Since the middle of last year, foreign exchange trading floors have been riveted on a scandal involving alleged manipulation of the 4 p.m. London fixing of currency prices. Switzerland, the U.K. and the U.S. have announced investigations into whether forex traders colluded to influence prices, and at least 12 traders have been suspended or placed on leave. Also, the retirement system of Haverhill, Massachusetts, has filed a class action suit against Barclays Bank, Citigroup, Credit Suisse Securities, Deutsche Bank, JPMorgan Chase & Co., Royal Bank of Scotland and UBS, accusing them of conspiring to fix forex prices.
Market authorities have begun asking if the forex market — the world’s largest financial market, with an estimated $5.1 trillion in transactions daily — requires greater regulation to increase transparency and reassure investors that they’re getting a fair price. Many investors were already unsettled by accusations dating back to 2009 that two large custodians, Bank of New York Mellon Corp. and State Street Corp., were giving clients unfair prices. Some of those cases are still before the courts.
The London fixing, which has a wide impact beyond forex because asset managers use those rates to price investments such as derivatives and exchange-traded funds, is administered by WM/Reuters, a division of Boston-based State Street. The prices are calculated by a complex formula taking average prices in the one-minute period starting 30 seconds before 4 p.m. Alicia Curran, a spokeswoman for State Street, said in a statement that WM/Reuters “supports efforts by the industry to determine and address any alleged disruptive behavior by market participants, and we welcome discussions on these issues and what preventative measures can be adopted,” though she declined to say if any changes have been implemented since the scandal erupted.
Richard Lyons, a foreign currency expert who is dean of the Haas School of Business at the University of California, Berkeley, points out that central banks used to conduct most currency fixings based on an open auction system but the market has moved away from that approach and is unlikely to return. “The reason was the central bank methods were based on very small transaction flows,” Lyons says. “That’s even more manipulable than having a Reuters system where many banks are trading.”
There’s pressure from institutional clients to trade at the 4 p.m. fixing because analysis shows that is when the market is most liquid, notes Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York. “We always talk about a 24-hour-a-day market, but you won’t get a liquid price 24 hours a day.” London accounts for about 40 percent of global turnover in the forex market, much of it at the 4 p.m. fixing.
To make it harder to game the system, Mark Taylor, dean of the Warwick Business School in Coventry, England, and a former forex trader, advocates changing the timing of the fixing methodology by taking an average over an hour or even 15 minutes, or choosing a random period within a certain window. “The current system gives you an exact time when if you hit the market with large amounts of money, just enough to move it even a few hundredths of a percentage point, that will create substantial profit opportunities,” Taylor says. “The main thing is moving away from giving a small target for people to hit and remove their incentives.”
Although the European Central Bank has discussed ways to increase forex regulation, UC Berkeley’s Lyons says such efforts would likely be misguided: “There are all kinds of unintended consequences when we start fooling with the rules of the game in financial markets.” For one, Lyons says efforts to increase transparency in the determination of the trades that constitute the fix might cause market players to shrink from the market, reducing the amount of liquidity available. “When you increase transparency you might reduce manipulation, but you will almost surely reduce liquidity. At a public policy level, that’s a big tradeoff.” Another uncomfortable revelation from the current scandal is that the top five banks control 80 percent of the interbank foreign exchange market. Even without collusion, thanks to their advance knowledge of client trades, those banks can take positions before trading client orders, benefiting their own bottom line more than their clients’. “It’s been kind of an open secret that people would keep big trades as an advantage for themselves until the fix,” Warwick’s Taylor says. “That’s why I say it’s hard to regulate these things and it’s much easier to take away the incentives.” • •
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