Buyer Beware: The British Regulator Is After Rate Manipulations in the FX Markets

Britain’s Financial Conduct Authority (FCA) has begun considering methods of investigating potential manipulation of rates across the FX market as a result of alleged instances of such conduct having surfaced again according to research conducted by Bloomberg, this time centered on what is known in the industry as ‘front running’.

Front running is a methodology whereby currencies have hourly fixing times which are used by institutions to price different derivatives or indexes. Therefore, if there is a multi-currency fund that tracks several indexes, the holding can change as the prices of different currencies change. Usually, there are three fixings, which are the Japan, London, and New York which are used to price funds that are matching indexes.

In March last year, what could certainly be perceived as a very unpleasant pattern of behavior, came to light in the form of a class action law suit being brought against BNY Mellon for charging inflated foreign exchange rates when buying, and deflated rates when selling. Although in the BNY Mellon case it was a non-government organization which filed suit against the bank, this time the regulatory authorities are considering intervention.

The Practice: Manipulation

Forex Magnates has expanded further on this, and according to our industry sources the current situation has arisen due to a proportion of traders taking advantage of the fact that fund managers are re-balancing their holdings around the fixings to match the index. Approximately 30 minutes before a fixing, a fund manager has an idea of the buys/sells that will have to be achieved at around the fixing time. At that point, orders are sent to traders to have the trade executed at the fixing prices.

On which form this investigation may take, Trevor Clein, Director of Compliance, MRLO at DF Markets, explained to Forex Magnates that "where a regulated firm has concerns about its systems and controls, procedures and record keeping it may appoint an external consultant to conduct a health check. It is much better for a firm to do it this way rather than wait for the FCA to use its powers by requiring a report under Section 166." This indicates that it may be more prudent for firms engaging in improper pricing of foreign exchange to show their hand in advance.

Mr. Clein makes the point that "compliance officers are required to carry out internal reviews for presentation to the board of directors on a continual basis. This is not always adhered to because firms are often in denial about their inadequacies and do not have the resources to fix things, hence the fines you sometimes see. Also, where a firm establishes breaches in its systems and controls it is required to inform the FCA by making Principle 11 statement."

In the case of BNY Mellon, the law suit took the form of a class action subsequent to which the bank proposed applying fixed margins over benchmark currency rates when automatically executing currency trades for custody clients in November 2011.

A major London broker which requested anonymity spoke to Forex Magnates to provide a view from within: “Best Execution rules do not apply to spot FX. There is nothing untoward here. Let’s face it, if every time I call my dealer to trade and the market moved away from the way I wanted to trade then I wouldn't trade with that dealer anymore” explained our source.

“FX trades are principle to principle transactions and if the dealer wants to take a position against you, or trade with you, that's up to them. Some clients’ dealers know that they are wrong and others dealers know they are often right from a directional point of view. This is how retail brokers decide who to B book and who to A Book”, the source concluded.

In terms of behavioral patterns relating to benchmarking, another source - which requested anonymity - within London’s financial sector explained that this is ambiguous: “Setting benchmarks I cannot really comment on. For us there is absolutely no part of our business that would benefit. All I would say is that the FX market is so large that it is very difficult for any one party to manipulate currency rates for long in a significant way. Only the top few banks and central banks could do this and even they get it wrong. For greater clarity, see the case of George Soros vs Bank of England.”

Prohibited Yet Prevalent

“Although it seems like there is a valid complaint, I wonder if this is all timed as part of a big push to regulate spot FX further and potentially bring it on exchange. I’m not sure the rules as they stand could even allow for prosecution of anyone in this case”, stated an institutional FX company in London which asked to remain unnamed.

As far as legitimacy is concerned, it is a prohibited practice to use client information for proprietary trading. However, it is very prevalent. Fund managers could complain that it leads to artificial price inflating which will reverse shortly after the trade.

On the other hand, it is a very common occurrence, and there is two-sided activity; whereas if a large client believes they are getting front run, they may send a large order to buy, when they are actually in the market with a larger order to sell. What this does is cause all the colluding traders to start buying, prices move higher. At that point, the fund manager starts selling to these buyers and becomes more aggressive with the selling. Seeing prices fall, and their buys losing money, the colluding traders will dump their positions, and take a loss. The prevalence of this is particularly evident in stock trading.

The question is: Who is making or losing money?