Can Forex Crash?
The short answer to this question is Yes and No, Forex markets cannot crash in their entirety, but specific currencies can crash at any time. Crashes in the Forex markets are quite different from those in the stock markets in that Forex crashes usually affect a specific currency. For example, when the Swiss Central Bank unpegged the Swiss franc from the euro, the franc soared and took down other currencies in what is known as a flash crash. A similar event occurred with the Japanese yen in early 2019 when the currency crashed overnight in another flash crash and took down many other currencies.
Difference between the stock market and Forex market crashes
Stock market crashes are very different from Forex market crashes in that a stock market crash usually affects most stocks given that they trade in a similar currency. Therefore, if the S&P 500 crashes, the majority of the companies that make up the index will see the value of their shares eroded, and the same is true for all stock markets and indices.
Forex market crashes usually affect a single currency such as the British pound or the US dollar and are usually triggered by unexpected events that shock investors and force them to sell the currency. However, given that Forex trades usually involve two currencies such as the GBP/USD pair, which pits the British pound against the US dollar, this means that the US dollar will rally as the pound falls.
Therefore, while people who were holding the pound will experience a significant drop in the value of their holdings, that is, a crash, those on the opposite side of this trade will witness a massive gain in the value of their trades as the US dollar rallies against the Sterling pound.
The same is true for any other currency that is affected by a crash, as its peers will post massive gains even as the affected currency crashes resulting in a massive erosion of its value in the global currency markets.
The fact that the Forex markets are made up of numerous currencies each representing different countries and regions means that it is almost impossible for the entire Forex market to crash given that each currency is usually paired against another currency, which benefits when its peer is losing value.
What causes currency crashes?
Now that we have established that the general Forex markets cannot crash, but that individual currencies crash from time to time, let’s look at some notable currency crashes and their causes. Firstly, we need to state that there are generally two types of a crash, that is, long-term crashes and flash crashes. Long-term crashes usually last for months or years, while flash crashes are known to occur in seconds and last for less than an hour.
Regardless of whether a crash is flash crash or a long-term crash investors holding the affected currencies usually sustain major losses that may even wipe out their accounts.
Long-term currency crashes
Long-term currency crashes are usually related to the existing socio-economic situation in a country and they usually last for a long time. These types of currency crashes usually occur when a country is facing a major crisis such as government coup, hyperinflation, or massive economic challenges.
For example, Venezuela is facing a significant currency crisis as the bolivar plummets in value following US sanctions that have basically crippled the country’s oil industry, which was a major foreign exchange earner.
The country is also being run by an autocratic government that has been isolated by the international community, which has hurt its economy in a big way. This is just one example of a long-term currency crisis, which could take years to resolve.
However, long-term currency crises are mostly seen in developing countries that do not have strong institutions and are led by dictators with unpopular policies that drive away investors, which affects the country’s economy negatively.
Beware of flash crashes
Forex traders were shocked by the Japanese yen’s flash crash that occurred on January 2, 2019, where the yen rallied about 3-5% against other currencies such as the US dollar in just eight minutes.
The sudden move saw traders who were holding currency pairs that included the Japanese yen post significant losses/gains. The move was short-lived but very damaging to most traders who saw their stop-loss orders hit and some even had their accounts wiped out given their exposure to yen crosses.
Most currency experts attributed the sudden move to algorithmic trading given that there were no extraordinary fundamental drivers behind the crash, which occurred during a week-long Japanese bank holiday.
Some experts pointed out that the crash happened between 17:00-18:00 New York time, also referred to as the witching hour given the low liquidity levels associated with the hour as the New York markets are typically closed and the Japanese markets are not yet open.
Other experts pointed out that Apple Inc. had announced weak revenues due to a slowdown in China after the New York close, which could have scared investors triggering the flash crash.
Swiss franc crashes
A month later on February 10, 2019, the Swiss franc also suffered a mini-crash during the Asian trading session where it dropped significantly against its major peers including the US dollar. Most experts attributed the mini-crash to low liquidity levels given that the Japanese markets were closed for the National Foundation Day celebrations.
Another memorable Swiss franc crash, which was more of a flash rally really, occurred in January 2015 when the Swiss National Bank announced that it would no longer peg the franc at 1.20 against the euro, which caused it to soar by up to 20% against the euro and other major currencies.
It is important to note that flash crashes are not new to the Forex markets as they have happened severally in the past despite the fact that the Forex markets as a whole cannot crash. However, the unexplained flash crashes such as the ones that happened earlier this year have become more common in the recent past. Always use proper risk management when trading the Forex markets in order to avoid catastrophic losses in case of a flash crash.