

Background to the London 4pm benchmark
Those unfamiliar with benchmark fixing and its uses should start with the basic fact that the institutional foreign exchange market operates uninterrupted for over five days of the week; from the New Zealand open on Monday to the New York close on Friday.

To delineate one trading day from another, 'fixing' rates are published to represent a daily closing price. Market convention records
this timing as London 4pm, with WM/Refinitiv's benchmarking service the most popular singular standard for the pricing of international asset portfolios and global benchmarks.

The mechanics of Refinitiv's fixing methodology utilises median market rates in a five-minute window around the time of the Fix—two and-a-half minutes before and after 4pm for benchmark daily closing rates. But these benchmark rates are not just used to revalue international assets, benchmarks, and derivative positions.

Market participants are also drawn to executing trades at the Fix, and for investors seeking to guarantee the fixing rate, they will typically submit an order to a counterparty bank in advance of the Fix. This then leaves the bank to manage the risk around that and other fixing orders before delivering on the fixing price alongside a preagreed spread.

There is no doubting what attracts a number of investors to execute at the Fix:
- Some seek the additional liquidity (trading volumes/ market depth) and narrow bid-ask spreads which accompany elevated trading volumes.
- Others are drawn to the potential benefit through netting some of their trading interest at a fixed time.
- There are those who seek to simply minimise the level of tracking error to their respective benchmarks.
- Some are drawn in by the transparency that the Fix offers.
- Others trade at the Fix to generate scale in their currency management practices.

It all sounds rather compelling except for the very significant, largely unrecognised, and wholly avoidable market impact costs accompanying rebalancing at the Fix.

By not considering how unbalanced order flows distort exchange rates, investors are skirting 'best execution' obligations and incurring unobserved costs which elicits a material dollar cost to the end investor.

In the next section, we explain how market impact costs from herd behaviour completely overwhelm any benefits that accrue from the surge in trading volumes.

Herd behaviour: Triggering an adverse market reaction
Individual investors follow their own self-interest. Leaving an order to be filled at the London 4pm fix would generally anticipate a minimum of market impact given the elevated trading volumes and deep liquidity. However, it is the collective of these individual decisions that generates herd behaviour which itself triggers an adverse market reaction. As per the Financial Stability Board's

Foreign Exchange Benchmarks Final Report:
"Price movements will always occur in the fixing window to reflect the net balance of supply and demand in the market."

Consider market moves around mid-March at the height of the COVID-19 crisis: global stocks suffered badly on March 12, 2020 with the MSCI World ex-Australia (AUD) Index falling 6.6%. As investors assessed the damage to their portfolios the following day,
one response was an urgent need to rebalance hedging programs. The natural reaction for an Australian investor in that situation was to sell Australian dollars and buy foreign currencies to realign the hedges and reflect the lower portfolio valuation.
Here, timing matters - a lot.

An investor waiting until the Fix will see their orders combined with those of other investors pursuing a similar objective. The sheer weight of orders going in the one direction creates a massive imbalance for the market - one which is resolved by the Australian dollar cascading lower in the hour ahead of the 4pm fix. The galling result as shown in Figure 1 is that the investor rebalancing
(selling) at the Fix will be doing so at a level that is 2% lower than where the dollar was trading just an hour earlier.

This result is not an accident or chance event. It is the natural outcome from a herd of investors rebalancing in the same direction and concentrating their flows at the same time. Nor is it an isolated incident, as the COVID crisis provided a host of examples where the concentration of investor flows saw a very material and detrimental movement into the London 4pm Fix in both directions.

This is demonstrated in Figure 2, with that March 13 move as the centrepiece. It is clear that herd behaviour generated a series of significant market moves into the Fix with investors often getting filled at levels at or near the extremes of that representative trading range.

Market impact: A systematic bias towards trading range extremes
It is also important to recognise that this herd behaviour phenomenon is not isolated to crisis conditions. There exists a systematic market bias to the fixing rate being set towards the extremes of the trading range. Our earlier research has found there is a persistent tendency for the AUD to peak or trough at the Fix.

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