The currency traders under investigation for FX manipulation of prices made to clients based on the 4:00 pm London fixing may well wish they would be brought to trial, if it comes to that, in America, where the common thinking is that you should be judged by a jury of your peers.
The reality is that the US Constitution promises only the right to “an impartial jury of the State and district wherein the crime shall have been committed,” but this is generally interpreted to mean a jury that has no bias one way or the other – and presumes you are innocent until proven guilty.
In this instance, the potential jury pool is already tainted by the LIBOR scandal and the host of other banking scandals that came before it.
The details of the wrongdoing are sketchy – with the snippets released in the media suggesting that some incriminating “instant messages” were sent. Maybe they were. But who should decide the difference between what is “incriminating” and what could be deemed rational market behaviour? Certainly not someone who never sat in a dealing room in his or her life.
Traders tell us they laugh when they get emails from friends asking about the case. “Did these guys REALLY front run client orders?” The answer is “Of course they did – who wouldn’t?”
One trader points out that getting London fixing orders is a “lose-lose” situation because the client order must be filled at the midpoint, determined by a third party, and not the actual bid or the offer in the market at the time.
The spot trader typically gets the client deal on his books at the midpoint and then the corporate/sales desk might add a point or two, depending upon the client, thus keeping the profit on the sales desk.
Say a spot trader is told to buy $250 million versus the yen for the London fixing for a client. He knows that more than likely he will be out a point (i.e. have a $25k-ish loss) once the order is filled. So he buys $125 million ahead of time, say at Y99.07, hoping that dollar-yen moves higher. The fixing is done at Y99.08 in a Y99.07/09 market. He buys the remaining $125 million at Y99.09 (the market offer for dollar-yen) and makes no money on the deal since the $250 million average is done at Y99.08.
If, instead, dollar-yen falls as the spot trader buys and that second $125 million is done at Y99.05 in a Y99.04/06 market the average on the $250 million is now Y99.06 and the trader has lost a point, i.e. has lost about $25,000 on a deal whose pricing he had no control over.
If dollar-yen rallies, yes the trader might make money. But it is the trader and ultimately the bank who takes the risk of the position, not the client.
In a $5.3 trillion dollar per day foreign exchange market (according to the BIS Triennial FX report), $2 trillion of which is spot foreign exchange, even buying $250 million worth of a given currency does not guarantee that you will be able to sell this FX pair at a better rate. You could just as easily lose money instead of making money front running a client fixing deal.
Traders viewed the whole London fixing process as being flawed and clearly in need of repair. “FX is the only market where you have to show a two-way price,” noted one. “Imagine calling your stock broker and telling them that you want to sell 100,000 shares of IBM at 11:00 a.m. ET. Oh and then by the way, I will call you back and tell you where my fill is,” he offered up as example.
For small orders or orders in exotic currencies, traders might just “eat” a fixing loss, merely to keep a client happy. For larger orders, there may be no choice but to front-run the deal, especially if you think other banks have similar deals. “For most of the large orders, you would have to ‘front-run’ the fixing just to do the volume,” a trader said.
Given the lay of the land and 50-50 chance of loss versus profit, it comes as no surprise to hear that banks often talk to each other about what orders they might need to fill at the fixing. “Does anybody need to do this (buy or sell xyz) at the fixing?” might be asked in the normal course of business, traders said.
Brokers and other bankers might try to match deals so that they are not left with uneven positions or losses after the London fixing is completed. If there are no matches, a banker might at least try to find out if others had similar orders which would make his own execution of a currency pair that much more difficult. This could be deemed due diligence in order to protect your bank against potential losses.
Such thinking would seem logical to someone who has actually traded and knows how difficult it is to get out of a losing position when other larger market players are trying to sell the same position at the same time.
To be fair, banks created their own bête noir, in the form of the London fixing, by gouging clients who in the past gave them “at best” execution orders.
Historically, there was an understanding between bank and client that in return for FX advice on hedging, there was a “fee” to be paid and that it was OK for a bank to pad a currency deal with a point or two. However, some banks took this padding to extremes and corporate and fund clients began to protest.
In the past ten years, these clients have become more sophisticated. They increasingly asked for two-way prices and have begun to “shop around,” i.e. ask several banks for a two-way price in a given currency pair. They have become big fans of the electronic trading platforms. Technically, the only party that has a right to a two-way price is one that will give you a two-way price back at your demand.
Along with this transformation, the London fixing has grown more popular, because this gives corporates and other players a published price that they can point to in case anyone questions the fill.
We can only hope the upcoming FX investigation results in new fixing rules that are fairer to both clients and bank traders. We also hope that whoever ends up judging trader ethics in the fixing case take the time to understand the business of foreign exchange ahead of time. So far, much of the language and the tone of the accusations shows that the critics really don’t know how the business works.
Barbara Rockefeller and Vicki Schmelzer – co-authors of The Foreign Exchange Matrix.