FX fixing controversy is so 2006: what they said back then

Sid Verma
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Dismayed by the media coverage of the FX fixing controversy as the new Li[e]bor, which suggests the fixing practice of FX dealers, exposed to principal risk for large orders, constitutes an open-and-shut case of outright manipulation and is a new controversy? Well, continue reading.

As global banks are assaulted by an avalanche of fines, law suits, a tighter regulatory noose and public opprobrium, here’s a sobering reminder that the so-called abuse of the FX daily benchmark, the WM/R fix, by pre-empting flows was considered par for the course, seven years before the controversy rocked global markets.

Sympathy triggered by the regulatory assault on FX dealers would merit the world’s smallest violin, given the backlash against bankers, more generally, but here’s a case for the defence in Euromoney’s investigation into the global FX market in 2006 that revealed the scale of the practice: 

Another issue hardly anybody is prepared to speak about on the record but which has been referred to, is that many of the very practices that help make FX so efficient would most definitely be frowned on or even deemed illegal in other markets and will almost certainly not pass muster in a market that falls under Mifid’s scope. Pre-empting orders, if not even actually front-running them – and there is a subtle but important difference – is almost the norm in FX.

... The growing popularity of trading on a fixing rate has ensured that the practice continues. UBS is one of the few banks with the courage to admit that its traders deal ahead of fix orders. “The market maker has to risk manage in advance of the fix. Also the fix rate is made up of rate cuts before the actual fix time,” says Fabian Shey, global head of FX distribution at UBS. But he stresses that the bank does not front-run client orders in order to make money.

(Shey is currently global co-head of currencies and emerging markets at Royal Bank of Scotland.)

Market participants, nevertheless, knew they were swimming in choppy regulatory waters and were unwilling to comment in public fearful of the backlash. 

When this article was being researched, a senior FX figure in New York asked whether Euromoney seriously expected him to answer truthfully the set of questions posed, saying they were “too close to the bone”. Every sell-side trader will have at least pre-empted or front run orders at some stage in his career. Ironically, as any FX dealer will tell you, this is often the only way to get an order filled, especially stop-losses, at anywhere near the specified rate.

[Another senior figure comments on the fix]: “A regular order goes at a price, a benchmarked price gives the trader a position at a point in time. He then has to use his judgement about management risk, so the trader will be trading before and after the fix. What he cannot do is push the market in one direction to manoeuvre prices. We have compliance involved in auditing and monitoring the process to ensure traders manage their positions, not the price.”

The fix sounds like a licence to print money; for large orders it probably is. Why anybody would wish to entrust a decent-sized order to be done against a fix, especially when it is a simple version such as a print-out of where a market stood at a point in time, is almost incomprehensible and basically smacks of either incompetence or an unwillingness to take charge of risk.

But there are some advantages to the fix, as Shell’s [senior dealer James] Dyas points out. “We use a fix to manage large numbers of low volume tickets to take away the administrative burden of these low value trades, and to take advantage of the additional liquidity around fix times,” he says. “Fixes also provide an auditable, transparent market based rate that all of our operating companies can access and validate. Large ticket items would not, however, be traded this way. I believe that there will always be some flows within a corporation that will benefit from this process, with the efficiencies it brings.”

In the main, however, our investigation painted a remarkable picture of regulators and market players largely content with the lack of best-execution regulations for the FX market, buoyed by stable spreads, apparent price transparency, innovation and the belief that players had enough skin-in-the-game to ensure a clean market. 

Even many of those charged with overseeing the FX market see no need for it to be regulated. One G7 central banker says: “In broad terms, investors are pretty well protected, due to their sophistication and the tight spreads. In terms of pricing, investors are well protected. You have to consider cost, need, feasibility and the implications of regulation. Regulation tends to lock in certain practices. The FX market has evolved in stages with the advent of new technology, from the phone to portals. Regulation would impede that and it is highly unlikely that national governments can enforce it. It’s an entirely professional market and there’s honour among thieves. The participants are keen on a clean market, not least because of the risk to reputation. Complaints are mainly from sophisticated, large hedge funds, which complain about front-running, or on the retail end, but here operators have become more reputable.”

Of course, outright collusion between FX dealers on buy/sell orders well advance of the fix is a different matter (though this would do little to affect global exchange-rate alignments given the size of the market). Do read the May 2006 investigation for a sense of how FX dealers defended the fixing practice, citing exposure to principal risk.