The big fix

How traders might have made money manipulating massive currency markets

October 17, 2013
October 17, 2013

Regulators in Europe, the US, and as of yesterday, Hong Kong are looking into whether the $4.7 trillion market for currency is being manipulated by a handful of traders in order to gouge their clients and pocket big profits. At face value, it seems impossible that a handful of traders could have a sizable impact on a market so massive. But if currency traders were conferring in group chats (paywall) over how to time their trades to game the system, then they very well might have been able to pull off this heist. (There’s no clear evidence as yet that this happened.)

Companies—including asset managers that invest your retirement savings—trade currency for a few reasons: to hedge their investments overseas, conduct transactions in different currencies, or generally make long-term investments in one currency as opposed to another. To do this cheaply, big companies typically use bank traders to get the right price and make sure their sizable trades run smoothly.

Until recently, the foreign exchange market was an incredibly opaque place. Currencies are traded over-the-counter—or between individual dealers—rather than through a centralized clearing house or exchange (as with stocks, for instance) that processes and time-stamps trades. That made it difficult to see what the price of a currency pair was at any given time, and difficult to know, after making an exchange, that you’d gotten the best price.

The “fix”

That’s where the “London fix”—a benchmark rate for the immediate (or “spot”) exchange of currencies—came in. Launched in 1994 and managed by the WM Company and Thomson Reuters, the benchmark is calculated based on trades that occur between 3:59:30 pm and 4:00:30 pm GMT. Unlike the scandal-ridden Libor, which is calculated using bankers’ hypothetical estimates of the rates at which they could borrow (and which made Libor open to manipulation), the fix rate for any two currencies is calculated using actual trades.

At the time it was introduced—well before the internet was commonly used—the benchmark increased transparency. Clients could compare their trades to the benchmark, and reassure themselves that they were getting a good price from their bank. And because currency prices fluctuate throughout the day, clients wanted to cram their trades in right at the end, at the rate closest to the “fix,” to make accounting easier. Michael DuCharme, the head of foreign exchange for Russell Investments, explained why this is in a June note (pdf):

Being able to demonstrate that the transaction was done at the market price is useful for financial entities trying to make FX trading efficient. For example, units of a firm located in various parts of the world may require a transparent and reportable set of rates to reconcile transactions among themselves.

Then came the internet. By 1999, anyone with a fast enough connection could trade currencies online. Now free websites will tell you the exact market exchange rate between two currencies at any second of the trading day. “People were able to actually have access to the markets. Before you had access…there weren’t really good clean updates of spot rates,” explains John Kicklighter, chief strategist at DailyFX.com, a company owned by foreign exchange broker FXCM. “There was so much inefficiency in the market that it was so easy for a bank to make a buck off of it.”

Now that we can see currency spot prices more easily, we can also see recurrent patterns that suggest suspect behavior. Bloomberg reported in August that a pattern appears on the last trading day of the month, when index funds, which manage some $3.6 trillion in assets according to Morningstar, exchange large sums to re-balance their investment portfolios. The most commonly traded currency pairs frequently see a massive spike before losing most of those gains, all in a very short time period. That has happened 31% of the time in 14 currency pairs during the last two years.

Rigged and wrong?

So what’s causing that spike? Whether it’s manipulation or an inevitable flaw in modern currency markets is unclear. To see why that is, here’s a walk-through what a currency trade might look like:

Let’s say that a trader knows she has many clients who want to buy euros and sell dollars at the fix. It’s two hours ahead of time, and she wants to make sure she can execute all those orders. So she’ll buy euros early—say, for $1.3500 at 3 pm GMT—with the intention of selling them to her client an hour later at the fix. Now imagine that there are quite a few traders whose clients are looking to buy euros at the fix. They, too, could be stocking up on euros that they’ll sell to their clients at 4 pm.

As traders place orders to buy euros and sell dollars, the price of the euro against the dollar rises, even though the clients’ orders haven’t been carried out yet. By the time 4 pm rolls around, the price for euros to dollars could be artificially high—$1.3520. Our trader bought her euros early at $1.3500, but now she’s selling them at $1.3520. Her client specifically said he wanted to execute the trade at the fix price, which means our trader’s bank pockets the difference: $0.0020 for every euro traded.

This has a huge impact when you’re buying a lot of currency. Bloomberg calculated that, if a client had traded 1 billion Canadian dollars (US$950 million) for US currency on June 28, the trade would have earned the client US$5.4 million more at 3:40 pm than it would have if executed during the minute the fix was calculated around 4 pm. If our trader executed the trade for this client—buying US currency at 3:40 pm to sell the client at the fix—her bank would have made that $5.4 million, which would factor into her bonus.

This behavior isn’t necessarily wrong, and the fact that currency pairs frequently see a massive spike ahead of fixing time doesn’t necessarily mean the game is rigged. Traders aren’t legally allowed to front-run clients’ trades like this in the stock market. But the foreign exchange market has always been less regulated and open primarily to sophisticated investors, so dealers have been allowed to buy currencies with the intention of selling them to clients as outlined above.

Moreover, the trading patterns Bloomberg saw could have been created (paywall) by the fact that many institutional clients (for example, pension funds, mutual funds) all want to trade around the time of the “London fix” on the last day of the month, for the reasons we explained above. Index funds especially use the “London fix” as a benchmark to value their portfolios, and don’t want to take the risk of trading at any other time during the day.

However, new reports suggesting that traders at different major banks were communicating in a chat room (paywall) have piqued regulators’ suspicions. If traders shared information about their positions in order to artificially inflate the “fix” to make sure their trades settled profitably, this would constitute a serious offense. It’s not yet clear what kind of communications these traders shared.

Three traders interviewed for this article argued that institutional clients might need to start trading at other times of the day if they want the best price. “Institutional investors think, ‘If I’m benchmarked to anything other than the close, I take on risk’,” a former trader, who worked at multiple major Wall Street banks, told Quartz. “90% of the time [they] would have been better off trading earlier in the day rather than on the close…People have just not done good solid analysis on this.”

“Put simply,” writes Russell Investment’s DuCharme, “while fix trading strategies sound appealing because of their apparent transparency, they are not generally the best approach for investors.”

Benchmarks for practically every other asset class have faced allegations of manipulation. That makes it easy to believe currency trades wouldn’t be any different.

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