Rogue Rage

"Ex-Daiwa Rogue Trader Says Most Unauthorized Trades Hidden"

    This short Bloomberg article is thought provoking.  If we remember correctly, the Daiwa trader (Toshihide Iguchi) never took a vacation during his 12 years of illicit activity.  His colleagues all thought he was hardworking.  In reality, he had to be in the office to prevent discovery of his fraud.  As one consequence, banks began enforcing a "two weeks away from the office rule" as a low-cost fraud mitigation tactic.

    As a long-time risk manager, we find some of Iguchi's comments in the article to be insightful and relevant while others are off the mark.  As an example of the latter, Iguchi explains his view that rogue traders are not motivated by greed by saying such people "engage in unauthorized trades in attempts to recover initial losses and protect their careers."  Well, this is greed - perhaps one could call it "defensive greed."  The choice is between honesty, with possible loss of job, versus dishonesty, with retention of job, salary, bonuses, and social standing.  Valuing money and ego over integrity is absolutely a character failing of some kind - the word "greed" is just as good as any other.

    We agree with Iguchi when he says "all traders ... lose money at some point" after which he adds that traders' natural instinct is to hide their losses.  He cites "corporate culture" as the "core problem" because the culture "is focused on profitability."  Aside from the sad spectacle of watching an adult blame somebody else for his own unethical choices, we agree that corporate culture is a core problem.  But the problem is not the desire to be profitable.  Rather, it's the false expectation and understanding of what a "trader" is and how he/she makes profits and losses.

    The folklore that WAY TOO MANY PEOPLE BELIEVE is that "good traders" reliably make money with little risk simply because they know "when to buy" and "when to sell."  The real-life situation bears little resemblance to this caricature.  Many prop traders, for example, are effectively dealers.  They're willing to accumulate long and short "inventory" and show bids and offers to the market.  This market-maker role is a valuable service which does merit a net positive return.  But there's risk and an honest calculation of capital to hold against the risk will show that a good prop trader can earn a good return on capital.  But this return on capital is not much different from a normal,  long-term investor's return on capital.

    Other explanations for "trader profits" run the good-to-bad gamut of "add true value to the market" to "misleading" to "dubious" to "illegal."  Quick examples are:

ADD TRUE VALUE:  Swap trader provides customized exchange of cash flows for a corporate Treasury department's hedging of interest rate and foreign exchange risk.

MISLEADING:          Bond trader keeps her book net long and counts bond coupons as trading profit.

DUBIOUS:                  Derivative trader finds simple pair trades that produce positive carry with no risk capital assignment due to his firm's (or a regulator's) flawed model for the trades.

ILLEGAL:                  Equity trader actively cultivates contacts in or near target companies to gain non-public information.

British regulators charge 3 Barclays bankers in NYC for Libor manipulation

NYT Dealbook reports that regulators from the British Serious Fraud Office announced charges against 3 former Barclays bankers based in NYC as part of the ongoing Libor manipulation prosecutions. This brings to 12 the total number of defendants facing charges in Britain for the Libor scandal, even though British prosecutors say they have identified as many as 22 individuals involved. Dealbook reports that one of the newly charged defendants is "expected to argue that he did nothing wrong and that the Libor manipulation was going on before he joined the bank two years out of college."  Perhaps he is thinking of striking a plea deal? 

Bloomberg: Traders Join Exodus as Forex Probes Add Pressure on Costs

Bloomberg reports that more than 30 traders from 11 firms have been fired, suspended, taken leaves of absence or retired since October of last year when government probes of potential forex manipulation started picking up. The worst hit banks, according to Bloomberg, are UBS and Barclays. Supposedly some of the departures are due to personal reasons. Compared to the Libor scandal, the forex scandal has played out quite differently. Fires and suspensions are occurring before any settlements have been reached, thus leaving out a great amount of detail as to what these banks have uncovered that led to the departures. The media is not reporting any rumored settlements either, so it looks like we will have to wait a while longer. 

Fannie, Freddie say overhaul would boost mortgage rates.

WSJ reports that Fannie and Freddie have written a memo stating that an overhaul of the mortgage market that excludes them would (surprise) increase the cost of a mortgage. With the midterm elections this year and lack of consensus even among Republicans, the smart money would bet that no reform bill gets passed this year. The WSJ link contains links to download the memos. The Senate bill being considered by the Senate Banking Committee would replace Freddie and Fannie with a system whereby private companies can package mortgages into federally insured mortgaged backed bonds. I have not yet studied the bill so cannot comment in a substantive manner but conceptually I do not see how the proposal can be better than what we have today. I am not saying that Fannie and Freddie are faultless for their roles in the credit crisis but a solution of a distributed system but with the federal government still on the hook seems like it could create as many problems as it solves. 

Financial Times: DoJ raises stakes in forex probe

The Financial Times reports that US DOJ criminal prosecutors have traveled to London as part of its forex probe to interview people potentially involved in the alleged manipulation of the forex market. The article points out an interesting distinction between US and UK law, where the US has the right against self incrimination whereas the UK authorities can compel potential defendants to answer questions. While there has been a lot of smoke regarding the forex investigations, many of us are still waiting to see the fire. What exactly did the banks do and how did they do it and for how long?  Leaks to media sources are not the best way for the public at large to understand the scope of this thing. 

Banks moving swaps overseas

The WSJ reports today (disclosure: I'm quoted in the article) that banks are moving their swap businesses (in particular credit default swaps) overseas. According to the article, this move could be to avoid the stricter regulatory environment in the US. While some see this as potentially reducing risk here in the US, others worry that risk isn't being reduced but rather just shifted around. 

What do you think?

Barclays loses a LIBOR case at the 2nd Circuit

Reuters reports that the 2nd Circuit Court of Appeals reversed a SDNY court decision and allowed a shareholder suit against Barclays related to LIBOR manipulation to move forward. A copy of the decision can be seen here and the notice from plaintiff's counsel, Robbins Geller, can be accessed here. Will this case be appealed to SCOTUS? 

The Raters Are Fine

As this recent WSJ article points out, the rating agency business are performing phenomenally well, riding the wave of bond and debt issuance. Rating agency stocks are the essential beta stock, a good way for investors to express a view of the debt markets. Interesting to note that despite the wide spread criticism of their business model, it has not changed and seems less likely than ever to do so.

Are Asset Managers Still Using the WM Reuters Benchmark Fix? Here are 2 Alternatives.

For almost a year the FX benchmark allegations against the banks have been in the news, as well as regulator and internal bank investigations.  Many asset managers use the fix to execute their FX trades.  There have been stories that trading at the fix has seen somewhat smaller volumes (OTC markets do not have published volume figures).

What are some alternatives available to a manager that wants to avoid fix trading?

1) This article in FX Week (subscription) says that there is anecdotal evidence that some managers, but not many, have switched to using time slicing algorithms over the period around the fix.  This allows a manger to establish how they want to trade to minimize the risk (e.g., time intervals and size) , rather than giving the entire trade to a bank to manage.  This sounds like an attractive methodology for many managers, but for those not currently using algorithms, may take some time to implement.  It requires time to learn about them, choose algos with which to execute as well as prepare operations and systems.

2)  Execute trades with banks in the same fashion as non-fix trades currently, but at a time of day other than the fix.  This avoids any potential manipulation and volatility from the fix.  This would include such methods as phone and the online portals.  Simplicity is the benefit but tracking error to the fix can be substantial.

What are some reasons to continue trading the fix in the same manner as it has been?

1) Confidence that there has not been any manipulation or that if there has, it will have stopped now that everyone is watching.

2) Legal constraints on particular funds require fix trading.

3) Tracking error being a bigger concern than achieving potentially better execution.

Credit Suisse Concludes FX Benchmark Rate Investigation

At the end of March the Swiss Competition Commission named 8 banks including Credit Susisse to be investigated for collusion in manipulating FX rates.  Reuters reported Credit Suisse to be "astonished" to be included in the investigation after not being included in a preliminary investigation in 2013.

Last week during the Q1 earnings release conference call, Credit Suisse's CFO stated that the bank's internal FX benchmark investigation was completed and nothing "materially untoward" was found.

It is not clear why the regulators feel that there may be collusion involving Credit Suisse while the bank sends out the "all clear" message after an internal investigation.  Time will tell.

UK Authorities Continue to Make Progress in LIBOR Prosecution Effort

Dealbook reports that 3 Former ICAP Brokers Appear in British Court in Libor Manipulation Case.  Efforts in the UK seem to advance faster than those in the US.  Can't wait to see what evidence will be revealed once the cases proceed.

If FX Benchmarks were Manipulated, How Often did it Occur?

FX Week (subscription) reports that the counsel for one of the plaintiffs in the FX benchmark class action suit says that their analysis of London Close benchmark trades for the six most liquid pairs on the last day of the month for the past 10 years shows manipulation occurred between 26% and 34% of the time.  The headline of the article, however, is a bit misleading: FX benchmark manipulated more than 25% of the time, plaintiffs say.

Even if the interpretation of these results can be said to be true, this still would not mean that there was that much manipulation on all trading days.  The last day of the month was most likely reviewed because most asset managers that hedge the FX in their portfolios adjust the hedges on that day, leading to particularly high volumes.  These high volumes, and the tendency for these hedge adjustments to be in the same direction, would make those the days most likely for manipulation if there was any.

So even if you did accept the results, it does not answer the question of how extensive was any FX benchmark manipulation.

Who needs Flash Trading when we have the FX London Close?!

The hotly debated, headline story of the moment is whether some HFT (high-frequency trading) firms are front-running all other U.S. equity investors by paying fees to the exchanges.  Good question .... but let's look at another topic in the news:  allegations of front-running and collusion in the London Close for currency trading in the WM/Reuters index.

Quoting an earlier and detailed Financial Pests account:

"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."

Instead of several MILLISECONDS of potential front-running, the London Close provides ONE HOUR of potential front-running!

Focusing on the London Close, what strikes us is that there's an easy answer.  First and foremost, it's a risk management issue.  Banks and dealers should not "guarantee to trade for [clients] at the London Close rates."  It's simply not possible to achieve the last price whereas giving a "guarantee" of last price is a difficult-to-quantify risk exposure.  With both this quantification difficulty and the appearance of manipulating markets that arises from trading as much as possible in the final minute, prudent risk management dictates "don't offer the London Close guarantee trade to clients."

As an alternative to banning the London Close trade, permit the pairing of such trades for clients on opposite sides.  Prior to close, the client may commit itself to executing a stated maximum notional at the fix price subject only to the dealer finding a client for the other side.  If confirmed prior to the market close, this trade execution can be posted to the exchange for all participants to see.  If no client materializes for all or part of the stated notional, then the original client order is not completely filled.

Class Action FX Benchmark Lawsuit Filed

A dozen individual lawsuits alleging antitrust and anti-competitive behavior on the part of the 12 largest FX trading banks, based upon their behavior at the WM Reuters London Close FX fix, were consolidated and filed as a class action last week.  The plaintiffs and defendants are listed below.

The allegations are similar to those aired in the press over the last nine months or so.  This suit has updated some of the individual suits based upon recent information from the Bank of England and recently fired or suspended bank traders and include some examples of how FX rates were allegedly manipulated.  While for bank customers and those interested in the integrity of markets, the issue is simply whether or not the allegations are true, for the success of the suit, antitrust and anti-competitive behaviors must be shown.  Thus much of the suit contains the plaintiffs' building of such a case.  Similar issues drove the LIBOR case.

Much of the information for the case and press stories, relates to banks' internal investigations and their cooperation with regulators.  As highlighted in the suit, DOJ LIBOR non-prosecution and deferred prosecution agreements require many banks to provide information relating to benchmark manipulation, including manipulation of FX benchmark rates.

The class has been defined as those trading FX at or around the London Close since at least June 1, 2003. Included are those not trading the fix but trading at around that time of day and those trading forwards and swaps as well as spot.

No attempt is made to quantify damages or who are the members of the class.  Reference is made that records should exist, which we can only assume would be held by the banks.

Plaintiffs                                                                        Defendants
Aureus Currency Fund                                                     Bank of America
City of Philadelphia, Board of Pensions and Retirement     Barclays
Employees’ Retirement System of the Government of       BNP Paribas
       the Virgin Islands                                                     Citigroup
Employees’ Retirement System of Puerto Rico Electric      Credit Suisse
       Power Authority                                                       Deutsche Bank
Fresno County Employees’ Retirement Association           Goldman Sachs
Haverhill Retirement System                                           HSBC
Oklahoma Firefighters Pension and Retirement System     JP Morgan
State-Boston Retirement System                                      Morgan Stanley
Syena Global Emerging Markets Fund                               RBS
Tiberius OC Fund                                                            UBS
Value Recovery Fund
United Food and Commercial Workers Union and
       Participating Food Industry Employers Tri-State
       Pension Fund

Quick Test of your Fraud Detection Skills

Which one of these interest rate histories does NOT look real?!

HINT:  One of the curves represents secondary market trading of the 4-week Treasury bill.  The other curve is 1-month LIBOR set by a panel of banks now accused of providing false and managed "LIBOR settings."

New Consolidated Lawsuit Filed on Alleged FX Rate Manipulation

The WSJ reports that a new lawsuit was filed by 12 investors, all of whom had previously filed individual suits that have been consolidated by the courts into this one suit, amending and expanding upon a suit filed in November, 2013 by A Haverhill Retirement System (first mover advantage for the fund, as it was the first of these type suits filed). Most of the plaintiffs are public pension funds in the US and Virgin Islands, with 12 major banks charged with colluding to manipulate benchmark currency rates.  Collusion is charged, based upon a " small and close-knit group of traders" using chat rooms and instant messaging, often having worked in previous jobs together, living in the same neighborhoods and socializing together.

Interestingly, the complaint did not quantify losses, calling the impact of the alleged manipulation "presently undetermined".  We have looked at this issue as well, but on an industry-wide rather than an individual firm basis.  The work requires many assumptions, particularly when there is no available data as to what, if anything, actually occurred on particular days. Thus, we assume that the plaintiffs will be seeking data from the banks and looking to what regulators unearth to help their case.

Can you spot Satoshi Nakamoto?

Courtesy of Dealbook. http://nyti.ms/1pLezBz 

Are you a miner of Bitcoin without even knowing it?

Two apparently popular Android apps were reportedly using the phones of users who downloaded their apps to mine for Bitcoin without informing them.  ZDNet has more details about the alleged scheme. The two apps, called Prized and Songs, were removed from Google Play as reports circulated about the apps but they are reportedly still available on App Brain.  Something to be said for Apple's gatekeeping role for iOS apps. 

Reuters: 30-some currency traders globally placed on leave, suspended or fired

Reuters reports on the latest casualty from internal investigations at banks relating to the alleged FX manipulation scandal.  While Kai Lew, Deutsche Bank's FX sales director is the first known female to be put on leave, the more interesting number is the tally by Reuters that there are 30-some traders globally who have had administrative action taken against them.  By my count people have been laid off, suspended or terminated on at least 3 if not 4 continents across the major banks.  The reporters over at WSJ have compiled a list for those who want to track.