The fix is in: how banks allegedly rigged the US$5.3 trillion foreign exchange market

Six global currency-dealers have agreed to pay a total of US$4.3 billion to regulators in the US, UK and Switzerland. Image sourced from www.shutterstock.com

Suppose you’re in the supermarket shopping for groceries. While you’re strolling the aisle with your cart, a shadowy figure looms over your shoulder and changes the prices on the items you want to buy before you get a chance to pick them up.

As you reach for some vine tomatoes, you notice the price just jumped 20 cents. When you select some brie from among the cheeses, you witness the number on the sticker change right before your eyes. Ditto when you look for your favorite brand of granola.

This is the essence of what regulators learned might be happening in the foreign exchange market, where US$5.3 trillion of dollars, euros and yen are traded every day. In June 2013, Bloomberg reported that traders at some of the world’s biggest banks worked to manipulate key currency rates, racking up profits and costing investors – including your retirement fund – hundreds of millions of dollars globally.

They are accused of placing their own transactions ahead of trades requested by clients – known as front-running – which was the reason prices kept changing as people tried to make their own trades, like in the shopping analogy above. They bought euros or dollars, driving up the rate, and then profited by selling to other investors at a higher level.

This week six of the currency-dealers being investigated – including JP Morgan, Citigroup and HSBC – agreed to pay a total of US$4.3 billion to regulators in the US, UK and Switzerland to resolve the allegations. The deal is likely only the first in a series of settlements and other penalties that will emerge from the ongoing investigations.

The investors most concerned with the alleged manipulation are funds that invest internationally, such as hedge funds, the endowments of charitable or cultural institutions and insurance companies. But it also includes the mutual funds in which many of your 401K or IRA assets are likely invested.

The daily fix

When institutions like these need to buy or sell assets across borders, they call a dealer at one of the big banks, which provides what is basically a wholesale version of the cambio currency kiosks you see at the airport. The dealer quotes a buying price and a selling price, and the fund chooses whether to buy or sell. In addition to trading with customers, the dealers trade among themselves, sometimes to manage their inventory and sometimes hoping to make money by taking speculative positions for a few minutes or even seconds.

And that’s how we arrive at the scandal. Every day at 4pm in London, the market sets special “fixing” exchange rates that are used to value the funds' international investments. The fixing price is set in a simple way: it’s just the average of all prices paid among dealing banks during the 30 seconds before and after the clock strikes 4.

Many international fund managers prefer to trade currencies at exactly the fixing price because it’s simpler and smarter to trade at the same price used to value your portfolio. To make these transactions happen, international funds often place large orders with dealers at major banks before the fix.

Suppose, for example, a pension fund with major investments in Europe knows it will receive a lot of new IRA money on November 30, when many US employees get paid. And suppose the fund plans to invest €100 million of that in European stocks. At 3:30pm that day the fund might instruct its bank to purchase €100 million at the fixing price. With this kind of advance order, the bank could book its own trades before the fund does, buying the euros it will later sell to the investor.

What the banks are accused of

The banks – or more accurately, specific dealers at specific banks – are accused of manipulating the fixing prices based on their knowledge of advance customer orders. In a nutshell, the accusation is that dealers from different banks got together before the fix and compared notes in chat rooms. Most currency trading is handled by 10 or so mega banks, so if just a few of them compared notes, they would have a good sense of whether the exchange rate would rise or fall during the fixing interval that day. The shadowy figure looking over your shoulder at the supermarket to see what you’re going to buy next is like the banks comparing their customer orders before the fix.

To finish the supermarket analogy, we need to know how and why the dealing banks could raise the fixing rate to the disadvantage of international pension and mutual funds. Suppose once again that many customers have placed big orders to buy euros at the fix, and the banks figure the euro-dollar exchange rate will rise during the window. This would give them an incentive to buy a lot of euros before it’s set (remember the golden rule of trading: buy low, sell high).

And they don’t have to stop buying when they have enough for their customers. They could buy a lot more euros for their own account, and then sell them at the higher fix price. If they could count on other banks doing the same thing, it becomes a lot less risky. That drives up the exchange rate ahead of the fix and means your pension fund has to pay more to buy those euros.

What it means for you

Why should you care? If your IRA fund manager pays more to buy euros and earns less when he sells them, your retirement account loses money to the traders, and your investments will suffer. And even though the price differences are minuscule, they quickly add up.

Suppose that just 1% of total investor trading happens at the fix and that the fixing price is just 0.005% distorted by manipulation. Those may sound like tiny numbers, but foreign exchange trading by US financial institutions is huge: roughly $700 billion every day, according to the Bank for International Settlements. So losses to US investors from tiny fix-price distortions could be anything but tiny: we could collectively lose almost $100 million per year!

Did this really go on? We don’t know. The dealers did have chat rooms and they were reportedly given names like “The Bandits” and “The Cartel,” so it’s not a big stretch to imagine that they compared notes and manipulated prices. But dealers have other important reasons to work together around the fix. It’s a very risky time to trade, since the exchange rate is unusually volatile, and dealers have to trade such large amounts for their customers. A dealer could easily end up buying euros at an exchange rate above the fix and then taking a loss by selling low (at the fix) to the pension fund.

Several regulators in the UK, US and Hong Kong continue to investigate the activities of the banks, which have all set aside large sums to pay any penalties that arise. JP Morgan alone has set aside US$5.9 billion.

Even with the settlement announced this week, don’t expect this issue to go away anytime soon.