As traders, we all crave liquidity when trying to get into or out of a position. That liquidity, tight trading spreads with plenty of bids and offers, is generally the result of other traders getting into or out of positions or merely providing bids and offers in an effort to earn the spread between the two. The rise of algorithmic trading has seen the market-making function largely mechanized but thousands of traders at banks and funds still add greatly to the smooth flow of markets.
Why do markets seem more disjointed than ever this year? To my mind, there has been a perfect storm. 2008 was a record year for most FX banks. Volatility was at an all-time high as credit and equity markets melted down amid the global economic contagion. But record years in the FX department will not translate into record bonuses for traders. Banks have been busy writing down billions in toxic assets and are under intense focus from regulators after many accepted public funds. Big bonuses for traders are extremely politically incorrect this year.
Worse, after record years, what do management teams generally do? They raise the budget for the departments that had record years. So as a trader you get stiffed for your record 2008 and have a much higher target thrust upon you for 2009. A lose-lose proposition.
Human nature being what it is, the trader then sits on his hands, feeling there is no sense in taking great risks to try and attain unattainable targets after just getting shafted on his bonus. Fewer trades equals less liquidity for the markets and the impact trickles down to you and me.