How The Forex "Fix" May Be Rigged
The colossal size of the global foreign exchange (“forex”) market dwarfs that of any other, with an estimated daily turnover of $5.35 trillion, according to the Bank for International Settlements’ triennial survey of 2013. Speculative trading dominates commercial transactions in the forex market, as the constant fluctuation (to use an oxymoron) of currency rates makes it an ideal venue for institutional players with deep pockets – such as large banks and hedge funds – to generate profits through speculative currency trading. While the very size of the forex market should preclude the possibility of anyone rigging or artificially fixing currency rates, a growing scandal suggests otherwise.
The Root Of The Problem: The Currency “Fix”
The closing currency “fix” refers to benchmark foreign exchange rates that are set inLondonat 4 p.m. daily. Known as the WM/Reuters benchmark rates, they are determined on the basis of actual buy and sell transactions conducted by forex traders in the interbank market during a 60-second window (30 seconds either side of 4 p.m.).The benchmark rates for 21 major currencies are based on the median level of all trades that go through in this one-minute period.
The importance of the WM/Reuters benchmark rates lies in the fact that they are used to value trillions of dollars in investments held by pension funds and money managers globally, including more than $3.6 trillion of index funds. Collusion between forex traders to set these rates at artificial levels means that the profits they earn through their actions ultimately comes directly out of investors’ pockets.
IM collusion and “banging the close”
Current allegations against the traders involved in the scandal are focused on two main areas:
- Collusion by sharing proprietary information on pending client orders ahead of the 4 p.m. fix. This information sharing was allegedly done through instant-message groups - with catchy names such as “The Cartel,” “The Mafia,” and “The Bandits’ Club” - that were accessible only to a few senior traders at banks who are the most active in the forex market.
- “Banging the close,” which refers to aggressive buying or selling of currencies in the 60-second “fix” window, using client orders stockpiled by traders in the period leading up to 4 p.m.
These practices are analogous to front running and high closing in stock markets, which attract stiff penalties if a market participant is caught in the act. This is not the case in the largely unregulated forex market, especially the $2-trillion per day spot forex market. Buying and selling of currencies for immediate delivery is not considered an investment product, and therefore is not subject to the rules and regulations that govern most financial products.
Let’s say a trader at theLondonbranch of a large bank receives an order at 3:45 pm from aU.S.multinational to sell 1 billion euros in exchange for dollars at the 4 pm fix. The exchange rate at 3:45 p.m. is EUR 1 = USD 1.4000.
As an order of that size could well move the market and put downward pressure on the euro, the trader can “front run” this trade and use the information to his own advantage. He therefore establishes a sizeable trading position of 250 million euros, which he sells at an exchange rate of EUR 1 = USD 1.3995.
Since the trader now has a short euro, long dollar position, it is in his interest to ensure that the euro moves lower, so that he can close out his short position at a cheaper price and pocket the difference. He therefore spreads the word among other traders that he has a large client order to sell euros, the implication being that he will be attempting to force the euro lower.
At 30 seconds to 4 p.m., the trader and his/her counterparts at other banks - who presumably have also stockpiled their “sell euro” client orders - unleash a wave of selling in the euro, which results in the benchmark rate being set at EUR 1 = 1.3975. The trader closes out his/her trading position by buying back euros at 1.3975, netting a cool $500,000 in the process. Not bad for a few minutes work!
The U.S.multinational that had put in the initial order loses out by getting a lower price for its euros than it would have if there had been no collusion. Let’s say for the sake of argument that the “fix” - if set fairly and not artificially - would have been at a level of EUR 1 = USD1.3990. As each move of one “pip” translates to $100,000 for an order of this size, that 15-pip adverse move in the euro (i.e. 1.3975, rather than 1.3990), ended up costing theU.S.company $1.5 million.
Worth the risks
Odd though it may seem, the “front running” demonstrated in this example is not illegal in forex markets. The rationale for this permissiveness is based on the size of the forex markets, to wit, that it is so large that it is nearly impossible for a trader or group of traders to move currency rates in a desired direction. But what the authorities frown upon is collusion and obvious price manipulation.
If the trader does not resort to collusion, he does run some risks when initiating his 250-million short euro position, specifically the likelihood that the euro may spike in the 15 minutes left before the 4 p.m. fixing, or be fixed at a significantly higher level. The former could occur if there is a material development that pushes the euro higher (for example, a report showing dramatic improvement in the Greek economy, or better-than-expected growth in Europe); the latter would occur if traders have customer orders to buy euros that are collectively much larger than the trader’s 1-billion client order to sell euros.
These risks are mitigated to a great degree by traders’ sharing information ahead of the fix, and conspiring to act in a predetermined manner to drive exchange rates in one direction or to a specific level, rather than letting normal forces of supply and demand determine these rates.