As five of the world’s largest banks pay fines totalling $5.7bn (£3.6bn) for manipulating the foreign exchange market it seems a good point to look at some underlying problems in the financial markets.
Firstly let’s be clear: I am not looking to exonerate the Banks involved. They have been deservedly punished for their crimes. And I am not looking to exonerate the individuals involved, who so far seem to have got off undeservedly lightly.
However one area that does not seem to have come in for as much criticism is the structure and regulation of the markets themselves that led up to these scandals.
What’s Libor?
Lets firstly look back at Libor. The daily setting of the Libor rate was a process that ran without change for many years. At 11:00, banks called the Libor office, run by Thomson Reuters, to report how much interest they would 
have to pay if they were to borrow money that morning. All those reported interest rates were then averaged, but the top and bottom quarters were excluded. This was supposed to prevent any one bank from having a disproportionate impact on the final Libor number.
With hindsight it’s all to easy to see flaws in this process:
- It was easy for the Banks to cross the fine line between reporting what they think Libor would be, and what they would like Libor to be. The Chinese Walls that were supposed to exist between those setting the rates in the banks and the traders were ineffective, even to emails.
- There was no check to see if the rate reported was anywhere near the rate they were paying. In fact, it was a self fulfilling prophecy because in many cases the rate they paid was set by Libor.
- Excluding the outliers in the top and bottom quartile didn’t stop the manipulation of of the final number. If a bank wanted to move the rate up they could still bid it up. If they were in the top 25% that was excluded, then another banks high quote which wasn’t quite as high would be counted. And it didn’t stop banks acting in concert.
- The biggest problem was simply that after the Financial Crisis in 2008 the Libor rate was largely theoretical. Because of the crisis banks stopped lending to each other. So there was no actual Inter Bank Offered Rate. The banks didn’t like to admit that they were having problems borrowing money. So the raye stayed low even though some of the biggest banks had either been bailed out or were only being kept afloat by the support of massive investment.
- But yet a large slice of the global trade in financial derivatives – hundreds of trillions of dollars worth of transactions – relied on Libor as a benchmark. So the smallest favourable movement in the rate could result in enormous profits.
- Despite the hundreds of trillions of dollars that were dependent upon the rate the market was run by the British Bankers Association – a cosy club of Banks, with little independent regulatory oversight. Paul Tucker, Deputy Governor of the Bank of England, compared the BBA LIBOR market to a “cesspit” of dishonesty. Responsibility for the administration of LIBOR was only handed over to Intercontinental Exchange Benchmark Administration Ltd on 31st January 2014.
Fix FX
The FX markets used a different daily rate setting mechanism but were also – arguable even more -flawed. A daily exchange rate fix is held to help businesses and investors value their multi-currency assets and liabilities – again many trillions of dollars, yen, euros and pounds .Until February this year, this happened every day in the 30 seconds before and after 4pm in London. The result is known as the 4pm Fix, or just The Fix – a very apt name in hindsight.
- Unlike Libor, which was supposed to have Chinese Walls between those setting the rate and those trading, the 4pm fix was actually set by the traders.
- Also unlike Libor which ignored outliers to stop one player moving the market, the 4pm fix took all the trades in the one minute period. So a single trader would build up a large position in a currency and, just before or during the fix, would exit that position, a method known as “building ammo”.
- And also unlike Libor where the Banks only had one quote each, the traders could increase the impact by splitting their sales into smaller trades which would move the market more as the rate was averaged on the number of trades and not the size of the trade.
- Regulators said that between 2008 and 2012, several traders formed a cartel and used chat rooms to manipulate prices in their favour. So a single trader could move the market and other members of the cartel were be aware of the plan and would be able to profit.
A number of other markets including oil and other commodities used similar rate fixing mechanisms to FX – and have also been exposed to market manipulation.
Incentives
In any court room drama, means, motive, and opportunity are the three aspects of a crime that must be established before guilt can be determined. We have seen how flawed financial market mechanisms provided the means and the opportunity for the crime. The motive is all too apparent. Traders were incentivised to make as much money from their trading for their Financial Institutions as they could by fair means or – as it turned out all to often- foul.
There is also a stunning lack of deterrent for individuals. Although the scandals have been running for almost a decade only one senior banker has been jailed. “The message to every Wall Street banker is loud and clear,” says Elizabeth Warren, a senator from Massachusetts. “If you break the law, you are not going to jail.”
Victim Support
There is no such thing as a victimless crime. In every deal there are winners and losers. The banks and traders were making money at the expense of millions of customers – although as many of the manipulations were for small percentages and were transient – nudging a rate up one day and down the next – it will be hard to prove. A group of investors has already struck a $394m deal with Citigroup over the FX market manipulation. So now the guilt has been established we can expect a tsunami of legal claims that will make the misselling scandals like PPI look like a ripple in the pond.
Cutting out the middle man
The reform of markets is clearly long overdue. Whatever the legal ins and outs, it seems odd to determine the price of a vast realm of financial products using a “fix”. In 2014 Global regulators considered the introduction of a global exchange that would have largely cut banks out of the business. They decided instead to expand the window of the 4pm benchmark from 60 seconds to five minutes.
This is just kicking the tin down the road.
- It is simply too expensive for the banks to keep their trading floors with expensive people, incentivised to manipulate the market. The complete replacement of costly humans by automated trading systems is just a matter of time. This will not remove the corruptible and fallible human element altogether, as they are still programmed by humans – as seen with high frequency trading.
- The bill for compliance is mounting. The FCA is capturing every trade in the city to monitor for market manipulation – which is not cheap. As an aside if the FCA is capturing every trade why not use that to expand the fix window to 24 hours, as stock markets?
- Ultimately the banks role in financial markets must be questioned. They will argue that their trading adds liquidity into the markets. However this cannot outweigh the fundamental issue that the banks are making large amounts of money at the expense of their customers in the course of their business.