FSB Updates FX Benchmark Progress

The Financial Stability Board (FSB), created in 2009 by the G20 to reform international financial regulation, includes as part of its mandate a role in standard setting and in promoting members’ implementation of international standards. In September 2014 it issued a report highlighting recommended solutions to prevent a repeat of the FX benchmark scandal. Today it released an update to look at progress made since that report.

The update is fairly positive ("having moved the market in a favourable direction"), highlighting improvements, but also mentioning areas where it believes that more work needs to be done.

The points made include:
1) There have been useful reforms in the methodology used in the WM Reuters (WMR) fix but that more can do done, and mentions certain central banks adjusting their fix methodologies as well. The FSB reiterates that all fixes need to be reviewed, not just the WMR fix.

2) "Recommendations suggested to increase transparency in pricing for fix transactions have seen good implementation among the largest market participants and for the most used benchmarks, but that elsewhere there is scope for further improvement".

3) "Steps to separate dealers’ fixings business from other activities are being taken by the larger participants and in the most active markets, but again there is room for further implementation in other areas of the FX market. For the execution of benchmark transactions, industry-led initiatives to promote greater use of independent netting and execution facilities are seeing welcome progress".

4) "Work is underway to improve market conduct practices, both within individual firms and through market-wide initiatives, including the global effort underway to develop a single code of conduct for the foreign exchange market through the Bank for International Settlements (BIS) Markets Committee working group on FX markets".

5) "While many index providers and end-users have increased their focus on the due diligence around FX benchmark use, there is scope for greater follow-through on this on the part of some market participants".

All in all, it appears that while some additional fix changes may be seen, for the most part fix reform will primarily involve broadening the changes already made to cover additional fixes and additional market participants. The probable exception will be the new international code of conduct being created by the BIS. This will replace the many different codes currently in force in markets around the world and will impact bank behavior.

FX Scandal Not Blowing Away

First of all, the rest of the world is looking at the US class action suit in which over $2 billion in settlements have already been made by 9 large banks, and lawyers and investors are planning additional suits in several countries. A $1 billion suit has just been filed in Canada relating to benchmark currency fixes.

Secondly, a Citi FX trader who had been dismissed in the UK relating to his sharing of client information with FX traders from other banks on chat rooms, is fighting his dismissal. He is claiming that it was a market practice at the time to share such information, especially regarding the trading of central banks. He mentions one M&A deal in which Citi front run the client's trade and made a profit of $35 million. He states that the very top Citi FX management actually had a hand in this deal.

There are other FX traders who were dismissed relating to similar charges who are also planning on disputing their firings.

Citi says FX Fines 2,500 Times the Illicit Profits

Bloomberg reports that "Jamie Forese, head of the Citigroup Inc. unit that houses trading and investment banking, said fines the firm paid for rigging foreign-exchange markets dwarfed the amount generated by the illegal conduct. Revenue from the trades amounted to about $1 million, while Citigroup paid out $2.5 billion in fines and penalties, Forese estimated Wednesday at an investor conference in New York."

Among commentators, and regulators as well, there has been a question regarding whether the size of fines in recent settlements have been painful enough to cause banks to prevent further occurrences of misconduct. Some suggest yes, many no, but without knowing the profits generated by misconduct, it is a difficult question to answer.

If this represents Citi's answer to the discussion, we suggest that it is incomplete. While the article does not mention how the 1 million dollar gain was calculated, perhaps it was strictly based upon the specific trades uncovered in the investigations, such as the trades highlighted in the CFTC - Citi settlement. However, the settlement states that "From 2009 through 2012 (“Relevant Period”), Citibank, by and through certain of its
foreign exchange (“FX”) traders, at times sought to benefit its own trading positions or those of certain FX traders at other banks by attempting to manipulate and aiding and abetting certain traders at other banks in their attempts to manipulate certain FX benchmark rates." So the plea is to misconduct at the fixes for 4 years.

In the DOJ settlement Citi pleads to having "entered into and engaged in a conspiracy to fix, stabilize, maintain, increase or decrease the price of, and rig bids and offers for, the EUR/USD currency pair exchanged in the FX Spot Market by agreeing to eliminate competition in the purchase and sale of the EUR/USD currency pair in the United States and elsewhere. The defendant, through one of its EUR/USD traders, participated in the conspiracy from at least as early as December 2007 and continuing until at least January 2013." Here the plea is to manipulating the EUR/USD pair for a period of 5 years, but not limited to only the fixing of benchmark rates.

If 5 years of misconduct in EUR/USD (DOJ) or 4 years in various currencies at benchmark fixes (CFTC) only lead to a 1 million dollar gain, it would lead one to question how Citi made about $2 billion in revenue per year in FX during this period. Thus we question not only if the fine was truly 2,500 times the size of the misbehavior, but whether such misbehavior was limited to about one-hundredth of one percent of FX revenues ($1 million / $10 billion).

Fine for the FX Banks (Pun Intended)

The 5 banks (RBS, Barclays, JPMorgan, Citi and UBS) were fined about $5.7 billion and all but UBS plead guilty to criminal charges (UBS gets off because they were the first to provide information on the scandal to regulators). Although having the banks plead guilty to criminal charges makes the regulators appear to be tough (more than just fines), the truth is that much of that is just appearances, as the SEC has already provided the banks with waivers. These waivers will allow the banks to continue in lines of business for which a felony conviction would typically bar them, such as operating as a fiduciary, including managing client assets. With so many banks pleading guilty simultaneously, the sting to any individual bank is lessened. And as the negotiations continued, the banks added to their reserves for these fines so that there will not be large one-time hits to earnings.

Of course the fines are a lot of money, but overall we have little reason to expect much negative impact to these banks from either the fines or the criminal charges. Our hope is that after these many scandals the banks, saddled with additional regulations and compliance costs, and hopefully having learned a lesson, will concentrate on their ethics. As it relates to the London Fix which was the start of all this, most banks are now earning their profits by charging customers either a fee or a bid offer spread, a much more transparent and ethical model than collusion, and hopefully a hint of a new direction.

6 Month Delay for FX Benchmark Fix Lawsuit

Reuters reported the stay in the case involving the antitrust class action against a dozen FX banks. As we reported in February, the DOJ requested a stay due to grand jury investigations ongoing in criminal cases being brought by the DOJ. The plaintiffs have gone along with the stay, however they have been granted exceptions that should allow them to continue to make their case during this period. These exceptions allow them to use discovery to access trade data (perhaps the most important item in order to estimate damages) and some ability to depose witnesses (although the limitations are unknown).

A hearing is scheduled in the case for March 26.

FX Manipulation Lawsuit Tsunami at Banks' Doorstep

First, about three weeks ago, JPMorgan settled an FX manipulation lawsuit for a reported $100 million. Now, Reuters reports that a judge allowed the investor plaintiffs' case to go forward to trial over the banks' objections. These included that there was a lack of evidence and that a prior LIBOR case alleging antitrust abuses was thrown out of court.

These two events alone should bring forth a barrage of suits as success seems more probable. In addition, now that this trial can go forward, the banks' position looks to be hurt by two factors.

First, depositions can now be taken, which may provide additional evidence of wrongdoing (several of the banks have already been fined by regulators following employee interviews). Second, a problem in suing to date has been attempting to prove wrongdoing and antitrust behavior. There is a lack of data on trades executed by banks on specific dates in specific currencies. Trade data released by banks during the discovery process may make the plaintiffs' calculation of any damages much easier, rather than relying upon models of what may have been manipulation based solely upon price movements.

While lawsuits from investors (money managers, pensions funds, etc.)and corporations are to be expected, many other groups impacted by currency rates can be expected as well. As an example,a few weeks ago we reported on British farmers that may have been affected by the conversion of subsidies from euro to British pounds.

Will the Banks be Hit by a Wave of FX Manipulation Lawsuits?

An article in yesterday's Telegraph reports that UK farmers were hurt by the FX benchmark rigging scandal, as there is a 2.6 billion pound EU subsidy that first has to be converted from euros before paid to British farmers. An unclear reference in the article cites one day's manipulation that cost the farmers 16 million pounds in one year.

Regardless of the details here, what struck us at FinancialPests, was the wide range of potential suits with which the banks could be hit. Beyond all of the financial players, who we would expect to be more likely to file suits now that JPMorgan has settled one US suit, there may be many others as well. UK farmers would not have been on our radar screen as potential litigants(although no suit was mentioned in the article). Europe is, of course, less litigious than the US, and slower to file suits, but this reinforced to us that potentially, there may be a landslide of suits filed around the world during 2015.

JPMorgan Settles FX Benchmark Manipulation Lawsuit

Reuters reports that JPMorgan settled an antitrust lawsuit which accused 12 banks of rigging the FX markets' benchmark rates. No other bank has commented or settled as of yet, and the terms of the settlement were not disclosed. Two other lawsuits remain.

This follows the fines imposed by certain regulators on several banks late last year on the same matter. Once regulators found wrongdoing, even if only poor oversight of traders, it becomes more difficult for the banks to defend themselves. The lawsuit depended on whether the banks' behavior was uncompetitive in nature. Regulator findings regarding collusive behavior among bank traders on chat room and other electronic media may have increased the pressure on banks for settlements.

It appears reasonable to expect some of the other banks to settle in the near future. Additionally, all of the US and international regulators have not yet weighed in, and criminal charges may be coming as well, although any such charges may be limited to individual bank traders rather than the banks themselves.

Estimate of Regulator Fines on Banks for FX Fix Misconduct - $41 Billion

Bloomberg reported that Citibank analysts' estimate of fines relating to the FX fix could total over $40 billion between US, UK and European regulators, spread among money center banks.  The analysis excludes fine reductions or waivers for those banks cooperating with investigations.  As many banks are cooperating (some required to do so by their agreements with regulators in the LIBOR scandal) this might substantially reduce the actual fines.

As most banks have been reserving for these investigations, which started in the middle of last year, there may not be a big hit to the earnings of the banks as a whole from the eventual fines.  As to reputational hits, the fact that so many banks will be included may, in effect,  protect all of them.

Outline of FX Fix Reforms is Clearer

The recommendations of the Financial Stability Board last week regarding changes to the WM Reuters fix will be presented at the G20 meeting in November.  These include extending the fix window (they support a move from from 1 minute to 5, but want the WM Reuters company to set the period), making prices transparent and appropriate for the risk borne (meaning that banks should be paid for fix trades, unlike past practice) and codes of conduct and internal guidelines should be more explicit.

While fully agreeing with all of the above, we see the two remaining major recommendation as problematic.  First is the recommendation that "banks establish ... separate processes for handling such orders".  Handling fix trades separately from other fx trades will be costly, probably causing some smaller players to eliminate their participation in the fix.  An article from FX Week (subscription or free trial) refers to banks considering the possibility of creating sealed trading rooms, away from other fx traders and order flow.   While it is unclear how seriously this is being looked at, such a possibility appears a bit absurd to us, as enforcing more explicit codes of conduct and internal guidelines as already suggested, should improve the outcome without the costs or need for quarantined traders.

The other problematic recommendation of the FSB is "the development of industry-led initiatives to create independent netting and execution facilities for transacting fix orders". While a longer term recommendation, this continues on the path of much higher cost and uncertain outcome.  Just to mention one issue, commonsense dictates that the largest incentive for manipulating rates is when there is a large discrepancy between buy and sell orders for a currency pair.  At such times, the only way to clear these separate trades is to trade with the rest of the market, the same traders that this recommendation is trying to avoid.

All in all, we approve of the recommendations as promoting that which Financial PESTs stands for - ethics, simplicity and transparency, albeit with the two exceptions discussed which require additional scrutiny before any implementation.

Settlements Approaching on FX Benchmark Rate Investigations

Reports are becoming more frequent that a settlement is in the works between the UK Financial Conduct Authority and money center banks regarding the FX benchmark pricing scandal.  These discussions are supposed to involve a total fine of about $3 billion (at the low end of expectations) and importantly, only charge the banks with maintaining insufficient compliance procedures to catch individual traders.  It is the traders who would be seen as the true purveyors of misconduct.

UBS today reported that it is in talks with an unnamed regulator that could result in material fines for not having sufficient controls to prevent misconduct of their employees.

There is a belief that the regulators of many countries are working multilaterly, even if not exactly together.  If they all pursue a line of reasoning as discussed above, this would indicate a much lighter hit for the banks.  The fines may be less than assumed, and importantly, the banks may not have to plead guilty to criminal behavior.  With settlement talks ongoing, some are now expecting settlements before year end.

Regulators/Prosecutors Moving Forward in UK and US FX Benchmark Investigations

Reuters sources  indicate that in the UK there is a push being made by the banks to come to a joint settlement with the FCA regarding the benchmark FX investigation.  A joint settlement reduces the reputational risk for each bank and would allow for the FCA to wrap up the investigation more quickly than pursuing each bank individually.  Indications are that such a settlement, if it occurs, could come as early as year end.

In the US there is a report that the DOJ has informants still working on the fx desks at several US banks. The DOJ is looking to charge individuals with crimes as an additional deterrent to the fines on the banks.  Perhaps it may also avoid a repeat of the criticism of the regulators following the LIBOR investigation that fines alone are merely a cost of doing business for the banks.

Report CFTC Finds Criminal Behavior in ISDAFIX Investigation

As we reported last week, the first lawsuit was filed in the ISDAFIX controversy.  This week Bloomberg states that the CFTC, which is limited to bringing civil cases, reported evidence of criminal behavior to the DOJ. The DOJ can then determine whether to pursue a criminal investigation.  Bloomberg bases the article on a person familiar with this matter.

The report alleges that ICAP, a broker with a central role in setting ISDAFIX through January 2014, accepted large numbers of trades from banks at the close, attempting to influence the fix.  This "banging the close" is similarly charged in FX benchmark cases.  In addition to these actual trades, banks also submitted rate quotes as part of the process of setting ISDAFIX.  The lawsuit last week alleged that identical quotes were submitted by multiple banks on most days, down to the thousandth of a basis point.

The ISDAFIX cases may have a better chance of reaching antitrust status, unlike the LIBOR case, due to the actual trades involved and the lack of reasons other than profit for banks entering into these ISDAFIX trades.

Comments Published Regarding FSB's FX Benchmark Recommendations

The Financial Stability Board had issued general recommendations for changing foreign currency benchmark fixes, open to comments through August 12.  This week the FSB released the comments from 36 interested players, including asset managers, banks and others.  A page with the links to these comments is included here.

Two areas that may be considered controversial seemed to have a lot of support.  The first concerns paying the banks for taking fix orders and charging a bid/offer spread or specified fee (discussed in a prior post here).  Comments included the logic of paying for this service to reduce the incentive for banks to look for ways to make profits in ways that hurt their customers.  Comments acknowledged that any such charge will not eliminate this possibility, and thus the need for a better process / monitoring the market makers will remain.

The second involves widening the period of the fix.  The current WM Reuters fix window is one minute for major currencies.  While there was much support for this, there seemed to be concern that the period not be widened to much, perhaps beyond a half hour, as this could add difficulty to managing trading risk and could add volatility from exogenous factors such as market news impacting the fix rates.

The FSB is scheduled to issue final recommendations in early November.

Who Likes the Financial Stability Board's Recommendation of a Fee for FX Benchmark Trades?

The Financial Stability Board released a consultative study on FX benchmark rates that includes several items for the industry to consider as well as a couple of recommendations.  One recommendation was to widen the period of the window for calculating rates.  Another was that the banks should charge for the service of filling fix orders.

As it currently stands, the WM Reuters rate, the London Close benchmark which is the fix with by far the largest daily volume, includes a bid, mid-rate and offer rate for each currency pair.  Most large and many small users of the fix are filled at the mid-rate, and thus do not pay any fee or bid offer spread to their bank for filling their order.

Why does this occur?  Banks allow it as the cost of doing business with large customers.  If others are doing it, you need to do it as well - it became a market practice in effect.

Bank customers, of course, would like all trades executed for free, so how did fix trades become the only trade type executed routinely without spread or fee? This occurred as many funds use the WM Reuters FX rates to translate their local currency asset values into base currency values each day.  The investment managers then wanted to execute any trades for that day at the same rate to avoid FX tracking error for their funds.  Many managers also saw these rates as a means to achieve market rates without going through the work of negotiating rates with their banks. Others such as corporates began using the mid rate for execution purposes while hedge funds and others did so for speculative purposes.

While this seemed to be a win for the customers, it was not for the banks.  When the fix began in the early 1990s FX spreads were quite wide compared to today and perhaps the banks could more easily tolerate these "free trades".  Apparently as pressure increased on traders to perform in an environment of reducing spreads, some misconduct occurred, including collusion, as a means to generate profits on these trades.

The FSB's suggestion seems quite sensible to us.  Expecting free services does not. In effect, the actions that traders took in recent years reinforces the adage regarding no free lunches.  Using bid offer spreads or a small commission should reduce this tension between bank and customer.

While not the only change required to benchmark trading, this change is reasonable and should go along way in making this a more rational part of the FX business.

Asset managers and other fix users may not like the concept initially, but its inherent reasonableness and the need to increase market participants' faith in benchmark rates should see customers agreeing.  The devil being in the details, however, the size of any commission or spread (tracking error to many) may be much more controversial.

FSB Proposes FX Benchmark Changes; UK Opens Criminal FX Benchmark Investigation

The Financial Stability Board (coordinates national regulators and international standard setting bodies)  published suggested changes to FX benchmark calculations in the following areas:

• The calculation methodology of the WM/Reuters (WMR) benchmark rates;
• The publication of reference rates by central banks;
• Market infrastructure in relation to the execution of fix trades;
• The behaviour of market participants around the time of the major FX benchmarks (primarily the WMR 4pm London fix);
• Recommendations from a forthcoming IOSCO review of the WMR fixes.

These are open to comments and should entail great diversity as there is much disagreement on how to reduce the possibility of rate rigging in FX markets.

In the UK, the Serious Fraud Office (SFO) has opened a criminal investigation into possible fraud occurring in benchmark rate setting.  The US DOJ has been looking into criminal angles for quite some time,and last week we reported their offer of immunity to junior FX traders in exchange for information. The SFO has an ongoing investigation into LIBOR rigging as well.

US DOJ Offers Immunity to Junior FX Traders in London

Reuters reports this interesting tactic which is not available to prosecutors in civil cases.  One can infer from this that the investigation into FX benchmark rigging has not made enough progress to bring any suits, but that the prosecutors believe that misconduct has occurred.  Will these offers of immunity bring in the information on senior traders and bank practices that the DOJ is looking for? Although that is uncertain, it will certainly make for some uneasy relationships within the FX trading community.

Reports of FX Traders Colluding on NonBenchmark Trades

Many of the charges in the FX manipulation  media reports are possibly explicable as banks carrying on risk management before and during benchmark fixings.  Without further details we do not know if there has been misconduct.  However, the reports of collusion between major banks in the time period when London Close FX rates are established certainly means that, if true, the banks were involved in misconduct.

Now Reuters reports that the British regulator, the Financial Conduct Authority, has chat room transcripts of top traders from three large banks in London discussing the spreads to be put on specific, apparently large non-benchmark trades.   If true, then collusion extended beyond benchmark trades to the general FX market as well.  As allegations continue to come out from the FX and other markets, conspirators who have long alleged that banks controlled "the markets" are looking less and less crazy and leading some to wonder just how pervasive was misconduct.  As reported here last week, estimates of regulator FX fines to come for banks are as high as $35 billion.  Such magnitude is apparently effecting banks and recent reports have mentioned that banks are moving to further increase their proportion of electronic trading as there is less regulatory risk and less chance of misconduct on the part of traders.

One Estimate of FX Benchmark Fines for Banks - $35 Billion

Reuters discusses the research report issued this week by an independent research firm, Autonomous Research.  Led by a former minister in a Labor government and a former head of equity research at Merrill Lynch, the report attempts to determine the size of government fines around the world to be assessed upon money center banks for the FX benchmark rate manipulation scandal.

While they admit that they are speculating, they use the theory that repeated wrong-doing will attract much larger fines and thus use the total $6 billion in fines from LIBOR as a base.  Their assumption is that total fines among banks will be a minimum of $12B (but capped for individual banks at a level equal to annual profits) but could rise as high as $35B in total.  Individual bank fine estimates in the report are $8B for UBS, $4.4B for Deutsche and $4.3B for Citi.

While we find it difficult to comment on what the fines may ultimately total between all of the regulators involved, a number somewhat higher than twice LIBOR  may be more reasonable.  In addition, banks will most likely need to acknowledge wrongdoing, rather than being able to deny such as in the past.  Some of the reasons we tend toward lower estimates is that regulators will still be able to herald record fines and that the additional sources of fines and litigation costs screaming toward banks' balance sheets and earnings from other scandals (including mortgages, other market manipulations, US sanction/embargo evasion and numerous others) are already going to strain the ability of many banks to meet more stringent capital requirements going forward.  The answer will not be known most likely until sometime next year.

UK to Increase FX Oversight

Bloomberg reports that the UK will announce new regulations for the FX market as a response to the stories of WM Reuters benchmark rate manipulation at the London close.  Chancellor of the Exchequer Osborne may announce these rules at his annual address to be held next week.  While details are slim at this point, it is expected that they may include making the manipulation of benchmarks a crime, as well as mandating additional oversight of bank employees involved in benchmark rate setting, by their employers.

Clearly some change is required following the news reports, suspension of traders by banks and the first hints by some regulators that misconduct has been found in FX.  However, maintaining the liquidity of the FX markets should be paramount.  The information regarding potential manipulation has already started many market participants to review how they can improve their use of, or whether they should use, FX benchmarks.