No, you can't keep making the same mistakes. There's no one at the wheel. Someone has to steer.
- The Cooper Temple Clause
This is the third in a series discussing the London fixings of OTC financial market prices. The market in question here is the foreign exchange market. For several reasons, foreign exchange is a different animal from other OTC markets:
- The spot foreign exchange market is completely unregulated.
- This market, alone among the OTC markets, may have no alternative to London location. If so, unless the governance of London finance changes its permissive ways, this market will remain a serial abuser of customers.
- The problems of currency market manipulation are only incidentally fixing-related. The currency fixing isn't dirty like the others. So, it neither seeks nor needs the approval of the Bank of England. Unlike the other fixings, it is not a dealer power-grab. Thus, there is no ICE Benchmark Administration (IBA), a division of Intercontinental Exchange (NYSE:ICE) stage makeup.
- Unlike the other OTC markets, the fixing is not the problem. The problem is plain vanilla trader collusion. But send them to jail. Fine the heck out of the foreign exchange dealers. It's a beginning.
What is exactly like every other OTC market, unfortunately, is the cupidity and foolishness of some of the traders of foreign exchange, and their dealer firms' limpid attempt to control them. The result was another corrupt OTC market that has generated settlements of legal suits alleging manipulation close to $10 billion to date, paid by the dealers. In this case, Barclays (NYSE:BCS), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), Royal Bank of Scotland (NYSE:RBS), UBS (NYSE:UBS), and Bank of America (NYSE:BAC), although litigants indicate other dealers may be named later.
The foreign exchange fixings scandal settlement amounts are enormous, even slightly ahead of the LIBOR fixings settlement amounts, at this writing. However, the race to the top of the OTC market legal settlement sweepstakes continues. There are multiple remaining active lawsuits.
This article will first explain the difference in purpose and the resulting higher quality of the WM/Reuters foreign exchange fixing methodology, compared to the more rankly cosmetic, dealer-friendly, IBA fixings. The article then characterizes the dealer collusion in foreign exchange markets. The article concludes with current developments in foreign exchange trading and the likelihood of future problems.
What is different about the currency manipulation scandal is that there is no guile within the currency fixing itself - in direct contrast to the IBA fixings. The currency scandals might have happened in any market. A group of rogue dealers was caught in the act, generating billions in legal settlements for price manipulation they pursued for nearly a decade.
This form of manipulation could, and does, happen in exchange-traded markets as well, although the single central location of exchange-trading, and a dedicated clearing house that is not itself a dealer, makes this collusion both more difficult and less lucrative when an exchange provides a single public market.
Why is the foreign exchange spot market the only unregulated financial market?
Good question. I'm not certain. US government explanations are lame in the light of the scandal, claiming to do with the "greater market soundness" of foreign currency markets. What??
Certainly, if the foreign exchange market were centered in any location other than London, it would be regulated by now. My only weak explanation is that forex's regulation-free status is related to being out of the US orbit. Foreign exchange is the only major financial market that could still thrive if the wholesale business were only in London.
Thus, non-UK governmental threats to regulate may produce a foreign exchange dealer counter-threat to migrate completely, on the low-down. There must be some better explanation, but that's all I have.
But a $5 trillion+ per day market that is unregulated is more trader malfeasance waiting to happen.
Why is London the inevitable center of foreign exchange trading?
Foreign exchange trading will not be centered in the US since the dollar is the numeraire. And foreign exchange can't be centered on the Continent, with its poorly performing banks and dubious bank regulators.
The decision the government of Great Britain made to regulate its own banks and currency separately from the Continent's was wise. As poor as the performance of the British banking system has been over the last decade, there is a light at the end of the tunnel.
Significantly, British regulators have "ring-fenced" the British banks' domestic operations. That is, having written off safety and soundness of wholesale banks' operations in London, the British have placed a kind of Glass-Steagall-like wall around their retail banking operations.
That's a good thing, because in regulation-lite London, where a $5 trillion-per-day currency market completely escapes regulation, wholesale dealing banks are neither safe nor sound, and never will be safe or sound. Ring-fencing acknowledges that fact; a common-sense approach to protecting the retail British public from losing their deposits and pensions, at a reasonable cost to taxpayers. Yet it leaves a separate regulatory path for aggressively seeking the income and tax revenues brought in by the global dealers.
Why is WM/Reuters' currency fixing an improvement over the IBA fixings?
WM/Reuters' currency fixing methodology is far more professional, less self-righteous, and more believably not-in-bed with the dealers than are the fixings of the IBA for other OTC markets. The essential difference between WM/Reuters and IBA is that the IBA uses opinion, not prices, because IBA fixes are designed to manipulate. This is explained in WM/Reuters methodology.
"There is no solicitation process to obtain underlying data, either by panel or by polling in the benchmark calculation process. Thomson Reuters uses transactional data entered into on an at arm's length basis between buyers and sellers in that market, where that data is available and reflects sufficient liquidity." (my emphasis.)
The critical reason for the difference between the kinds of fixings is the different purpose of the currency fixes. The IBA fixings are designed to set a non-market price; WM/Reuters, to measure an asset value for portfolio valuation purposes.
But customers of WM/Reuters then made a predictable decision: "If my portfolio is going to be valued using the 4:00 London fix, I would like a guarantee from my dealer that I get execution at the 4:00 price." And this guarantee became industry practice. With the unfortunate tag, "fixing." But using a price at a fixed time for portfolio valuation is not unique to currency valuation, or even unusual. Portfolios of common stocks, for example, are priced at the market close.
The guarantee attracts attention for two reasons.
- From the dealer's point of view, these pre-fixing dealer-guaranteed price orders are a net benefit, not a burden. If a dealer accumulates 100 billion in orders to buy sterling at the fixing, for example, well before 4:00 London time, it is reasonable for that dealer to suppose that the fixing price will be higher than the current market price. Absent representations to the contrary, there is no reason the dealer could not place an order to buy for her own account in advance of the customer order that must wait for the fixing.
- Over time, this strategy is very likely to profit the dealer. However, the strategy does not come with guarantees. This dealer's front-running is not without risk. Dealers make a profit this way in every liquid market.
The difference between the currency fixings and the other IBA-blessed fixings is night and day. The WM/Reuters fixing itself made the currency markets more efficient, and more useful to customers. Thus, the foreign exchange manipulation not built into the fixing process. The manipulated price is driven by demand and supply. All markets are. No market fixing can either create this behavior nor prevent it.
But the IBA fixings of the other OTC markets are different. The IBA fixings are themselves a market manipulation. They are not there to make the market more efficient or useful to customers.
Following the settlement
The proposed solution to the misbehavior of people trading in the foreign exchange markets seems to be electronic trading. But the collection of what are essentially electronic dark pools, managed by individual banks, that is developing post-scandal in foreign exchange trading leaves open the temptation of future foreign exchange market manipulation by computer.
This disease already infects the stock markets. By making exchanges the property of dealers, the forces of competition will be blunted, preventing volume from its natural migration to a single market. The existence of multiple dark pools is a prescription for the creation of the high frequency trading-related abuses that now characterize the US stock exchanges.
As with the other OTC markets, foreign exchange would function more effectively with a single organized exchange outside dealer control. But market manipulation can only be made more difficult and less profitable by such improvements in market efficiency. It will never be eliminated.
And so long as the dealers are unregulated, control of pricing in foreign exchange will remain tightly in the dealer's grasp.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.