The "European Volcker Rule" is emerging! What we like about the linked article is the broader principle poking through the surface. To wit:
"... separate large banks' riskier trading activities from their deposit-taking business ... to keep client deposits and other operations [eg, payment processing] serving the real economy from being affected by a bank's failure."
AND
"Several lawmakers argue all trading activities should be completely separated from the retail operations."
What we see taking form is advocacy of "narrow banking" and "full reserve banking." Europe - especially the UK - has hosted far more debate on these innovations than the US. In brief, the innovation is that banks retain all deposits. No lending, no risk-taking, nothing! Banks would be free to pursue their normal activities of lending and market-making but could do so only with segregated equity and debt capital.
It's simple. It's transparent. It will end bank bailouts (because it's politically feasible to let the banks fail). Largely speaking, both bankers and regulators hate the idea - which means it must be right.
Promotion of Ethics, Simplicity and Transparency in Finance
Thursday, January 30, 2014
A Third WM Reuters Fix Class Action Suit Filed; Deutsche Suspends Head of Emerging Markets FX Trader in NY
It was also reported today that Deutsche suspended this senior trader in mid-December.
The stories continue, but at this point neither of these sheds any more light on what actually happened. The filing of lawsuits is understandable, and possibly encouraged by the banks continued suspension and firing of employees related to internal bank investigations of the fix allegations.
Wednesday, January 29, 2014
How does Bitcoin help criminals? Let him count the ways.
Dealbook reports that law enforcement officials testify as to how virtual currencies like Bitcoin help criminals.
Access to capital and banking services to become restricted
As expected, certain types of people and entities will find limited access to capital and banking services.
WSJ reports that U.S. banks like JPM are ending banking relationships with potentially troublesome customers like virtual currency firms and legal marijuana businesses rather than put up with the additional compliance work involved. Will this drive these types of capital flows underground?
WSJ reports that U.S. banks like JPM are ending banking relationships with potentially troublesome customers like virtual currency firms and legal marijuana businesses rather than put up with the additional compliance work involved. Will this drive these types of capital flows underground?
Tuesday, January 28, 2014
Recent development in the LIBOR litigation
From Buckley Sander LLP: "SDNY retains jurisdiction over three LIBOR suits"
Quantum Mechanics and the Volcker Rule
Nearly 100 years ago, a great physicist surmised "if particles behave like waves, there must be a wave equation." Next thing you knew, the world had the Schrodinger Equation of Quantum Mechanics.
Now the World of Banking has the Volcker Rule. Regardless of your point of view, almost all would likely agree that US banks should have reduced risk once they shed the Volcker-prohibited activities.
Just as Schrodinger created the math to describe quantum wave functions, what we now need is for financial quants and regulators to create the models of economic and regulatory capital to show how much LESS CAPITAL banks should have post-Volcker implementation.
If the Volcker premise of risk reduction is correct, we should see the impact in bank capital models, right?!
Now the World of Banking has the Volcker Rule. Regardless of your point of view, almost all would likely agree that US banks should have reduced risk once they shed the Volcker-prohibited activities.
Just as Schrodinger created the math to describe quantum wave functions, what we now need is for financial quants and regulators to create the models of economic and regulatory capital to show how much LESS CAPITAL banks should have post-Volcker implementation.
If the Volcker premise of risk reduction is correct, we should see the impact in bank capital models, right?!
Purpose of Bitcoins to avoid paying bank fees?
Dealbook reports on the hearings today called by NYS's top financial regulator, Benjamin Lawsky. Reading the post it appears that the major benefit for Bitcoins as provided by those testifying, was to avoid bank fees and move "money" around faster. But there are reasons for why money should not move so fast. Why is a person's life improved if they can move money from one account to another in 2 days as opposed to 3? And there is a cost to ensure that the movement of capital is not being used to facilitate illegal activities.
Bitcoins: Bonanza for the regulators?
Given all the noise about Bitcoins I can't resist another post today. Regulators are apparently jostling to be among the first to regulate Bitcoin businesses as money transmitters following the announcement by the U.S. Treasury Department’s Financial Crimes Enforcement Network. Assuming that no federal regulatory framework is proposed, I expect a handful of the states looking for "impact regulation" will be the first to propose specific regulations. But then I also expect that eventually, the federal government will preempt all state laws and regulations involving Bitcoin. Until then, Bitcoin will provide a rich source of laws and regulations (and potentially fees and taxes) for state governments.
You say marijuana, I say Bitcoin?
According to Bloomberg, the SEB AB Bank has refused to set up Bitcoin accounts due to concerns about money laundering. The news about Silk Road getting shut down and prominent Bitcoin speculators being arrested for money laundering comes at the same time that legal marijuana businesses appear to have no access to banks due to the same money laundering concerns. Except of course that legal marijuana business can transact in cash whereas Bitcoin only has value if it can be converted into another currency. Unless one were to shop at Overstock.com where apparently they still take Bitcoins, money laundering concerns be damned! Does anyone know if Overstock's Vice Chairman, Jonathan Johnson, is as worried about Bitcoin and money laundering as he is about gay marriage?
Ramifications from the regulatory probes of potential FX manipulation
Bloomberg reports that RBS has informed clients that it will no longer accept orders for some of the currency benchmarks. Could this be the beginning of a wave where the benchmark rates, which used to be the most heavily traded, will become the most illiquid?
Monday, January 27, 2014
Shakespeare and the Volcker Rule
If we were to strike the pose of Hamlet and ask: Volcker Rule? Or No Volcker Rule? We'd go with "YES" and then add a forgettable soliloquy with phrases such as "no more bank bailouts" and "get the risky activity away from taxpayer support."
Sullivan & Cromwell today issued a good, lengthy discussion of Volcker. (Thank Heaven for Executive Summaries and Tables of Contents!)
Supporting the Volcker Rule has its downside. It is not "a step in the right direction." The right direction is elsewhere - future posts will spill our thoughts!
Sullivan & Cromwell today issued a good, lengthy discussion of Volcker. (Thank Heaven for Executive Summaries and Tables of Contents!)
Supporting the Volcker Rule has its downside. It is not "a step in the right direction." The right direction is elsewhere - future posts will spill our thoughts!
Bitcoin miner beware!
NY Times's Dealbook has reported that 2 executives of Bitcoin business have been arrested, accused of facilitating drug transaction on the now defunct website Silk Road. Investors looking to profit from Bitcoin should tread carefully lest they be accused of being a part of a money laundering scheme.
Reduced Foreign Exchange Fix Trading and Reduced Fixed Volatility Since Manipulation Allegations
This Bloomberg article discusses how the FX market at the fix is changing in light of the allegations about collusion by large banks at the London close fix. Fewer asset managers, the largest fix customers, are trading at the fix and Bloomberg review of currency moves at the fix shows much lower volatility in the second half of 2013, after the allegations were published. Possible explanations for the lower volatility are discussed, from banks no longer colluding, lower currency volatility in general during this period, to changes at banks (new internal bank trading rules, new traders replacing those suspended or fired or banks covering their risk over a longer time period rather than right near the fix).
Perhaps most importantly, if volumes at the fix remain reduced, there is less inherent conflict. Customers trying to trade at a price to be set in the future, create the opposite incentive structure customers normally expect from their banks. On a large non-fix trade, customers typically value, and thus pay for the service of, a bank that can execute the trade with the least market movement. In a fix trade, with no bid-offer spread income available to pay the bank for its services, banks seem to have an incentive to create the most volatility possible at the fix to generate income. Although there is no proof that banks engaged in such behavior, eliminating the incentives to do so will decrease the mistrust of bank traders by customers and will PEST (Promote Ethics Simplicity and Transparency) in the foreign exchange market.
http://www.bloomberg.com/news/2014-01-27/london-afternoon-currency-spikes-subside-under-regulators-glare.html
Perhaps most importantly, if volumes at the fix remain reduced, there is less inherent conflict. Customers trying to trade at a price to be set in the future, create the opposite incentive structure customers normally expect from their banks. On a large non-fix trade, customers typically value, and thus pay for the service of, a bank that can execute the trade with the least market movement. In a fix trade, with no bid-offer spread income available to pay the bank for its services, banks seem to have an incentive to create the most volatility possible at the fix to generate income. Although there is no proof that banks engaged in such behavior, eliminating the incentives to do so will decrease the mistrust of bank traders by customers and will PEST (Promote Ethics Simplicity and Transparency) in the foreign exchange market.
http://www.bloomberg.com/news/2014-01-27/london-afternoon-currency-spikes-subside-under-regulators-glare.html
Bitcoin is NOT Money !!
Yes, bitcoin is fun.
But it’s not money. It
fails the most critical and basic test of “money.” Along with many other people, we wish it could be money. The problem is NOT that bitcoin exists
only in electronic (or virtual) form.
The problem is also NOT that bitcoin is independent of governments and
banks. In fact, we love these
properties! We’ll say it
again: Bitcoin fails the most
critical test of money. To
explain, we digress.
Role
of Money
Let’s start at the beginning. Every adult must acquire the survival necessities of food,
shelter, and clothing. The most
direct means of acquisition is to grow one’s own food, build one’s own shelter,
and make one’s own clothing. Free
people, however, choose otherwise.
Just as baking two pies is little more effort than baking one,
production of food, shelter, and clothing admits vast economies of scale. A farmer can double the size of her
“garden” to feed two families rather than one without doubling her labor or
investment in tools. By doubling
her production, the farmer will exchange the excess crops, perhaps, for the
clothing and firewood that her neighbor provides.
The superior efficiency of this exchange, or “barter,”
system is indisputable. All
participants in this barter system earn their necessities with less time and
effort. Direct barter is potentially
manageable in small communities but suffers from the complexity of innumerable
“exchange rates” among the barter items (e.g.,
vegetables, meat, clothing, livestock, lumber, barn construction, medical
services, et cetera). The establishment of money simplifies
the barter system tremendously.
People exchange their goods and services for money that they use, in
turn, to exchange for items they need from others. Money becomes the pre-eminent barter item but has meaning
only in its ability to facilitate free market exchange of goods and services.
Money is an extraordinarily simple and elegant solution to
the barter exchange rate problem.
Further, the size and scope of the barter market increases
astronomically due to our ability to save money for future years, borrow money
for future repayment, and transmit money easily over long distances. All human societies invent money, just
as they discover fire, in their pursuit of survival and advancement.
Yet what particular barter item could serve as money? The requirements “to save money for
future years” and “transmit money easily over long distances” eliminate most
candidates. Crops and cattle, for
instance, are of great value and some historical accounts consider them as
early forms of money. But they are
not well suited as money. The
dominant money of the thousands of years of recorded history has consisted of
coins of metals and alloys such as copper, bronze, silver, and gold.
The requirement that trumps all others is the certainty
people have that whatever serves as money has enduring value. A man will agree to accept copper coins
for his bushels of wheat only if he is confident in the value of other goods he
can purchase with the same coins – whether now or next year or within the same
village or many days’ travel away.
Gold
and Silver through the Millennia
What substance or physical item could possibly inspire such
confidence simultaneously in almost all people? What would all people agree has value “now” and will have
significant value at all future times?
There is nothing tangible on
Earth that can provide this certainty of value. Surprisingly and with no strong explanation, however, the
metals gold and silver are history’s best answers to these questions.
Gold, and to a lesser extent silver, has smitten human
beings through all of recorded history and across a wide range of
cultures. No society rejects
gold. (Lenin may have said “we
will make public toilets out of gold,” but neither he nor his successors in the
Soviet Union followed through on this promise.)
The history is clear.
Human beings have always regarded gold and silver as “valuable.” This persistence and confidence are
precisely what one needs for viable money. But there’s a counter-argument: why should this work?
If a society bases its money on gold or silver and then, suddenly, a
large fraction of the society realizes one “cannot eat” gold or silver and that
there is no evident value other than “shiny and pretty,” what happens
then? The monetary system would
fail. But it has never happened.
There is no certainty gold or silver will always work as money, but the world has thousands of years of good
experience.
Fiat
Money
Earlier we stated that the dominant requirement for money is
the people’s certainty of “enduring value.” Yet we then expressed the view that there is nothing tangible on Earth with this
certainty. Gold and silver are
merely the best candidates.
Fiat money consists of tokens such as coins or paper certificates with
little or no inherent value that a government decrees has stated value.
The enduring value of such money, then, stems from the people’s
confidence in the government to
maintain the value and validity of the money. One critical aspect of maintaining value of the otherwise
worthless money is that the government mandates that businesses and people
accept the fiat money in all payments.
Like many ideas in life, fiat money can certainly work as
intended in one’s imagination. If
our employer pays us for our labor with colorful pieces of paper and we know we can exchange this paper for
immediate or future purchases, then the money is functioning. An evident risk is counterfeiting of
the colorful paper, so the government must take pains to produce the paper
money in a manner that is difficult to emulate. The government will also create and enforce laws to forbid
the counterfeiting.
Since fiat money has no intrinsic value, the citizen
implicitly relies on government to maintain the money’s value relative to goods
and services in an economy. We
don’t like fiat money – we see it as a disaster waiting to happen. But at least fiat money has a
premise: “trust government to
create and supervise money.”
Bitcoin
has No Enduring Value
The big problem with bitcoin is that there will never be
widespread, popular certainty that it has enduring value. We may be able to buy food or clothing
or pay our college tuition today with
bitcoin, but what about tomorrow? Proponents of bitcoin might argue that
there’s a plan to cap the total bitcoin supply and such fixed supply should
maintain stable bitcoin prices.
But why trust that arrangement?
Why trust the unknown and unaccountable group of people that manage
bitcoin? While there may be arguments for trust, public behavior
does not derive from carefully parsed arguments. There’s no stability if people need to think about their
money and wonder why it has value.
Perhaps the “easy fix” to this problem is to get government
to enforce (or compel or otherwise support) bitcoin somehow. Yet the existential point of bitcoin is
to move away from government control of money.
We’re not economists here at Financial PESTs!! This is not an argument from the musty
library of “Economic Theory.” Good
economists know that they don’t build the theories first and then expect people
to follow them. It works the other
way. Observe how free people
pursue their own self- and communal interests.
(We excerpted portions
of this essay from J. M. Pimbley and L. E. McDevitt, Banking on Failure at Lehman, to be published in 2014.)
Media reporting UK Broker ICAP to lose role in ISDAfix swaps benchmark
A number of media outlets are reporting that UK Broker ICAP will lose role in the ISDAfix swaps benchmark. Possible outcomes of the reported investigations into Libor and ISDAfix could include greater oversight of interbank dealers like ICAP. Expect more to come.
Friday, January 24, 2014
"A Giant Historic Mistake"
Giant Historic Mistake
You've got to admire people who say what they think in colorful terms. But what is it about the Euro that Ken Rogoff finds disastrous? Is it the simplest possible observation that individual Eurozone countries "lost control" of their monetary policies? The article we link here doesn't say. We'll go for a different reason (which may well be ours rather than Rogoff's). The ECB and European leaders wrongly interpreted "single currency" to mean "the Central Bank mandate now includes sustaining insolvent banks and sovereigns." That's not what the Maastricht Treaty says, but that's what has happened in practice.
You've got to admire people who say what they think in colorful terms. But what is it about the Euro that Ken Rogoff finds disastrous? Is it the simplest possible observation that individual Eurozone countries "lost control" of their monetary policies? The article we link here doesn't say. We'll go for a different reason (which may well be ours rather than Rogoff's). The ECB and European leaders wrongly interpreted "single currency" to mean "the Central Bank mandate now includes sustaining insolvent banks and sovereigns." That's not what the Maastricht Treaty says, but that's what has happened in practice.
WSJ - BOE Governor Carney: Regulators Must Fix Mechanics of Libor, Forex Benchmarks
"The" quote from the article: "While regulators will fix the mechanics of benchmarks in markets ranging from LIBOR to foreign exchange, only private individuals and institutions can reform the behavior that has made such changes necessary," Mr. Carney said.
This quote confirms our belief in additional regulation to come. The article infers that this quote only refers to banks and traders, but we suggest that in the case of FX, it should also include asset managers who were requesting execution of their trades with no profit for the banks, at a benchmark rate to be determined. Such a situation is fraught with peril.
http://online.wsj.com/news/articles/SB10001424052702303448204579340354242747762?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303448204579340354242747762.html
This quote confirms our belief in additional regulation to come. The article infers that this quote only refers to banks and traders, but we suggest that in the case of FX, it should also include asset managers who were requesting execution of their trades with no profit for the banks, at a benchmark rate to be determined. Such a situation is fraught with peril.
http://online.wsj.com/news/articles/SB10001424052702303448204579340354242747762?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303448204579340354242747762.html
Thursday, January 23, 2014
In the "Oh No They Didn't" Category
The New York Times Dealbook reports that S&P alleges that the US government's lawsuit against the rating agency for fraud was retaliation for the downgrade of US Treasuries. S&P cites in particular a conversation that former Treasury Secretary Geithner had with S&P's Chairman, Harold McGraw, III. Could Geithner have called Attorney General Eric Holder to direct a U.S. Attorney to file suit against S&P solely for the downgrade? How would this compare to Bridgegate?
Why is Bitcoin sucking all the oxygen out of the room?
One of our other bloggers, Joe Pimbley, is currently working on a book that we expect will touch upon the topic of Bitcoin. While he is Financial PEST's resident Bitcoin expert, I couldn't resist posting something about it. The New York Times Dealbook features a critical piece by Edward Hadas about the virtual currency while Bloomberg Business Week recently published a feature story about the virtual currency and the economy that has erupted in pursuit of this "fool's gold." I wonder, however, whether Bitcoin fits into the classic definition of a "currency" and whether, perhaps, there may be more similarities to the Great Tulip Mania of 1633-37 in the Netherlands.
More FX manipulation lawsuits to come?
Based on media reports there are currently two class actions against the major banks regarding the alleged manipulation of the FX market, filed by Haverhill Retirement System and Simmtech Co. Ltd. Given the steady reporting of additional details of investigations and suspensions and firing of traders at the top banks, the question probably isn't whether more lawsuits will be filed but when and how soon.
Bloomberg: Banks assist regulators in FX probe
Libor, ISDAfix, FX, it all becomes one big blur. Bloomberg today reports that cooperation agreements that banks entered into with regulators to settle Libor are now providing regulators with evidence as they investigate the FX manipulation. Could these agreements reach other potential manipulation in the oil and gold markets? http://www.bloomberg.com/news/2014-01-23/banks-aid-u-s-forex-probe-fullfilling-libor-accords.html
Tuesday, January 21, 2014
Could more regulation be on the way for the FX market?
With banks either firing or placing traders on leave, one has to wonder whether a result of the investigations into the alleged FX manipulation will result in more regulation. http://dealbook.nytimes.com/2014/01/17/hsbc-and-citigroup-suspend-currency-traders/?_php=true&_type=blogs&nl=business&emc=edit_dlbkam_20140121&_r=0
Rate Manipulation News May Shake Investor Confidence in Markets
The
news stream on alleged benchmark manipulations in different markets continues,
including commodities, interest rates and FX. While banks have only admitted
wrongdoing in the LIBOR scandal, the news in just the past week has been
widespread and includes:
1)
Reports of firings and suspensions have been increasing in frequency, to include 2 employees suspended at each Citi and
HSBC just this past Friday.
2)
Deutsche Bank is withdrawing from the London Gold fix.
3)
German regulator Bafin says that the alleged gold and FX manipulations are
worse than the LIBOR scandal as they
would include actual trades rather than reported rates.
4)
A new mechanism and administrator for the LIBOR fix (ICE) has been announced
5)
New regulators, now the Federal Reserve and the Monetary Authority of
Singapore, are joining the FX benchmark investigation.
The
connection in all of these alleged scandals is that a limited
number of large market participants are colluding to set benchmark prices that bring
greater profits to themselves at the expense of their clients and other
investors. Large notional amounts of executed
financial transactions are directly impacted by being priced at allegedly
rigged rates. All of the holdings of
investors in funds whose assets are marked to market at manipulated rates are
indirectly impacted when shares are purchased or sold. If true, the scope is
such that large swaths of the investment landscape may have been affected by
one or more of these collusions.
Banks
have admitted wrongdoing in the LIBOR scandal and have paid $6 billion in fines
to date. Investigations continue in the
ISDAfix, FX WM Reuters London Close, the London Gold fix, oil and other
commodities as well. It can be inferred
from the banks’ personnel actions, that they too see improper activity by
traders. In fact, these reports have
come up so quickly, in so many markets, that all benchmarks may very well now
be suspect in the eyes of investors.
What
is most important is that regulators thoroughly review the actions of market
players and then fully report to the investment world what has occurred. Only by such investigations, proving to
investors that the markets are not (or no longer) rigged against them, can new
more reliable benchmarks be devised, and investor faith in the fairness and
efficiency of markets be maintained (restored).
Friday, January 17, 2014
WSJ: HSBC, Citi Suspend Currency Traders
According to WSJ, 2 more banks have suspended FX traders. Wonder what the banks and regulators found? http://on.wsj.com/LpXgcC
Thursday, January 16, 2014
May a Bank "Tell-All" to Regulators Regarding FX Benchmark Rates?
This article discusses prior investigations by regulators and the incentives to the first mover to cooperate.
http://www.sfgate.com/business/bloomberg/article/Banks-Said-to-Snitch-on-FX-Competitors-in-Race-to-5080967.php
http://www.sfgate.com/business/bloomberg/article/Banks-Said-to-Snitch-on-FX-Competitors-in-Race-to-5080967.php
Bloomberg News: Currency Dealers Told Bank of England of Fix Trading in 2012
Bloomberg News reporting British regulators knew of some of the alleged manipulative behavior back in 2012. http://mobile.bloomberg.com/news/2014-01-15/boe-officials-discussed-trading-around-currency-fixes-in-2012.html. If true, why wasn't this information shared with public sooner?
Wednesday, January 15, 2014
WSJ: Deutsche, Citi Face Forex Pressure
WSJ reports US regulators are in Citi's London offices as part of FX investigation. For our take on the matter check see our post earlier today.
Reuters reports FBI suspects front running of Fannie, Freddie in swapsmarket
Yet another investigation into potential wrongdoing in the derivatives market.
FX probe implicates more traders
NYT Deal Book reports Deutsche Bank has suspended several FX traders in NYC resulting from its probe into FX manipulation.
http://nyti.ms/1eIVuxw. See our earlier post today for our take on the scandal.
The “Great” Alleged FX Manipulation By Jon Wetreich and Jack Chen
When news broke of the alleged
manipulation of the world’s largest market, the daily five trillion dollar
foreign currency (“FX”) market, this appeared as another entry in the long list
of scandals implicating some of the world’s largest financial institutions. The
investigations are centered on the possibility, reported by Bloomberg News in
June 2013, that dealers shared information and used client orders to influence
widely-followed FX rates to boost trading profits. Specifically, the index is
the WM/Reuters currency rates published by World Markets Co., a unit of State
Street Corp., and Thomson Reuters Corp. at 4 PM London time, also known as the
London close (“London Close”).
While we have seen reports of
the FX market size in the press reports, what we have not come across are some
estimates of possible dollars affected.
We have prepared the following
table to provide a very high level assessment of the potential impact that such
market manipulation could have on financial institutions. We obtained publicly
available information about the portfolio holdings of a large public pension
fund, two life insurers and industry information for life insurers and mutual
funds. Our assumptions on portfolio turnover are based on our initial review of
the public information. The assumption on percentage of trades manipulated is based
upon our initial review of the currency mixes in the portfolios and on media
reports of how the alleged manipulation occurred. For the table we provided a
range of 10 to 30 bps of manipulation based upon a study reported by Bloomberg
News.[1]
A more accurate picture of damages requires a review of actual trades and
portfolio information as well as a better understanding of whether the London
Close was actually manipulated and, if so, how often and to what degree.
For our table:
§
We selected a pension fund and life insurers
because they are more likely to have entered into trades referencing the London
Close.
§
We included four asset classes in our analysis:
foreign equities, foreign bonds, forwards and swaps.
§
We considered American Depositary Receipts but based
on preliminary information we do not see significant impact from any potential
manipulation.
After the table we present a
list of FAQ along with our answers.
The following information is on an annual
basis.
Annual Damages
(Millions)
|
||||||||||||||||
By Entity
|
Notional Value of Foreign
Assets (Millions)(A)
|
Level of Manipulation (bps)
|
||||||||||||||
Bonds
|
Equity
|
Forwards
|
Swaps
|
Other (B)
|
10 bps
|
20 bps
|
30 bps
|
|||||||||
Large US Pension Fund
|
$56,000
|
$4,000
|
-
|
-
|
-
|
$16.0
|
$32.0
|
$48.0
|
||||||||
Large US Life Insurer #1
|
$28,200
|
$2,000
|
$1,100
|
$8,000
|
-
|
$9.2
|
$18.3
|
$27.5
|
||||||||
Large US Life Insurer #2
|
$12,700
|
$2,650
|
$4,200
|
-
|
-
|
$8.2
|
$16.4
|
$24.5
|
||||||||
By Industry
|
Notional Value of Foreign
Assets (Millions)(A)
|
Annual Damages
(Millions)
Level of Manipulation (bps)
|
||||||||||||||
Bonds
|
Equity
|
Forwards
|
Swaps
|
Other (B)
|
10 bps
|
20 bps
|
30 bps
|
|||||||||
Insurance Industry
|
$608,498
|
$30,608
|
-
|
$77,904
|
$3,098
|
$169.8
|
$339.5
|
$509.3
|
||||||||
International Equity Mutual
Funds
|
-
|
$1,248,000
|
-
|
-
|
-
|
$624.0
|
$1,248.0
|
$1,872.0
|
||||||||
(A) Dashes are used for
notional values for which we have no or insufficient data.
|
||||||||||||||||
(B) Includes preferred shares
and replications.
|
||||||||||||||||
Assumptions
|
Equity Variables:
|
Forward Variables:
|
||||||||||||||
Annual Portfolio Turnover:
|
100%
|
Turnover x Spot Sensitive
|
175%
|
|||||||||||||
% of Trades Manipulated:
|
50%
|
% of Trades Manipulated:
|
50%
|
|||||||||||||
Bond Variables:
|
Swap Variables:
|
|||||||||||||||
Annual Portfolio Turnover:
|
50%
|
Annual periodic payments
|
4%
|
|||||||||||||
% of Trades Manipulated:
|
50%
|
% of Trades Manipulated:
|
50%
|
|||||||||||||
Sources:
NAIC, 2013 ICA Factbook.
Frequently
Asked Questions
What are the allegations?
Although the WM/Reuters index
provides exchange rates for 160 currencies hourly and half-hourly for the 21
most traded currencies, regulators are focused specifically on the rates that
constitute the London Close. Media
reports say investigators suspect that FX dealers at banks may be sharing
information and “banging the close,” which involves executing a large number of
trades over the 1 or 2 minute period during which the rates are fixed for the
London Close, to move the rates to their advantage.
Why is the London Close important?
The London Close rates have
significant market importance as they are widely used by index and benchmark
providers such as FTSE Group and MSCI World Index, which are in turn used by
fund managers to determine their own performance and by banks to establish
conversion rates for its customers. Many banks provide a service to their
customers where they guarantee to trade for them at the London Close rates. Customers
provide the trade amounts to their banks within the one hour prior to the
London Close, also known as “the fix”.
Those banks that have agreed to make transactions for funds at the
London Close need to push through the bulk of their trades during this window
where possible to minimize losses from market movements.
Mutual funds, investment
managers and others use the WM/Reuters rates to:
1. Value,
benchmark and mark to market their international portfolios because most main
stock and bond index compilers, such as FTSE and MSCI, use these rates for the
currency portion of their calculations.
2. Execute
spot trades with banks.
3. Settle
maturing futures contracts
How do banks make money trading typical FX and London Close FX?
Fix-related flows might be large
but banks do not profit for executing the orders as they would in the course of
other FX business. Banks generally make much of their profit in FX trading by
capturing the difference or “spread” between bid and offer as they execute
customer trades. Although
WM/Reuters rates provide a bid, mid-point and ask rate for each currency pair,
most customer trades based upon these rates are converted at the
mid-point. Thus, there is no bank
spread income for most of these trades.
A typical trade where the bank
is earning a spread (and thus is not based off of the published fix) would work
as follows. If a bank sells a
customer 1 million Euro at the ask rate of 1.3746 in return for a payment of $1,374,600
and then purchase the same 1 million Euro at the bid price for $1,374,500, the
bank would have earned $100. The
wider the spread, the higher the bank’s profit. A five point spread would yield the bank $500. On a 5 or 10 million Euro transaction,
which is a typical size in the interbank market, the 5-point spread would
generate $2,500 or $5,000.
Two realities complicate this scenario
for banks. The first is that the
interbank market rarely allows a bank to capture a spread much above 1 or 2
basis points on large trades. The
second is that the spread takes certain market costs into account, such as counterparty
credit and market volatility and thus not all of the spread should be
considered profit.
Nonetheless, the banks know the
London Close orders before the fixing and may place trades to benefit from the
fixing. As Michael Melvin and John Prins of BlackRock wrote in 2011 in “Equity
Hedging and Exchange Rates at the London 4 P.M. Fix,” “The large market-makers
are adept at trading in advance of the fix to push prices in their favor so
that the fixing trades are profitable.”[2]
How could a bank profit by manipulating the
WM/Reuters rates?
Example: a fund notifies the
bank counterparty that a spot trade to sell €500 million / buy US dollars needs
to be executed at the WM/Reuters fix that day. If the fix rate was $1.4020, then the fund pays €500 million
and receives $701 million. If,
however, the bank manipulated the fix so that the rate was 1.4000 (a
manipulation of 20 pips or about 14 bps), then the fund would only receive $700
million US dollars, a manipulated loss of $1 million for the fund. As many funds execute trades at the fix
on a daily basis and in many different currencies, the number of potential
manipulations can be substantial over a period of time.
Could activity perceived as potential manipulation be justifiable risk
management?
Increased volatility can be a consequence
of high volumes, similar to what can be observed at the opening and closing
times in stock markets. Because the London Close is widely used by asset
managers and other institutional clients, it is not unusual for a bank to
receive a large order, sometimes extremely large, a few minutes before the
fix. The bank, having promised its
customer the London Close rate, must reduce its position in a short amount of
time or else the bank is stuck with a potentially large loss. These flows are especially large at the
end of each month and quarter as these managers put new money to work or
reposition their index portfolios.
In a typical transaction, the
bank’s spot traders would be able to fulfill the transaction by conducting a
series of $5 or $10 million in the course of the trading day. The result would be an average rate for
the customer and a minimal impact on the marketplace. This averaging is desirable because a market impact of a
large transaction would move the market in the opposite direction desired by
the client. The client would
effectively be trading against itself.
A one point in time fix, at 4pm London time, is not ideal for minimizing
market impact, making price swings bigger and easier to achieve.
Simple prudent risk management
requires a bank to make sure that it is not harmed by the customer order. For example, if the bank is running a
$50 million short position in EURUSD, and the desk gets an order to buy $400
million, it is in the bank’s interest to close out its position before executing
the client order. Whether this
constitutes front running (dealer profiting or avoiding losses for its own
account by trading for its own account before executing a client order) or
simple risk management explains some of the controversy surrounding the fix.
If the FX market is so large, how could it be manipulated?
In the 24 hours a day, 5 days a
week world of currency trading, there is no closing price. For convenience,
traders, funds and benchmark providers use the London Close as a reference point
in a number of ways. Thus, if
banks really wanted to manipulate FX rates, by focusing on the London close,
which is a sliver of time in the trading day, they can still affect a
significant amount of FX activity.
Moreover, despite the overall
size of the market, FX trading is actually concentrated in a handful of banks,
where the top six banks reportedly receive collectively around 60% to 65% of FX
customer flows. Because they receive client orders in advance of the London Close,
and some traders allegedly discuss orders with counterparts at other firms,
banks have an insight into the direction of rates before the London Close. That
would allow them to maximize profits on the client orders and sometimes make
their own additional bets.
Who are most likely to have been damaged by the alleged manipulation?
Because of the reference by
large financial institutions to the WM/Reuters rates, we suspect that private
individuals and smaller firms and entities that engage in FX transactions at
all hours of the day are less likely to have been directly impacted by any
potential manipulation. Smaller participants would experience indirect impact,
for example, buying and selling fund shares that are based upon a share value
including manipulated FX rates. The mutual funds, pension funds and other large
institutions that trade at London Close rates will be the most directly impacted.
Why do fund managers track indices?
First and foremost, fund
managers must do what the fund documents require, which often will reference
published indices. Additionally, fund performance is often compared to an
index, thereby further incentivizing managers to rely on published rates.
What do we not know?
Unfortunately there is in fact
much that we do not know.
Unanswered questions that would provide critical information include:
Was there actual manipulation?[3]
Which banks were manipulating?
For how many years did the
manipulation occur and did this occur on a daily basis or only sporadically?[4]
Which currencies did they
manipulate and by how much?
Is the London Close the only ongoing fix case?
In addition to its FX
manipulation investigations, British, EU and US regulators have so far assessed
a combined $6 billion in fines over manipulation of the London interbank
offered rate, or Libor, used to price $300 trillion of securities from student
loans to mortgages. Separately, more than a dozen banks have been subpoenaed by
the U.S. Commodity Futures Trading Commission over allegations traders worked
with brokers at ICAP Plc to manipulate ISDAfix, a benchmark used in
interest-rate derivatives. Other benchmark price investigations currently under
way include the London Gold Fix (set twice daily by five banks) and Brent Crude
oil (involving three major oil companies and a pricing service).
***
About the Authors
Jonathan Wetreich is a
Co-Founder of the blog Financial PESTs (www.financialpests.org) and has spent
20 years working in the foreign exchange markets, beginning with Honeywell
International where he managed the foreign exchange execution and hedge
programs. He was responsible for
managing the risk to this multinational firm from changes in foreign exchange
rates, which included buy side trading in spot, forwards and options. Jonathan followed his corporate foreign
exchange experience with sell side positions at Brown Brothers Harriman, a
private bank. His positions at the
bank included consulting with the senior management of corporations to improve
their foreign exchange risk management and execution. Jonathan also spent several years on the foreign exchange
trading desk, working primarily with asset management firms, as well as
spending time as an FX Strategist, authoring commentary on news and market
activity. Since 2012 Jonathan has
run FX Hedge Consulting, an independent consultant to corporations on matters
of foreign exchange risk management, as well as on litigation matters dealing
with foreign exchange. Jonathan
received an MBA from Columbia Business School in Finance and Accounting.
Jack Chen is a Co-Founder of the
blog Financial PESTs (www.financialpests.org) and a finance professional who
has testified in federal court on financial products and currently provides
litigation support services on LIBOR and capital markets related matters. He is
a recognized expert in structured finance where he has nearly 20 years of
experience working in different roles in the capital markets. He started as a lawyer working at
Willkie Farr & Gallagher and then Sullivan and Cromwell before going to the
business side rating structured products at Moody’s Investors Service. He subsequently worked in asset
management firms before beginning his consulting practice. His product
expertise includes credit default swaps, interest rate derivatives and total
return swaps, cash, market value and synthetic collateralized debt obligations,
collateralized loan obligations and structured investment vehicles. Mr. Chen has appeared on the CBS
Evening News and has been quoted or cited in a number of newspapers and trade
journals, including Wall Street Journal, Market Watch News Hub, Risk,
Creditflux, Asset-Backed Alert and Structured Credit Investor.
To contact the authors please
call or email Jack Chen at 646.580.9372 or jack.chen@financialpests.org.
About Financial PESTs (Promotion of Ethics, Simplicity and
Transparency)
With deep experience and
expertise in capital markets, banking, investment products, insurance, and
legal disputes, Financial PESTs cover the gamut of Wall Street activities. We promote eternal core values of
ethical conduct, simplicity, and truth at the intersection of the legal,
financial and regulatory worlds.
Economic development, wealth
creation and social progress demand efficient global capital markets and
financial infrastructure. Guiding
capital effectively to existing and new businesses, inventions, and industries
is a noble endeavor when properly imbued with core values. Unfortunately, the ideal of
uncompromised promotion of ethics, simplicity, and truth often fails to win its
battle against perceived self-interest within financial organizations.
Knowledge and information are powerful tools that
best serve the common good in distributed, rather than concentrated, form. Through writing, lecturing, and
training, Financial PESTs bring our core values to center stage to advocate the
sharing of knowledge and information so that today’s markets serve all
people. We analyze financial world
issues to create clarity, context, and corrective proposals. Financial PESTs push professionals to
the highest standards of probity, candor, and conduct. We distill complex topics to their
simplest forms and campaign incessantly for the simplest implementations of
financial transactions, fiduciary investment programs, government laws and
regulatory rules. We seek truth in
the disclosure of risks, conflicts, agendas, and loyalties.
[3] While we do not know for
certain whether manipulation has occurred, various media sources have reported
that about a dozen currency traders from the major banks have been fired, suspended
or put on leave in relation to this matter.
[4] Bloomberg News has reported
that the alleged manipulation could have gone on for over a decade.
http://www.bloomberg.com/news/2014-01-13/federal-reserve-said-to-probe-banks-over-forex-fixing.html
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