Politicians and regulators in charge of our foreign currency markets can’t see the wood for the trees. Even the banks themselves recognise allegations the world’s largest financial market has been rigged amount to the most serious scandal since Libor, and yet the solutions on offer are just a quick fix.
Chancellor George Osborne wants to criminalise rate rigging, for instance, a smart move but not one that will adequately address the situation. If our foreign exchange markets were sometimes rigged, as prosecutors allege, this happened not because traders operated outside of the law. It turns out the market is particularly susceptible to rigging due to a variety of structural issues that go far deeper than a simple act of rigging, criminal or otherwise.
So here’s a radical proposal: let’s have a centralised foreign exchange market, similar to those that exist for trading stocks and shares.
This change would be achievable. The suggestion is simply that foreign currency (forex) be switched from one type of financial market – over-the-counter – to the other, a centralised exchange.
In the latter, there is one market price which all buyers and sellers adhere to. A stock exchange is indeed a good example of such a market; at any given time the price of a share in Apple or BP is the same for everyone, regardless of who their broker is or how much they know about Apple’s latest sales figures.
In an over-the-counter (OTC) market such as forex, prices are negotiated between traders for each individual transaction, which means there can be many prices at any one time on the market. If the going rate for a UK pound is one and a half US dollars, but someone is willing to offer you two dollars per pound, why let the fool keep hold of his money? It’s difficult to keep track of this sort of stuff. OTC markets have no central register of prices or even the amount of orders.
Over-the-counter markets do have their uses. Ideally, they are employed in areas where product traders require sophisticated knowledge, where products are highly customised and where there are few buyers and sellers. The market for complex derivatives is suited to an OTC market, for instance.
But this is clearly not the case with forex: anyone can set themselves up as a currency trader and understand the rudiments of the market fairly quickly. The product which is bought and sold – a unit of currency – is one of the most generic you can get. The market is of course massive, there is no shortage of buyers and sellers.
This begs the question of why forex is an OTC market when a centralised exchange could quite easily do the trick.
One price fits all
What is rather astounding to many outside observers is that regulations which we take as a matter of course in the stock market simply don’t exist in forex.
For instance, in the stock market, using information gained as part of your daily activities to gain an unfair advantage in trading for yourself is illegal – it is considered insider trading. In forex, using information gained as part of your job to place trades for personal gains is perfectly legal. This creates an unfair situation whereby a small number of insiders benefit at the expense of a vast number of people on the periphery of the market.
There are clearly differences between insider trading on equities and forex traders using their privileged access to information to benefit from currency. However, the general lesson stands – regulations and institutional infrastructure designed to ensure a small handful of insiders do not have an unfair advantage in markets tend to create benefits for everyone.
Currently over-the-counter forex dealing means those who have a proper overview of the market have big informational advantages, and there is significant scope for collusion. US prosecutors are now looking at sales techniques employed by traders, for instance. The allegation is that sales people were exploiting their unsophisticated clients to charge far higher commissions on trades – this is a direct result of the OTC market structure.
A centralised marketplace similar to the big stock exchanges wouldn’t breed bad behaviour to the same extent, but creating such an exchange wouldn’t be easy. First you have the sheer scale of the forex market. $5.3 trillion a day changes hands, more than 80% of which is speculative.
Trading is also highly concentrated: more than 40% takes place in London, and over half involves just four large banks. These same banks would vigorously resist a move to a centralised exchange, as they have already built their own currency trading platforms and are looking to further automate the currency trading process to reduce the human input (and thus the potential for manipulation). But such moves do not go far enough in creating a properly transparent and centralised exchange – the big banks running their own exchanges still have more information than others in the market, information they can use to their advantage.
New legislation, such as that announced by Osborne in a recent speech to City bankers, will certainly help things. His legislative changes involve extending the criminal regime which had been set up following Libor to cover the foreign exchange, commodities and fixed income markets. This would mean evidence of wrong-doing in these markets could result in criminal prosecution.
But having a criminal law on the books is no good unless there is a willingness to actually use it. Passing a law does not make much difference; using the laws to prosecute traders does. After all, nothing is a better warning that seeing one of your number behind bars, and forex traders are a particularly tight bunch.
Indeed there is a risk that only pursuing criminal prosecutions will tend to get regulators focused on individual wrong doers and to ignore what actually caused this bad behaviour in the first place. If the government is serious about cleaning up the forex market, it needs to consider more drastic changes. This leads us back to the idea of a central currency exchange.
But the broader issue perhaps is whether it is healthy for the wider economy to have such a large speculative trade in currencies. As we have seen many times in the past, such free flowing speculation can often lead traders to undertake attacks on national currencies which can cost governments dearly. In some cases, it can represent a serious threat to national sovereignty.
A centralised exchange where everyone pays the same price and all trades are reported openly would level the playing field and prevent the worst excesses of the recent scandal. But it should be only the start of a much bolder rethink of a system which has allowed a handful of currency traders to behave badly for decades at a great cost to us all.