Is the Forex market beyond control?

How big is too big to rig? Can the scale of a market put it beyond anyone’s ability to manipulate? Forex trading may soon answer these questions, as investigations into possible breaches begin on both sides of the Atlantic. Even a market that trades $5.3 trillion per day may not be beyond the ability of unscrupulous traders. But, is it realistic to expect forex markets ever to be truly fair and transparent? Central banks around the world routinely intervene to support exchange rate targets. Indeed, the recent currency volatility in emerging markets seems to have increased intervention. This is often in complex ways that minimise actual use of foreign exchange reserves for currency support. If forex trading is so distorted, how can regulators separate out any wrongdoing from the legitimate actions of central banks?

This month, the US Justice Department announced it was looking at forex manipulation, following earlier announcements of a UK Financial Conduct Authority probe and from the Swiss Financial Markets Supervisory Authority. This appears to be focusing on a $379 trillion market for interest rate swaps. While currencies are hard to move, if information is shared and some client orders are pooled, there could be potential for gain. The key is that a currency move need not be permanent or significant. Much of the volume is traded within specific time windows, and the huge volumes involved make even small movements meaningful.

Many customers converting currency find it convenient to let banks settle this at specific times of the day and to use those levels in valuation. And, the year end has a significance for many firms, well beyond the low volumes typical on that day. Foreign exchange benchmark rates are typically calculated using actual trades hourly throughout the trading day, with the closing rates “set” or “fixed” at 4pm in London. Although an independent firm compiles the fixing rates, effectively the scenario is another benchmark problem. The impact of any distortions can be magnified, or even emerge in another market, remote from the currency trade. Currencies impact many eco
nomic variables and securities, giving ample opportunity for benefiting from a manipulated rate.

While traders are unlikely to know an exchange rate in advance, any pooling of knowledge of client orders, particularly in less traded currencies, could give an edge. Knowing how much hinges on the key times that determine a rate, and the likely balance of orders, frontrunning or arbitrage would be possible. The market itself is not directly regulated in the way that stockmarkets are, and so the key issue may not be market abuse. What matters is the regulatory framework applying to participants, and also whether customers have lost out. As other benchmark cases have shown, the threat of civil action from customers who feel they have lost out may be the biggest penalty.

Questions have been asked about the forex market for some time. Many commentators have noted the ways in which currencies can jump around at the fixing time. Although the setting process is automated and anonymous, the key could be orders and information, rather than anyone compiling the published rates. For any traders to benefit from this, something must also need to be wrong with incentives. The simplest explanation for any wrongdoing would be that it can create profit for the firms involved, and bonuses reward individuals for that.

Benchmark problems that have already emerged have included lack of independent governance, and failure to identify conflicts of interest. There is often enormous public interest in a benchmark for which there is no payment and no direct accountability. Consider how many organisations and borrowers based their payments on Libor, yet knew little of how it was determined. In some cases, regulators have stepped in, or the bodies involved in benchmark setting have raised their game.

Yet forex is a complex global market that would be difficult to regulate in the same way as commodities or securities. Instead, the focus must be on ethics and operating practices in the banks and other financial institutions conducting the trade. The root of the problem is society’s wish to turn continuous real-time marking to market into discrete hour by hour or daily moves. And, governments also like to smooth out change in exchange rates. There will always be some times and dates that have greater significance, even though trading goes on around the clock. Many companies and individuals like to maintain the fiction that currencies only change their value at set times; real-time modelling of their risks and valuations would be too complex.

Complicating the drive to investigate the possibility of any wrongdoing on forex, is the increasing involvement of central banks in trying to wrest control of rates from traders. The world has seen a gradual movement towards free-floating rates, with even Russia and India heading in that direction. It is difficult to compete for capital globally, whilst maintaining any form of capital controls on foreign investors. Painful as currency volatility and speculation are for many nations, they have an interest in joining the freely trading world.

But, 2013 looks like a step back from that process, as emerging markets try to protect their foreign exchange reserves and monetary policy from the impact of capital movements. It means that governments can be intervening in markets in undeclared ways, and trying to pick the times and instruments where they can make the most impact. Forex has become much more complex this year.

The investigation is a wake-up call for the forex market. Greater transparency and accountability in rate fixing is urgently needed. Any potential conflicts in remuneration structures must also be addressed. And, even if the industry cannot be fully regulated, it would still be helpful to have more clarity over the actions of central banks and others who manipulate the market legally. It is time some light was shed on this important but opaque market.

A version of this article appeared as Op-Ed in Financial News on October 21 2013.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.