It’s of grave concern to some that the world’s largest trading market is for the most part unregulated. Boasting a turnover of $5.35trn a day at last count, the forex market has been allowed to charge on largely unchecked since its ancient beginnings. However, the extent of fraud uncovered in these past few years has called into question the system’s long-supposed integrity.
The sheer size of the market has led many to believe that the prospect of rate fixing is entirely out of the question, though recent forex probes have served to illustrate quite the opposite. The on-going investigations into the Libor scandal, for one, have pushed the prospect of benchmark rigging to the fore, and brought to light the extent by which traders have been allowed to manipulate the system without consequence.
The realisation has jolted regulatory authorities into action, and prompted many to work towards ridding the system of its shortcomings, whether they are a lack of transparency, oversight or clarity. Nonetheless, the fact remains that the forex market is an incredibly difficult market to regulate, owing to its size and complexity, and instead targeted reforms appear to be the best course of action for the time being.
“I think just regulating the market and saying ‘you shouldn’t do this’ is very difficult, because financial markets are by their very nature large and opaque. The foreign exchange market is by definition an international global market,” says Mark Taylor, Dean of Warwick Business School and former foreign exchange trader. “So, very very hard to regulate, because the markets will tend to find ways of circumventing that regulation.”
“[F]inancial markets are by their very nature large
and opaque”
That being said, investigations are growing in size and stature, with more than a dozen regulators across four continents currently looking into suspect trader activities at some 15 or so banks. As a result, 11 firms have been made to dismiss, or at the very least place on leave, over 30 employees, and no doubt these numbers will continue to climb for as long as investigations carry on with quite the same level of enthusiasm.
By far the most prominent form of misconduct is that with regards to benchmark fixing, which was made famous most notably in the wake of the Libor scandal. Since then, regulatory authorities have made it their utmost priority to set about reforming the benchmark-setting process, for fear of investors growing increasingly averse to benchmark rates the more they are subjected to manipulation.
Benchmark principles
In an effort to restore waning confidence in financial benchmarks, The European Securities and Market Authority (ESMA) along with the European Banking Authority (EBA) have together penned a report entitled Principles for Benchmark-Setting Processes in the EU. “The final principles now give clarity to benchmark providers and users in the EU about what is expected of them when engaged in this critical market activity,” said ESMA Chair Steven Maijoor of the work. “These Principles reflect the wider work being carried out on benchmarks and their immediate adoption will help restore confidence in financial benchmarks and prepare the way for future legislative change.”
The document quite simply sets out a framework by which data submission, administration, calculation, publication, and continuity can all be decided upon, with the end goal being to instil greater confidence in financial markets and restore integrity to financial benchmarks. While the proposals amount to relatively simple governance, supervisory and transparency-related provisions, the recommendations represent a significant leap forward for the largely unregulated market.
The ESMA and EBA, however, are far from the only regulators to have taken note of benchmark fixes, with the Financial Stability Board (FSB) having also put forward reforms for consideration. “The cases of attempted market manipulation and false reporting of global reference rates, together with the post-crisis decline in liquidity in interbank unsecured deposit markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates,” wrote the FSB in its report to G20 finance ministers and central bank governors late last year.
The FSB, which brings together leading financial authorities, institutions, regulators, supervisors and committees of central bank experts, was tasked by the G20 to ensure national and regional authorities take a coordinated approach when arriving at financial benchmarks. In response, the group has established an Official Steering Group (OSSG) of regulators and central banks whose role it is to guide the process of deciding a reference rate.
“The official sector has an essential role to play in ensuring that widely used benchmarks are held to appropriate standards of governance, transparency and reliability,” says the FSB. “As part of its wider role, the FSB will promote adoption and good practices in relation to benchmark setting and the use of benchmarks.”
Front running the 4pm fix
Ambitious efforts to reform the benchmark setting process, however formidable, so far appear to have failed in bringing the process of rate rigging to a complete standstill, and instances of exploitation seem only to be growing. The latest rate to be proposed by regulators as a likely problem case is the WM/Reuters “fix”, otherwise known as the London fix. The benchmark rate, put simply, is ascertained from a snapshot taken of forex market movements 30 seconds prior to and 30 seconds after 4pm, and is so often used as the go-to rate for institutional clients conducting trades.
Many have speculated, as they have been doing for well over a year now, that bank traders are colluding to artificially affect the London fix and turn a healthy profit for themselves. “You can put through, you know a big trade, a couple of billion dollars, 20 seconds before 4pm. That in itself is not illegal. If somebody said, why did you put through that big trade, they could say, well it’s not illegal to trade, obviously! But what is illegal is colluding,” says Taylor. “If there is evidence that banks got together, senior traders from some of the big banks got together and said you know, I’m going to put through this billion dollar trade, dollar-sterling, I’m going to buy dollars against sterling 10 seconds before 4pm. Why don’t you do the same thing, and we can both together affect the market rate?”
“[I]t’s not really so much regulating the market that’s important. It’s actually taking away the incentives for people to cheat in that market”
Bumping the rate up by as little as a fraction can have huge ramifications for those involved, especially when the trades can so often amount to billions of dollars. What’s more, the underlying reasons for the scandal are very similar to that of Libor, at least in theory, and should serve to reinforce the importance of reform if the industry is to avert scandal of a similar sort in the years to come.
While the WM/Reuters rate has been subjected to minor changes over the past two decades, the overhaul that looks soon to come promises to change the system’s methodology on a fundamental basis. Whether it be expanding the period of analysis or boosting transparency, the reforms will no doubt represent the most important response to the rate rigging scandal yet.
“As a former foreign exchange trader myself, it is part of the folklore of the market that traders do try to affect the reference rate,” reveals Taylor. “To my mind it’s not really so much regulating the market that’s important. It’s actually taking away the incentives for people to cheat in that market.” Considering this to be the case, it may well prove that taking a brief snapshot of the market – as is standard practice today – might not be the best course of action when arriving at a reference rate.
Although concerted efforts to overhaul benchmark rates are still very much in their infancy, this is not to say that the implications will be anything short of colossal once they come into being. It’s perhaps too much of a leap at this stage for authorities to introduce a raft of regulations, considering the market’s sheer size and complexity, however, a crackdown on benchmark rates should serve to restore integrity to the some-would-say disgraced market.
If financial benchmarks are to again gain favour, benchmark administrators must take pains to abide by an agreed upon set of principles when arriving at a rate. Only then will the industry rid of its muddied reputation and become known not as a haven for scandal, but a market that once again can be trusted.
