I hope you’re hungry, because Bloomberg is serving up the next financial scandal. Last summer we learned about LIBOR manipulation, and how various panel banks had attempted to nudge the daily LIBOR fixing up or down with contributed rates that were “suggested” by their trader-friends, who would benefit from the resulting small directional movements. By all accounts, the rate scandal was a very big deal, shaking faith in over $300 trillion in linked financial instruments, spurring numerous investor lawsuits, and leading to The Wheatley Review, with its call for overhauling the structure, ownership, and oversight of this benchmark interest rate. If you thought it would be hard to imagine a bigger scandal, then apparently we all just lacked imagination. The LIBOR scandal is but a mere Hors d’oeuvre, compared to the enormously large feast that is the fixing scandal in foreign currency markets.
If what Bloomberg reported last week is true, then we have more than a decade of manipulation in the $4.7 trillion-a-day FX marketplace, where transactions are often tied to WM/Reuters fixings. WM/Reuters reports exchange rates hourly or half hourly on nearly 160 currencies, where fixings are based on incoming trade data over a one minute period that starts 30 seconds prior to and ends 30 seconds after the fixing time. Traders are accused of “banging the close” – deliberately structuring and sequencing customer trades just prior to or within the crucial period – in order to nudge the resulting fixings ever so slightly to benefit their proprietary positions. This is only possible because of the volume of FX customer trades that contractually must be completed using specified time stamps, such as the 4PM London close. The behavior is especially egregious at period ends.
We are, of course, talking about spot FX transactions. Reform advocates will quickly note that spot FX falls outside the purview of the European Union’s Markets in Financial Instruments Directive (Mifid), and are exempt from Dodd-Frank. That means the people who are policing the markets are the market makers themselves! Many have signed on to a voluntary code of conduct, which already considers manipulative practices by banks with each other or with customers to be “unacceptable trading behavior.” That would no doubt bring more comfort, if there hadn’t been multiple financial scandals in the intervening years since signing these voluntary agreements.
Some banks would argue that FX manipulation isn’t even possible. After all, central banks try to move currency markets all the time – with their currency interventions, quantitative easings, and interest rate decisions – yet often with only limited effect. How then, can a mere trader with customer orders, possibly effect daily fixings in these deep, liquid markets? This argument, though, is fundamentally flawed. The allegation is that traders attempted to manipulate currency markets. If they were unsuccessful, would that make it any better? If the activities were confined to less liquid currencies, should that make a difference? I would not want to be one to make the case that there is no manipulation, based on the defense: “I-tried-but-failed-to-move-currency-markets.”
The scheme may seem overly complicated to outsiders, and the results not be guaranteed for the inside traders, and yet this does not take away from the true nature of the scandal – that the banks have an inherent conflict of interest. They have asymmetric information in the form of customer trade details, including the number and size of trades to be executed, which need to get done using specified WM/Reuters fixings. And they have knowledge that their own proprietary positions could be harmed without trader intervention. Information in hand, the banks then allegedly act on that knowledge, against their customer’s best interests and in favor of their own.
This scheme is also made possible by the ambiguity of when and how trades are executed, relative to their actual marks. The last time we saw an FX scandal this sensational was back in 2011. A prominent dealer bank was accused of overcharging its custodial customers when buying and selling currencies, and then recording trades at or near the “best” marks of the day – regardless of when and how they were actually traded! The same elements of information asymmetry, inherent conflict and dilemma (helping you hurts me), and ambiguous actual trade details, fueled both of these schemes for too long, and regrettably could still happen again.
So, what can be done to avoid getting fleeced in FX? Chatham will always tell you to work with someone who is independent and has your best interests in mind when structuring and executing deals. But what else can be done? As much as possible, you should transact at current rates – not closing marks or specific fixings. This would lessen the trader’s ability to break up and sequence your trade to benefit his own book. Just prior to transacting, you also need to know where the market is trading right now, to inform and manage your expectation of where your deal should get done. In that moment a wide mark would stand out like a sore thumb. You should insist on post trade details with time stamps, which can be compared historically to actual market conditions, and periodically audit the results. And, you should manage a diverse set of counterparties, eager for your business, and mindful that you can go elsewhere at any time, for any reason. That’s what we would do. Please do not hesitate to call if we could do it for you!