DOJ Charges HSBC Traders with FX Front Running

In the DOJ's first charges against individuals in the FX market investigations of the last three years, HSBC's head of FX trading and a former colleague were charged with using inside information from a large forthcoming client trade to make an $8 million profit for the bank (and we assume thereby increasing their bonuses).

While many charges have been made and settled with the banks, here individuals are being charged, perhaps in response to claims that just as in the financial crisis, fines are levied but no individuals are held responsible. Earlier this week the Fed barred a UBS trader from the currency markets for life, due to participation in the FX currency benchmark rigging scandal. There may be a few more charges to come both in the US and Europe, for regulators to show that more than financial penalties against the banks will be levied in this and any future financial scandals.

UK Fraud Agency Drops FX Rigging Investigation

The Serious Fraud Office, a British government fraud agency that investigates and prosecutes complex frauds, has announced that it is dropping the FX fix manipulation investigation. While several government agencies around the world investigated and settled with banks for over $10 billion in fines (with many banks pleading guilty to felony charges), the SFO announced that it is dropping its investigation (while continuing to liase with the US Justice dept in its investigation of FX fix manipulation). It said that there was insufficient evidence to realistically gain a conviction.

The lion share of FX trading occurs in the UK. We will have to wait and see the effect of this matter on the law suits that reportedly are being considered for filing in the UK, as well as on further regulatory investigations in the US and elsewhere.

Investigations of Electronic FX Trading Continue

Reuters reports that the New York Department of Financial Services (NYDFS) investigation of several money center banks for FX rate manipulation on electronic trading platforms is continuing. They report that NYDFS has interviewed dozens of traders and executives at Barclay's, Deutche Bank and Credit Suisse among other banks (NYDFS has its strongest remit with foreign banks) over the past several months. Subpoenas have also been sent to BNP, Goldman Sachs and Societe Generale according to Reuters sources.

NYDFS has already been known to be investigating FX algorithms on these platforms at the banks to determine if there is an attempt by the banks to advantage themselves at their clients' expense during the time between a rate being posted and then being accepted by a client. The concern is that this period may be used to front run client orders or otherwise manipulate FX rates. Earlier bank settlements with regulators covered spot market trading, but NYDFS agreements particularly, did not cover electronic trading. The Department of justice is also investigating FX electronic trading.

No information is available on how these investigations will play out against the various banks involved. The fact that they continue and appear to have widened from initial reports limited to Barclay's and Deutche, may indicate that regulators have found potential issues worthy of investigation, but do not provide clues as to the outcome.

FX Investigations Widen Beyond WM Fix

When Bloomberg's initial story hit the wires in June 2013, the allegations, later confirmed to be true, were primarily limited to banks manipulating the WM benchmark rates. Since then regulators in the US, UK and Switzerland have instituted over $10 billion in fines on major banks related to FX, and in many cases, banks have acknowledged criminal wrongdoing. These fines related primarily to collusion by the banks in attempting to manipulate the fix, on the back of transcripts of chat room conversations by bank FX traders that clearly showed their collusion and attempts to profit at the expense of market participants. (For other wrongdoings acknowledged in bank settlements earlier this year, please see our blog post from June 1, 2015, FX Bank Settlements — More Misconduct than the Fix)

These regulatory and criminal matters relating to the fix are at least partially behind us now (individual traders and local emerging market fixes remain under scrutiny), although a class action civil lawsuit in the US related to these same matters is ongoing, with 9 banks having settled so far. In addition, law firms around the world are reported to be attempting to institute civil lawsuits in other jurisdictions as well, particularly in the UK. There, in the largest FX market in the world, new laws as of October 1 will allow suits similar to class action suits in the US (and will allow non-UK residents to participate). With over $2 billion in settlements to date in the US (with 7 banks remaining in the suit), there may be several billion pounds of additional settlements in the UK. Regulators in Australia, South Africa, Brazil and South Korea (and possibly others) are investigating benchmark rate rigging as well.

Banks fined by regulators and those settling the US class action have agreed to cooperate with regulators and the parties bringing the suit. Lawyers from the suit are reported to have said that evidence from the cooperation in the US points to bank manipulation of the bid-offer spread on currency trades through the rest of the day, not having to do with the fix. How this may have been done is not clear, but if true would dramatically increase the scope of bank wrongdoing. It would mean that the rates on many more trades are not entirely market driven and all such trades would have the bank gaining at client expense, while the benchmark manipulation had some clients gaining and some losing from each manipulated rate.

Until more information is released it is hard to know if there was additional rate-rigging in FX markets. Should it be shown to have occurred, a further move toward exchange-type trading should be expected, as well as further criminal prosecutions and civil suits. Bank traders and investors beware.

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.

All Announced on One Day: Five Banks Fined for FX, One for Precious Metals and BOE Chief FX Dealer Fired

As had been rumored for a few weeks, FX settlements between multiple regulators and several FX banks were announced on the same day, today. The banks prefer not to be singled out for misconduct but just to be one of many, so that this is viewed as more of a market problem. The banks were not found to have attempted to manipulate FX rates but instead found to have had ineffective controls allowing traders to engage in manipulative behavior. However, the DOJ is still looking into criminal charges, the New York regulator would not sign on to this agreement as it was felt to be too weak and penalties against many other banks by these same and other regulators will be forthcoming.

The Swiss regulator FINMA also fined UBS for precious metals misconduct, finding "clear attempt to manipulate precious metals benchmarks", particularly in the silver market. As FINMA also fined UBS for FX market violations, UBS would certainly have wanted both announcements at once.

Then the Bank of England hopped onto the bad news train today as well. They have been quiet for several months after announcing that an unnamed employee had been suspended for misconduct regarding FX. Today they announced that the chief FX dealer had been fired yesterday, but still provided little information, other than misconduct was discovered as part of the FX manipulation probe but the behavior itself was not related to the probe.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)