First it was the conspiracy theory that Li(e)bor traders were manipulating the entire rates market which a year ago became conspiracy fact. Then it was commodities with an emphasis on the energy market (but not gold – gold is never, ever manipulated) with even such luminaries as JPMorgan’s Blythe Masters, subsequently implicated. And moments ago, via Bloomberg, to absolutely nobody’s surprise, we learn that that final market which so far had not been exposed as the “wild west” of manipulators, the FX market, is part of the conspiracy “fact” too. According to Bloomberg, “employees have been front-running client orders and rigging WM/Reuters rates by pushing through trades before and during the 60-second windows when the benchmarks are set, said the current and former traders, who requested anonymity because the practice is controversial. Dealers colluded with counterparts to boost chances of moving the rates, said two of the people, who worked in the industry for a total of more than 20 years.”
The specifics should be well-known to those who have followed all other “fixing” scandals to date, because for the most part they are identical, just cover a different asset class:
The behavior occurred daily in the spot foreign-exchange market and has been going on for at least a decade, affecting the value of funds and derivatives, the two traders said. The Financial Conduct Authority, Britain’s markets supervisor, is considering opening a probe into potential manipulation of the rates, according to a person briefed on the matter.
“The FX market is like the Wild West,” said James McGeehan, who spent 12 years at banks before co-founding Framingham, Massachusetts-based FX Transparency LLC, which advises companies on foreign-exchange trading, in 2009. “It’s buyer beware.”
The $4.7-trillion-a-day currency market, the biggest in the financial system, is one of the least regulated.
Now we know why, and it’s not only because this is the primary venue where the central banks of the world try to outsmart and outtrade each other in the New Normal.
How is WM/Reuters implicated?
The WM/Reuters rates are used by fund managers to compute the day-to-day value of their holdings and by index providers such as FTSE Group and MSCI Inc. that track stocks and bonds in multiple countries. While the rates aren’t followed by most investors, even small movements can affect the value of what Morningstar Inc. (MORN) estimates is $3.6 trillion in funds including pension and savings accounts that track global indexes.
One of Europe’s largest money managers has complained about possible manipulation to British regulators within the past 12 months, according to a person with knowledge of the matter who asked that neither he nor the firm be identified because he wasn’t authorized to speak publicly.
The WM/Reuters rates data are collected and distributed by World Markets Co., a unit of Boston-based State Street Corp., and Thomson Reuters Corp.
Reading through the article one can’t help but feel a modest smugness by Bloomberg which in the past month had been repeatedly slighted by Reuters due to the infamous Bloomberg “surveillance” scandal, which promptly faded following the news that the government was doing just that to, well, everyone.
Bloomberg LP, the parent company of Bloomberg News, competes with New York-based Thomson Reuters in providing news and information, as well as currency-trading systems and pricing data. Bloomberg LP also distributes the WM/Reuters rates on Bloomberg terminals.
As for the details, think Libor setting and fixing. Only in FX:
Introduced in 1994, the WM/Reuters rates provide standardized benchmarks allowing fund managers to value holdings and assess performance. The rates also are used in forwards and other contracts that require an exchange rate at settlement.
“The price mechanism is the anchor of our entire economic system,” said Tom Kirchmaier, a fellow in the financial-markets group at the London School of Economics. “Any rigging of the price mechanism leads to a misallocation of capital and is extremely costly to society.”
The rates are published hourly for 160 currencies and half-hourly for 21 of them. For the 21 — major currencies from the British pound to the South African rand — the benchmarks are the median of all trades in a minute-long period starting 30 seconds before the beginning of each half-hour.
If there aren’t enough transactions between a pair of currencies during the reference period, the rate is based on the median of traders’ orders, which are offers to sell or bids to buy. Rates for the other, less-widely traded currencies are calculated using quotes during a two-minute window.
And since it is a very rapid and largely liquid market, everyone waits until the last minute:
As market-makers, banks execute orders to buy and sell for clients as well as trade on their own accounts.
Companies and asset managers typically ask banks to buy or sell currencies at a specified WM/Reuters fix later in the day, most commonly the 4 p.m. London close. That arrangement is open to abuse, as it gives traders a window in which they can adjust their own positions and try to move the benchmark to boost their profit, three of the dealers said.
Customers often wait until the hour before the 4 p.m. close to place large orders to minimize the opportunity for banks to trade against them, one investor and a trader said.
Index funds, which track baskets of securities from around the world each day, are particularly vulnerable because they need to place hundreds of foreign-exchange trades with banks using WM/Reuters rates, according to two money managers. The funds buy securities to match their holdings to the indexes they are required to track. The issue is most acute at the end of the month, when index-tracker funds invest new money from clients.
Specifically, the “manipulated” trades occur using such tried and true methods as banging the close. End result: massive profits on a daily basis for dealers.
By concentrating orders in the moments before and during the 60-second window, traders can push the rate up or down, a process known as “banging the close,” four dealers said.
Three said that when they received a large order they would adjust their own positions knowing that their client’s trade could move the market. If they didn’t do so, they said, they risked losing money for their banks.
One trader with more than a decade of experience said that if he received an order at 3:30 p.m. to sell 1 billion euros ($1.3 billion) in exchange for Swiss francs at the 4 p.m. fix, he would have two objectives: to sell his own euros at the highest price and also to move the rate lower so that at 4 p.m. he could buy the currency from his client at a lower price.
He would profit from the difference between the reference rate and the higher price at which he sold his own euros, he said. A move in the benchmark of 2 basis points, or 0.02 percent, would be worth 200,000 francs ($216,000), he said.
It’s a small, manipulative club, and you’re not in it. Also, the club meets every day for about 60 seconds and then promptly disperses.
To maximize profit, dealers would buy or sell client orders in installments during the 60-second window to exert the most pressure possible on the published rate, three traders said. Because the benchmark is based on the median of transactions during the period, placing a number of smaller trades could have a greater impact than one big deal, one dealer said.
Traders would share details of orders with brokers and counterparts at banks through instant messages to align their strategies, two of them said. They also would seek to glean information about impending trades to improve their chances of getting the desired move in the benchmark, they said.
The tactic is most effective with less-widely traded currencies, the traders said. It could still backfire if another dealer with a larger position bets in the other direction or if market-moving news breaks during the 60-second window, one of them said
So there you have it – the next Li(e)bor scandal:
Bloomberg News contacted foreign-exchange traders and investors after some market participants expressed concern that the WM/Reuters rates were vulnerable to manipulation. The traders and investors said they expected their market would be the next to be scrutinized.
And the punchline: it is all self-policed. Brilliant – a bunch of sociopaths promising to do the “right thing”
While U.K. regulators require dealers to act with integrity and avoid conflicts, there are no specific rules or agencies governing spot foreign-exchange trading in Britain or the U.S. That may make it harder to bring prosecutions for market abuse, according to Srivastava, the Baker & McKenzie partner.
Spot foreign-exchange transactions aren’t considered financial instruments in the same way as stocks and bonds. They fall outside the European Union’s Markets in Financial Instruments Directive, or Mifid, which requires dealers to take all reasonable steps to ensure the best possible results for their clients. They’re also exempt from the Dodd-Frank Act, which seeks to regulate over-the-counter derivatives in the U.S.
“Just because Mifid doesn’t apply, the spot FX market shouldn’t be a free-for-all for banks,” said Ash Saluja, a partner at CMS Cameron McKenna LLP in London. “Whenever you have a client relationship, there is a duty there.”
Sixteen of the largest banks, including Barclays, JPMorgan Chase & Co. (JPM) and Deutsche Bank (DBK), signed a voluntary code of conduct for foreign-exchange and money-market dealers in 2001 that was later included as an annex to guidelines issued by the Bank of England in November 2011.
The BOE’s Non-Investment Products Code, which some banks use in contracts with clients, states “caution should be taken so that customers’ interests are not exploited when financial intermediaries trade for their own accounts.” It also says that “manipulative practices by banks with each other or with clients constitute unacceptable trading behavior.”
“The thing about the code is it is a voluntary code,” the lawyer said. “It may be that compliance with that has almost been seen as optional.”
Wait, you mean bankers signed a voluntary code of conduct promising not to steal and cheat their clients and… proceeded to steal and cheat? Unpossible: bankers would never do that.
But since the FX market is indeed huge, and since this is like the Office Space strategy of taking tiny bits of “other people’s money”, even as everyone in the circle was making illegal profits, and since everyone’s interests were aligned, here once again we get the perfect example of what everyone previously said could not happen: a massive manipulative conspiracy which is “impossible” as someone is always expected to talk. Guess what – they never talk if they have enough incentives not to.
But the real bottom line is if any idiot is still wondering why there will never be a great rotation out of bonds into stocks, FX, commodities, or whatever, it is because by now everyone knows that the market is one giant rigged and manipulated casino. And it is much more enjoyable to blow your money away in Vegas that alongside the E*trade baby. Period.