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)
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[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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