FX survey 2014: The reign of terror

By:
Clive Horwood
Published on:

Investigations into allegations of market fixing in foreign exchange are spreading into the very heart of the business. Those running the world’s biggest FX houses live in fear of what analysis of hundreds of millions of calls and emails will unearth. Do investigators and regulators risk bringing down the axe on a market that has always provided unrivalled liquidity and ultra-tight pricing for clients?

The global head of foreign exchange stares into space, shrugs and musters up a weary smile. He rises from his chair and opens the door to his office, which leads to one of the world’s biggest trading floors.

“Listen,” he says. 

There is an eerie calm, almost silence.

It’s by far the most eloquent response to a question Euromoney has put to foreign exchange chiefs at most of the world’s leading traders over the course of several weeks: how are the current investigations into allegations of wrongdoing in the FX market affecting the ability of you and your clients to do business

The answer is right there on what should be a bustlingly busy floor full of traders and salespeople on a Thursday afternoon in April. Fear stalks the FX markets. Bankers talk of traders too scared to pick up the phone when it rings, lest they tell the client something that might now be considered inappropriate by one of the hordes of legal and compliance officers that have dominated the room for several months. 

“We have as many lawyers as traders on the floor these days,” the FX chief says, the shrug now more pronounced. 

The irony of this exchange is that it takes place at 4pm in London, a point on the clock that is the root of the crisis in foreign exchange. This is the time of the now infamous fix; the time at which closing prices for a market that trades 24 hours a day globally throughout the week were decided upon. It appears that some unscrupulous traders colluded on terminals such as Bloomberg to manipulate the fix through chat rooms that were cunningly given such secret names as ‘the Cartel’: a sign perhaps of the time when FX revelled in its supposed status as an unregulated market; or a reminder that some people, as in any walk of life, bend the rules beyond breaking point or are just plain stupid.

Investigations into the manipulation of the fix continue; the tally of traders that are either suspended pending the results of the inquiry, or have left the business, numbers around 30 and counting. Most leading FX houses expect to be fined heavily at the end of the process.

The problem is, the probe is no longer confined to the fix. Investigators – both from external regulators and the growing army of legal officers within the banks themselves – are poring over millions of emails and phone calls. Within them, bankers admit, will undoubtedly be evidence of other behaviour that regulators might consider inappropriate, and evidence of collusion. 

The terms of the investigation are already spreading beyond trading at the fix and into the entire nature of the sales and trading process within FX. The exchange of information between trading desks of FX banks themselves and with their clients has always been an integral part of the business. Now it is likely to become the cause of billions of dollars in fines and a number of very senior FX bankers leaving the industry under a cloud.

“There have been a couple of times already when I thought I should leave for my own sanity, especially when people on the legal side have caused issues that show they are completely ignorant of how this market works,” says another head of foreign exchange. “I owe it to my team to stay in place for now. However I know that, at some point in the future, I am probably going to have to carry the can for the fine that will be given to our firm. The buck will stop here.” 

Do you think the current investigations into the FX market will impact banks’ ability to provide the level of service you need?

The reign of terror is in full swing in the world’s busiest financial market, which proudly turns over more than $5 trillion a day. But is the terror justified? And what impact is this current environment having, not just on the banks subject to the investigation, but on the clients that regulators are meant to be there to protect?

The atmosphere of fear is pervasive. FX bankers – usually among the most gregarious and easy to speak to in financial markets – are wary even of talking to a journalist. Some simply will not, hiding behind the spectre of the investigation and their communications teams’ refusal to countenance any discussion that would, inevitably, have to touch on how the current environment is affecting the industry.

Most discussions are strictly off the record. This is reinforced every few minutes of the conversation. So much so that, when at the end of one meeting a PR officer spills a glass of water all over our notebook, we wonder for a split second if this really was an accident. 

But at least we’ve spoken. Increasingly, FX bankers are wary of speaking to clients. “Our sales guys and traders are painfully aware that, every time they communicate with someone outside the bank, they are subject to scrutiny,” says a veteran FX banker. 

Communication has always been at the heart of the industry. FX has been as much an exchange of information as of currencies. Traders spoke to each other; they gave market colour to clients; they made markets, matching client needs. This information sharing has traditionally been the liquid that oils the machine that is global FX. 

As one veteran trader says: “Just like in any other market, a client expects to get information that is better than the rest of the street. They’d always be phoning up and trying to find an angle, an advantage. Of course you shouldn’t be disclosing precise details of your positions or your trades. But there were always a lot of grey areas and accepted practices that now might cause you to get into trouble.”

Certain types of conversation have been standard market practice, such as: “What’s in your book?”; or “Are you seeing support or resistance at certain levels?”

Now those normal market practices are changing. Post the financial crisis, in the wake of the Libor scandal, it’s the turn of foreign exchange. For many bankers, retrospectively applying a new code to the grey areas of accepted practice in the past is just plain wrong. 

“It’s the equivalent of saying that we’re changing the speed limit from 70mph to 55mph today, but if you were caught on camera going over 55mph in the past 10 years, we’re going to fine you and give you points on your licence,” says one trader.

One head of FX says the implications for the markets and for clients are already apparent. “Foreign exchange has been run on one set of practices for the past 20 years. These have included traders talking to traders, sales people giving clients colour on the market, and people managing risk around the fix. Now there’s huge uncertainty around what can and can’t be said. So people are just sitting on their hands, doing nothing. The system is clogging up.”

Another senior trader puts it this way. “I have two options: one, I continue as normal. But one slip of the tongue and I’m terminated, all my stock is clawed back, and my career is over. Option two is much more palatable: I may get fired for doing no business, but my stock gets paid and I can get another job.”

Others fundamentally disagree with this point of view. One FX head at a top bank says: “I don’t think anything has fundamentally changed. What was inappropriate before remains inappropriate today. Yes, a flow business relies on market colour. But there should be no issue in providing that in a market-compliant way.”

But compliant to which market? What is collusion and what is not? Is the FX market being singled out unfairly by regulators looking to hammer the banking industry as a whole?

Some FX bankers point to a standard practice in the US Treasury bond market. There, big funds will normally ask dealers to provide them with inverse pricing. The banks do it for three reasons: first, the broader relationship with the client is too important; second, if they don’t do it, plenty of other banks will; and third, the banks know, every now and again the client will, as one trading head says, “throw us the juicy bone of a nice big trade with some fat fees on it”.

That’s hardly a model of transparency. 

Or take the debt markets. Think of how a bond deal is put together. A group of syndicate managers at rival banks work together to find the right price for a bond to clear at the size the issuing client wants. They work privately together to set the price. It’s all seen as above board in the debt markets. But there would be a race to leniency quicker than the men’s 100 metres Olympic final if any such discussions on pricing took place today in FX. 

Most FX bankers say that activity in the first five months of the year has been low. Some say it is not abnormally so – only that volumes look relatively depressed compared with an unsustainable boom in activity during the fourth quarter of 2012 and the first quarter of 2013. 

This fall in volumes they attribute largely to a lack of volatility, which in turn is partly caused by the stasis in the monetary policy of most of the world’s leading central banks. “The easy carry trades have disappeared, and institutions are looking to make 5% returns rather than 20% returns. All of this is depressing volumes,” says a global head of e-trading. 

Another says that the first quarter of 2014 was “a desperate time” for fast-money clients: “Many of these funds have used up much of their capital or are close to being stopped out for the year,” he says. 

The global head of FX at a top-five bank says that corporate volumes are also depressed. “Interest from corporates is low as they see hedging as a potentially expensive exercise as very little is happening in the market,” he says. 

But it goes deeper than that. Volumes from hedge funds, for example, have declined for the past two years, from $42.5 trillion to $36.7 trillion, according to data from this year’s annual Euromoney FX survey. In part, that was because the number of hedge funds active in foreign exchange declined (from 1,148 in the 2012 survey to 819 this year). In fact, the average volume per leveraged fund is at an all-time high of $44.86 billion.


Leveraged fund volumes on the slide
Volume and vote count, 2010 to 2014
YearTotal FX survey volumeTotal vote countTotal leveraged fund volume Leveraged fund vote countAverage trading volume per leveraged fundLeveraged fund vol as % of total volLeveraged fund vote count as % of total survey count
2014$225,182,166,511,31414,050$36,741,253,667,011819$44,861,115,58916.30%5.80%
2013$225,286,973,490,00016,298$39,207,294,740,000944$41,533,151,20817.40%5.80%
2012$208,499,718,533,48715,423$42,470,469,257,9271,148$36,995,182,28020.40%7.40%
2011$177,457,204,016,83913,038$39,488,829,095,3491,102$35,833,783,20822.30%8.50%
2010$167,302,345,503,64711,715$29,314,190,180,065723$40,545,214,63417.50%6.20%
Source: EuromoneyFXMarketData

That volume number looks certain to fall even further in next year’s survey, given the lack of trading activity cited by many FX bankers so far this year.

“Hedge fund performance generally has not been good in 2014 in FX,” says one banker. “But these are clients that rely on information flow. For now, that information flow is paralysed."

Hedge funds are not the only client group that might suffer. As part of Euromoney’s annual FX survey, in which more than 14,000 clients voted globally, we asked corporates and financial institutions if the investigations into the FX market, and their consequences, would affect banks’ ability to provide the same level of service to them in the future. 

More than half of the clients thought the investigations would have some negative impact. Around 15% said they would be impacted heavily, while 39% said they would be impacted at least a little. Only 20% thought they would not be impacted at all. 

In a pulse survey that Euromoney conducted in March in association with Thomson Reuters, also published this month, clients that conducted annual trading volumes of more than $5 billion were equally if not more concerned with the fallout from the investigations. Some 53% of this client group said they were not as confident about trading the FX markets as they were two years ago. 

Among the same client base, an overwhelming 88% said that their internal processes for trading FX had become more onerous since the advent of new regulation. In all, 35% said that processes were much more onerous. 

Spot trading, even before the fix investigation, was becoming more and more an electronic business. The top e-trading houses already carry out as much as 85% of their spot business electronically. That proportion will accelerate towards 100% at the biggest firms, and rise at second-tier and third-tier firms. 

“In G10 spot, voice trading is a marginal activity, almost a residual service that clients have to actively choose to use,” says one top-five FX chief. 

Increasingly, FX banks are likely to redefine the roles of sales and trading. “A big client doesn’t want to speak to a sales guy any more,” says a head of FX. “He wants to talk to a research guy about ideas and a trader about execution.”

Increasingly, FX is likely to mirror the equity markets, where research and trade ideas are divorced from execution completely. The problem is that most FX research is long-term, macro views, whereas most big clients want intra-day information about flows in the market that only traders can see. 

Execution itself will probably become increasingly divorced from the principal side of the business. “We think the investigations, combined with new rules on market-making and capital, will accelerate the trend away from a principal business to one more like an agency model. We’ll provide liquidity to clients who want it, or we’ll simply execute trades for them. We’re happy with the move to a more agency-like model. Remember everyone said electronic trading would be the death of spot? In fact, it revolutionized it. Spot volumes soared and costs went down.”

Fx survey 2014
Clients in FX enjoy the best and most transparent margins for executing trades in the financial markets. They’re often priced down to the fifth decimal place and are available on a plethora of platforms. But at some point, do these tight margins have to succumb to upward pressure? 

“Volumes are in decline, at least for now, so that is hitting revenues,” says the FX head at a European bank. “The cost of doing business is going up. You have compliance, lawyers and so on. Tech is even more important: it’s not hundreds of millions of dollars to build something over three years, it’s the same sum every three years to stay on top of the game. At some point, at least a proportion of these costs have to be transferred to clients. At the moment, all of the costs are being absorbed by our businesses.”

Clients can probably sit quite easily for now: imagine the furore if prices to clients went up across the board in a market that is being investigated for collusion, even if there were legitimate business reasons for the change in margins.

As bank profits get squeezed, two things are likely to happen. First, the biggest players with the biggest and costliest infrastructures will need to increase their volumes as the cost per unit of business rises. That might play into the hands of the top four or five houses. 

“Foreign exchange has experienced spread compression for the past three years,” says the head of FX at one of the top-five banks. “In terms of net margin, this is by far the most competitive part of the industry. We measure profit in fractions of a basis point. Costs are relatively inflexible. You need a huge infrastructure to execute hundreds of thousands of trades a day. If you don’t have volume, then this is not a good business to be in. That trend will intensify rather than go away.”

One of his rivals in the top five says: “Right now, FX is a less attractive business to be in for all of us. Revenues will be down substantially in the first half. I hope that trend continues for a while. At that point, some of the banks ranked in seventh to 15th spot – which continue to have aspirations to be top players – may finally start to wonder why they are in the business at all.”

But other banks further down the league tables spot an opportunity. They are unlikely to be fined or have their names dragged through the investigational mud as the top 10 or 15 houses are. They reckon the technology advantage that the bigger banks have enjoyed up to now is eroding, as the core tech behind electronic trading becomes more commoditized. 

Some of the second- and third-tier banks also see a clear opportunity in mid-cap corporates, an area that they say remains highly profitable and that the bigger houses are ignoring in their quest for high-volume, electronic business. 

The head of FX at a bank ranked between 10th and 20th place overall in the Euromoney FX survey says: “I like our position. If you’re 15% of the market and there’s a 15% compression in margins, it’s much harder to grow your way out of trouble than if you have just 1% of the market.”

Another banker outside the top 20 overall says: “We’ve benefited from being small. Hardly any clients ever asked us to deal around the fix because we weren’t in the top bracket. So we’ve not been caught up in the investigations.”

Rising up the Euromoney FX overall rankings
Top 10 risers in overall rating, 2011 to 2014
BankRank change since 2011Market share change (%)Volume change ($mln)Volume change (%)
National Australia Bank250.431,012,005694.3
ANZ Banking Group220.521,205,097725.6
Westpac Banking Corporation100.61,534,418241.3
BBVA90.13386,335104.1
State Street60.691,772,736223.8
Bank of America Merrill Lynch51.434,634,19788.7
Citi37.1820,402,779129.7
Standard Chartered30.311,207,18563.8
Sumitomo Mitsui Banking Corporation30.01152,25431.5
Natixis30.04199,95647.5
Source: EuromoneyFXMarketData

The FX head leans back in his chair, a friendly if slightly disdainful look on his face. “Look, let me tell you how it worked. There’s a big difference between pre-loading and front-running. If you tried to fill your position after the fix, we’d have concluded you were stupid and you’d have been fired.”Let’s get back to where it all started: was the fix being fixed? 

Most FX bankers dislike the fix. They say it was never seen as an opportunity at a strategic level to make money. They just lived with it. Or so they thought. 

Then reports emerged in the financial media detailing allegations that major currency pairs saw huge swings in price ahead of the 4pm fix, or London close as it is also called, which is produced by WM/Reuters. Often those swings would melt away shortly after 4pm. A Bloomberg report published in September looked at two years’ worth of closing fixes on 14 currency pairs on the last trading day of a month. Bloomberg said its analysis showed such swings happened 31% of the time across the 14 pairs. 

The fix is primarily used by pension funds and asset managers to determine the price they paid for foreign exchange deals or benchmark themselves against indices. 

Such price spikes were known in the market as “banging the close”. If traders could manipulate prices to their advantage, in the knowledge of what orders would take place at the close, they could potentially make millions on trades. Banks argued that any spikes in activity were legitimate attempts to position themselves around a time when volumes and volatility were higher because these funds chose to execute around the fix. 

“The fundamental problem with the fix has always been this: if I have to execute a trade at the time of the fix, I have to position myself for that beforehand,” says the trading head at a bank that has not been linked to the investigation. “Otherwise, I am taking on a huge amount of risk as a trader by giving a free option to the client to buy or sell at a certain price. It’s my job to do the best I can for the client, but also to protect my bank. Is doing the latter unacceptable market practice?”

That argument might have stood up to the investigations that were already under way. But, come December last year, it was revealed that at the centre of the inquiry was the role of instant-messaging groups. These were made up of FX traders under names such as ‘The Mafia’, ‘The Cartel’ and ‘The Bandits’ Club’, in which these traders allegedly exchanged information about client orders and made agreements on how to trade the fix, a Bloomberg report revealed. 

One trader sums up the way that dealing around the fix is considered now: “If I pre-order around the fix, I am front-running. If I do all my trades at the moment of the fix, I am banging the close. And if I match trades, I am a colluder. Yes, it seems some people acted in bad faith, and they need to be dealt with. But it’s a handful of people in an industry that employs tens of thousands.”

In the meantime, some banks are looking to solve the problem of trading around the fix by asking clients to complete disclaimer agreements, in which the client accepts that on occasion, around the time of the fix, the bank might have to operate in markets in a way that is not directly in the client’s best interests, but to diminish market disruption. If the client doesn’t sign the disclaimer, the bank won’t execute around the fix. 

Such disclaimers also get around the problem of legal documentation: many funds have hundreds if not thousands of sub-accounts; putting in place an overall disclaimer obviates the need to rewrite every agreement these must have. 

Other bankers say the fault lies with the funds that choose to depend on the fix. “I’ve reminded some of these funds that they’re paid to invest and manage people’s money,” says one. “If you’ve got a fund in multiple currencies, surely you should be managing that to the best of your ability on an intra-day basis, rather than simply fulfilling your fiduciary duty by dealing at the London close?”

Euromoney asked clients during this year’s survey process if the fix needed to be changed. Half thought it did. The other half was split between those who thought the fix was fine and those who did not know if it should change. 

There are similarly mixed answers from the FX bankers. Most say that some form of trade-weighted or volume-weighted average pricing is the way forward. Some think the answer is for trading around the fix to become commission based. All preface their comments with the standard line: “We have never made any money out of the fix.”

But there’s a more fundamental question at play here. Is the analysis of what happened around the London close correct? 

One bank has shown Euromoney detailed analysis of EBS and Reuters volumes from 2011 to 2013 in major currency pairs. The bank does not want to disclose these publicly, but the findings have been passed on to regulators investigating the industry. 

The analysis is stark: that spikes in volatility at the time of the 4pm close are, in general, in line with the natural rise in volume that takes place because of the number and size of the orders going through. Indeed, the variance in volatility to volume closely mirrors that seen in terms of the concentration of business around the closing of equity markets. 

Although there are undoubtedly some price spikes before 4pm and fall-back after 4pm beyond normal volatility-to-volume ranges, these tend to happen once or twice a month. “You’d probably find exactly the same frequency of anomalies if you looked at spikes around 8.33am or 1.27pm,” says a banker involved in the analysis. 

The irony is not lost on bankers in the market – that their industry, once the most lightly regulated, could find itself with a new set of rules and regulations – not because of systemic malpractice, but rather because of the wrongdoing of a small group of people who will play no further part in the industry. 

One former senior regulator attempts to bring an element of sang-froid to what is often a heated and emotional discussion. He begins by going back to the onset of the global financial crisis in 2008. “It’s easy to forget that the interbank market was down. No one, even in FX, was putting up trades,” he recalls. “So regulators asked people to start to exchange information on positions to try to bring activity in the market. Once liquidity returned, that practice should have been phased out.”

But he adds, it’s important that the FX market is not regulated to the point at which banks struggle to do business for the clients. “We must remember that FX is a client business. It is not about investment banking or prop trading. It could just as easily fit into the corporate bank or into the asset management business.”

That will be small comfort to FX bankers, who see their industry being hit harder than other parts of the financial markets. 

“The policies we’re talking about bringing in to FX go far beyond what happens in other markets,” says one. “Of our own volition, we’re considering locking down our order books internally. Compare that to the futures market: that’s highly regulated, but salespeople can see order books in those markets.”

He spits: “The main agenda here seems to be to make the banks suffer. It’s not necessarily about making it better for clients.”

Among all the alarms, the soul-searching, the investigations and the move to electronic business, FX remains a people business. And it is heartening to see that the sense of humour of many of its leading professionals endures, even if the humour is now tinged with the spectre of the gallows.

“Well,” concludes one head of FX at a top-five firm, as he finishes his summary of the number of compliance and legal officers now involved in the business, “at least we’ve created a lot of employment opportunities.”