November 12, 2013 8:46 pm

Foreign exchange: The big fix

Banks fear a repeat of the costly Libor scandal after traders were suspended over currency concerns
©Reuters

A currency exchange office in Kiev, Ukraine

For years, the chatroom cacophony in the clubby world of foreign exchange traders was peppered with allusions to drinks, drugs and women. But in the spring of 2012, debate in the private Bloomberg chats suddenly turned serious.

The conversations centred on a committee meeting of an elite group of the City of London’s most senior currency traders and their counterparts at the Bank of England. Traders were agitated about rumours that BoE representatives may have raised concerns in an April meeting over possible manipulation of daily currency fixings, said people familiar with the interbank chatroom conversations.

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While the traders’ chatter does not chime with the meeting’s minutes, it would not have been the first time that regulators had discreetly raised the issue in the past two years. One member of the BoE committee said regulators had asked senior traders on various occasions whether the daily “fix” could be manipulated but those traders had repeatedly allayed their apprehensions.

Today there is no more scope for reassurances. At least 12 foreign exchange traders at global banks in London, New York and Tokyo have been suspended amid scores of regulatory and internal inquiries into possible attempted manipulation and collusion in the foreign exchange markets, where $5.3tn changes hands every day. Three of these traders – Richard Usher, Rohan Ramchandani and Niall O’Riordan – are members of the chief dealers’ subgroup. 

Regulators in the UK, Switzerland and the US, assisted by authorities in Hong Kong, are investigating at least 15 banks including Barclays, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley, Royal Bank of Scotland, Standard Chartered and UBS. The banks, and a number of others, have launched internal reviews. The European Commission has also started preliminary antitrust inquiries.

The sprawling global investigations add to what have become myriad manipulation probes into benchmarks – ranging from the Libor interbank lending rate to Isdafix interest rate swaps and the oil spot markets – hitting banks’ earnings and reputations and costing them political goodwill. Bankers, lawyers and investors fear the benchmark probes might become one of the sector’s most damaging legal entanglements.

What regulators are targeting is at the heart of the global financial system. Foreign exchange is the largest financial market globally, one that is used by a vast number of companies, institutional and retail investors and central banks. It is also one of the most unregulated areas of trading.

“This area has effectively been non-complianced. There are hardly any rules or oversight,” said one lawyer involved in the investigations. Traders insist there are rules but admit many of the finer points are vague.

In spite of its size, the foreign exchange market is run by a small group of global traders. One corner of foreign exchange – the $2tn spot market – is controlled by a group of fewer than 100 individual traders at a handful of large banks.

Regulators are investigating whether members of this network used their combined market power to try to manipulate prices in their favour – resulting in higher costs for simple transactions for clients such as pension funds. 

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So far, the probes are focusing on the most liquid currencies in the world, with the euro-dollar market, which accounts for almost a quarter of the spot market, under particular scrutiny, according to two people familiar with the internal probes. Regulators and banks are also looking at sterling, the Australian dollar and less liquid Scandinavian currencies, these people said.

Interviews with more than a dozen foreign exchange veterans and investors suggest recent changes in the structure of banks’ businesses have increased incentives and opportunities for collusion.

The largest four banks in foreign exchange – Deutsche Bank, Citigroup, Barclays and UBS – have amassed more than half the overall market share, up from less than 20 per cent 15 years ago.

Moreover, post-crisis job cutting means that spot foreign exchange trading desks, even at the largest banks, are typically staffed with only eight to 10 traders, many of whom have worked previously with their counterparts in other banks. “This is a market in which price fixing and collusion could actually work,” said a former Citigroup fixed income banker.

A big part of currency spot trading is still done by old-fashioned voice spot traders, who deal with clients over the phone. Traders on other desks have tended to regard forex as a backwater, a banal and unsophisticated part of the market.  

But increasing competition among banks since the financial crisis has spurred a fierce talent war for a new breed of mostly London-based spot foreign exchange traders, with the stars being paid up to $2m.

Competition has also eaten into spreads – often down to a fraction of a basis point – offered to clients placing big orders. Given that this is the only source of client-driven income for banks in forex trades, it may have encouraged traders to seek less transparent ways to cut their risks. 

Some argue that forex is a utility trade – essential for pension funds and large corporations to conduct day-to-day business but not one that requires the skills of other types of lucrative trading. Other experts say banks should move to a fee-based model for currency trades.

As with the Libor scandal, the allegations centre on yet another set of benchmarks. In the foreign exchange market, the pivotal one is the WM/Reuters 4pm fix. Large mutual funds around the world trade currencies at the fix, a daily rate determined by trades in a 60-second window. While the clients know that this gives their dealers an information advantage, they do not want to be out of kilter with the exchange rate valuation of their portfolios, which are also based on the fix.

But for years, savvy investors and regulators have detected unusual surges in the benchmark. “We have told our clients for several years that if you don’t have to trade at the WM fix, then don’t,” a senior investment manager says. “We know it is happening at an illiquid time and we have seen strange things going on.”

Axel Merk, president of Merk Funds, says he is not surprised that some investors are questioning the role of currency fixes. “Whenever you outsource a task to someone else, it’s not surprising if you do not get best execution on a price. That’s how markets work.”

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But traders might have gone a few steps further. Ever since the Libor scandal burst into the public view last year, regulators have been asking about trading businesses that involve benchmarks. In the UK, the Financial Conduct Authority sent out letters in April asking lenders to review their foreign exchange operations.

In May, there was a breakthrough. A whistleblower, a trader who used to work for one of the leading banks, gave the regulator information about chatroom discussions between rival traders that allegedly allowed them to share information about pricing and order books. Since then, the FCA has stepped up its investigations, forcing banks to sift through millions of trader conversations conducted via Bloomberg terminals, instant messages, mobile phone calls and text messages going back as far as 10 years.

Banks found a number of chat rooms for different currencies where potentially “problematic” sharing of information among traders took place, said three people with knowledge of or involvement in the internal investigations. The groups went by names ranging from the Bandits’ Club to the Sterling Lads. Traders were often members in several chat rooms.

One specific chatroom, whose group was known alternately as the Mafia or the Cartel, was used by some of the most influential traders in London. Among them are Mr Usher, a former Royal Bank of Scotland trader who went to JPMorgan as head of spot foreign exchange trading in 2010, Mr Ramchandani, Citigroup’s head of European spot trading, Matt Gardiner, who recently joined Standard Chartered after working at UBS and Barclays, and Chris Ashton, head of voice spot trading at Barclays. All of these senior traders are on leave. Neither they, nor Mr O’Riordan, has been formally accused of any wrongdoing and none could be reached for comment.

Regulators are looking into allegations that traders might have used chat rooms to get a view about overall order flows and to use this information to build up positions just ahead of and during the fix. By buying and selling a currency before the fix, a trader can try to influence the final fix price to profit from the whole range of client orders he is handling that day. When the fix is set, some clients will end up profiting in line with the trader while others will be worse off.

While collusion is illegal, lawyers say it is less clear if front-running or “pre-hedging” amounts to criminal market abuse or mere misconduct or not even an offence at all.

An executive at one of the banks contacted by regulators says: “If clients want really tight pricing then they have to expect banks to pre-hedge . . . the issue is whether that was discussed among banks or not.” Sharing information was a “natural” development, the former Citi employee says. “Yes, it’s collusion – but in a lot of ways it’s also risk- management.”

But lawyers and people familiar with the internal inquiries say that in the wake of the Libor scandal the existence of these chat rooms may be an issue in itself. “After the Libor scandal  these idiots still used bank chat rooms. How on earth they thought they would get away with it I don’t understand,” says one person involved in the internal probe of a large bank.

“Pretty much everything that is being discussed about individual trades is problematic from a competition perspective,” says a lawyer with knowledge of the inquiries.

. . .

With EU antitrust regulators about to slap a record fine of up to €5bn on a handful of banks for operating a cartel to rig global benchmark interest rates, banks are worried about the antitrust implications of the forex probes. The fact that some traders went by the moniker of the Cartel is not helpful to the banks.

But some say the implications are more wide-ranging. Investors are already launching civil class action suits against the banks and questions are being asked about other currencies and fixes.

Currency traders point to the “Tokyo fixes”, benchmarks widely used by companies that, like Libor, are based on submissions by banks instead of real transactions. Individual rates published by banks have been considered suspicious for a long time, they say. Dollar/yen rates often rise before fixing time at 9:55am, particularly on days when many importers want to buy US dollars to settle contracts.

The probes might also spell the end of unregulated foreign exchange markets, with industry insiders predicting tighter rules, a move away from fixings and the end of the cagey world of voice spot traders. The move towards lower-paid electronic traders could be accelerated.

“Clients are waking up,” the senior investment manager says. “Some asset managers have said in recent weeks that they no longer want to trade at the WM fix.”

The fundamental question now is whether regulators will force banks to overhaul their sales and trading businesses. “Will there be much more regulation of trading as a result of this? I’d say the chances are 99 to one,” says a senior consultant.

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One-minute window that sets the pace

What is the fix?

The fix is a time of day when banks guarantee investors a certain rate for their currency trade. Normally, trades are done immediately. There is a bid/offer spread whereby the trader will offer a higher or lower price to an investor depending on whether they are buying or selling, writes Alice Ross.

At the fix, investors are guaranteed the mid rate – between the bid and offer price – of whatever the currency trades at in the one-minute window around the time of the fix.

But investors place their order with a bank in advance, so the trader knows how much he has to buy or sell in half an hour. The investigation so far has centred on the WM/Reuters fix at 4pm GMT, which is the most commonly used.

Who uses the fix?

Investors who are regularly buying or selling bonds, equities or currencies. Many investors like to use the fix because it removes any need to try and time the market that day. The fix at 4pm is used as a benchmark for currency rates in funds, too.

How could you manipulate the fix?

A trader’s job is to try and get an extra slice of each trade he makes for a client. Normally he can do this by looking at the market in real time. But with the fix, he knows he has to buy a certain sum in half an hour. He sees that obligation to buy as his risk for the bank that he needs to hedge.

He wants to buy at a lower rate than the mid price of the fix – the price he has guaranteed to the client – to make his profit. So he wants to try and work out where the market is likely to trade at 4pm. If he thinks the price of the euro might be lower at 4pm, he might try to sell some in advance.

The investigation seems to have centred on chat rooms where traders at different banks may have shared details of their positions to gain an informational advantage.

If the fix was being manipulated, how would it affect investors and the wider financial market?

Pension funds and other institutional investors could be affected if they have regularly paid too high a price for their currency trades.

While these could be just slivers each day, they would add up over time if there was regular manipulation.

Additional reporting by Michael MacKenzie, Caroline Binham, Ben McLannahan and Kara Scannell

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