Central bank credibility

An interesting comment has been made around the financial news sites and blogs since the Swiss National Bank decided to abandon the 1.20 EURCHF peg on Thursday.

It’s that the Swiss National Bank has somehow damaged their credibility by abandoning the peg and thus market participants lost a fortune on Thursday. Some FX dealers that let their clients trade with high leverage needed to raise additional capital to meet regulatory requirements and open on Friday.

If anything, the Swiss National Bank has proved the power of central banks is limited and that they are very credible because if they weren’t credible then no one would have lost money on Thursday. But they had given guidance that they’d keep the peg against the Euro for some time.

There hasn’t been any discussion of the net winners in the money market on Thursday. When the European Central Bank starts up quantitative easing then the Euro will weaken further and some of the mark-to-market losses the SNB has incurred will be recovered.

For other market participants, this is a lesson that trying to intervene in the foreign exchange market to protect your currency from becoming too valuable or too undervalued is a fool’s errand. A central bank with a balance sheet equal to 85% of GDP is basically a sovereign hedge fund up against the global financial markets.

In terms of what impact this will have on Switzerland itself, higher spreads are a likely result. This will suck for CHF denominated loans that need to be rolled over and Swiss firms or foreign firms looking to rollover or reissue CHF denominated bonds.

There is another lesson about risk and leverage. Retail investors have no business trading FX with leverage of 50:1 when the largest FX desks at the biggest banks in London, New York and Tokyo probably wrote off $1 billion on Thursday. I don’t understand what could compel people to think they have an edge here, when clearly almost all market participants were surprised and the spot market for CHF dried up meaning people couldn’t liquidate positions.

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