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Is Forex the new LIBOR?

February 2014

Another Scandal hits the banks: Manipulation of the Foreign Exchange Market

Another scandal appears to be unfolding in the banking industry. Even as the fines are still being handed out for manipulation of LIBOR, investigations are under way into suspicions of manipulation of foreign exchange rates. So is this just the second instalment in what may become a long series of investigations gradually taking in all of the markets in which banks trade?

Well possibly, but not necessarily. Although the headlines are looking similar, the underlying story is looking rather different.

At the moment, definite facts are thin on the ground. What we know for sure is that a number of regulators and government agencies around the world are conducting investigations into a number of firms relating to trading the foreign exchange market. A number of institutions have said that they are cooperating with those investigations. And a number of individuals working in the market have gone on leave and can not be contacted by the media. Thus far, nobody has been accused of any wrong doing.

What follows is speculation on my part based on what I have read in the media so far.

The investigations appear to be centred on the WM/Reuters Closing Rate which is calculated at 4:00pm London time each day. This is not, of course, a closing rate in the true sense of the word. There is no organised exchange for trading currencies so there is no official opening or closing time. In fact it trades on a 24 hour basis whenever and wherever a willing buyer and seller can be found. But with approximately 40% of business transacted in London, it is accepted by many as the next best thing to a closing rate.

It appears that the regulators have been alerted to sudden movements in certain exchange rates at or around 4:00. And, according to some reports, particularly at month end. In the absence of any obvious news flow at that time, that must surely arouse suspicions. Particularly since the spikes often reverse shortly afterwards. And clearly one possible explanation for this is that the market is being manipulated around the time of this important fixing.

But that’s by no means the only possible explanation. The efficient market hypothesis suggests that the market price is generally the best reflection of  fair value because it discounts all the known information. And the closing price is the most reliable of all because anybody who might have been waiting on the sidelines to place their trade must surely have done what they had to do by close of business. For this reason, and for several more besides, some market participants like to place their trades at the closing price. That’s fine so long as the trades concerned are not too large. But a large trade could move the market at any time. Imagine then if a number of large trades all came in at the same time. That could have a quite significant impact on the market. But what’s the chance of a load of large orders all coming in at exactly the same time. Well if enough people deliberately seek to put their orders in at exactly four o’clock, the chance is quite high.

That could be quite a problem. If the orders hitting the market at 4:00 exceed the liquidity available at that time, they would have the potential to cause a quite substantial market move - even if there is no market abuse at all. Now that might be quite right and proper. If a counterparty has said he wants to buy a currency at 4:00 irrespective of price, then maybe that is what must be done. But is it really what the customer would want. If you could do better for your customer, shouldn’t you try? After all, there are competitors who would be all too happy to have the business if they could.

What is the better approach? It’s difficult to say. Clearly you can only do it one way or the other. So you will never know for sure whether it would have turned out better if you had done it differently.

Although many reports seem to be stressing that the foreign exchange market operates on an over-the-counter basis with no centralised exchange, many of the issues here are not unique to forex. The issues of fixings and closing prices, and of large volumes of business being done at those times, can equally be seen on the stock exchange. Observe the so called ‘triple witching’ when equity derivatives expire and large volumes of hedges are unwound. Or even the closing auctions on the London Stock Exchange. Price spikes are not uncommon depending upon the orders hitting the market at those times.

And as regards the prior disclosure of client orders, the London Stock Exchange even provides a mechanism for doing it. For SETSqx stocks, orders can be entered for the closing auction up to one and a half hours before it takes place. This only differs from the alleged practice in the forex market in that the orders are then visible to the whole market rather than only to the counterparties that the bank informs.

So there might be nothing amiss. It may all make sense when properly examined.

Or not. Market manipulation and client abuse are nothing new. The LIBOR case is fresh in our minds. But deliberate market manipulation has happened before. On 28th November 1997, two traders at J P Morgan deliberately placed trades in a number of stocks at the close of the market with a view to suppressing the closing level of the FTSE®100 index. They were successful in their attempt, pushing the level of the index down by over half of one percent in the final moments of trading. And although they lost money on their trades, they made a far greater profit by preventing a payout on a binary option linked to the closing price of the index. They were banned from working in the industry and ordered to pay costs of £375,000

The current forex market investigation, however, sounds more similar to the case of Brandeis, a former member on the London Metal Exchange. Brandeis, and a number of its brokers, were found guilty of offences including abuse of information relating to client trades and intentions, trading ahead of their biggest customers to take advantage of the resultant price movements, accepting cash payments from a third party for confidential information relating to customer orders, and even mispricing client orders - executing trades at prices which did not reflect market conditions at the time.

There were a number of considerations in the Brandeis case. But one that is particularly worth noting was the nature of the agreement between the broker and his client. It was that agreement which established the nature of the relationship and had a considerable bearing on the types of duties owed to the client. It was quite clear that legally it was possible for such a dealing relationship to not give rise to agency-type obligations. However, in this case they did apply.

Where regulated business is carried on for customers, the FCA will take the view that at least some form of agency obligation must arise. However, the spot foreign exchange market does not fall within the scope of FCA regulation, so the FCA’s rules do not apply. They are covered by the Bank of England’s NIPs code, which sets out guidance on best practice in such markets. That code has no statutory underpinning, however, the FCA does expect regulated firms to take due account of it when conducting relevant business. Consistent with point the observations on the importance of setting up the relationship correctly referred to in the Brandeis case, point 4 of the code states:

4. When establishing a relationship with a new counterparty or client, firms should take steps to make them aware of the precise nature of the firm’s liability for business to be conducted, including any limitations on that liability and the capacity in which they act…

As things stand, there is no accusation of any wrong doing. And there may in due course be no such allegation so long as firms have acted in accordance with their clients’ reasonable expectations in the light of their contractual agreements. Much will depend on the individual circumstances in each case.

There are inherent conflicts in many types of financial business. And this is particularly true in the dual capacity operations found on the LME and in the currency markets. If you would like to discuss the conflicts inherent in your own business, and the way in which you manage them, please feel free to contact us.