Macaskill on markets: Front-running and the death of fixed income
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Macaskill on markets: Front-running and the death of fixed income

The case against two HSBC employees for front-running a foreign exchange order from a client could hasten the death of the principal model for FICC trading by banks. A shift to an advisory-based approach is possible, but banks will struggle to make up lost revenue.


December 7, 2011, could prove to be a day that will live in infamy for HSBC, if a case brought by the US authorities against two of its senior foreign exchange traders results in further sanctions for the bank.

The dealers are accused of mounting a sneak attack on the sterling/dollar exchange rate that day in order to profit at the expense of a client that had arranged to convert $3.5 billion into sterling.

It was the 70th anniversary of the surprise Japanese attack on Pearl Harbor, which brought the US into the Second World War, a date that is unlikely to have resonated with two FX traders in London as they set about maximizing their profits from a substantial order placed by a UK client. 

Mark Johnson, HSBC’s global head of foreign exchange cash trading at the time, and Stuart Scott, then head of FX trading in Europe, are now accused of fraudulently handling the client order.

Johnson was arrested at JFK airport in New York on July 19 in what amounted to a surprise attack by the US authorities. Johnson was in the process of transferring from London to New York with HSBC, which indicates that he was not unduly concerned about the risk of a legal assault in his new base related to trades he conducted in the UK almost five years ago.

US prosecutors take an expansive view of their ability to pursue wrongdoing wherever they see fit, however. An affidavit that was unsealed the day after Johnson’s arrest outlined the case against the two HSBC staff and set up a legal battle that could have far-reaching consequences for banks and their ability to profit from handling client trades.

Johnson and Scott are accused of front-running the foreign exchange trade with deals that helped to generate roughly $5 million of execution gains for HSBC and $3 million of associated proprietary dealing profits, while raising the end cost for the customer.

The client is described in the affidavit as ‘Victim Company’, but it is clear from the dates and trade details that it was Cairn Energy of the UK converting part of the dollar proceeds of the sale of its subsidiary Cairn India to Vedanta. 

The main charges are that Johnson and Scott used confidential information from the client to conduct trades that pushed up sterling against the dollar to the benefit of HSBC and the expense of the customer, then lied about the bank’s role in the movement of the FX cross. Allegations of ramping of prices by dealers in wholesale markets at the expense of clients are nothing new, but an attempt to punish individual traders is unusual.

As is the case with most modern financial sector lawsuits initiated by governments, unguarded comments that were recorded are at the core of the case for the prosecution. Scott is accused of telling the client that the transaction went “OK” despite a sharp spike in the sterling/dollar exchange rate ahead of the 3pm London fix, which had been agreed as the execution time for the trade. He is also accused of falsely attributing that move to trading by a Russian bank. 

There are potential weaknesses in the US government’s outline of its case against Johnson and Scott. One is that the traders were not guaranteed a profit

A comment by Johnson in a conversation with Scott attracted the most attention when the charges were unsealed, and will be used to try to demonstrate that the two men knowingly defrauded their client with front-running trades. The US prosecutors’ affidavit claims that the client gave HSBC confirmation of its order to buy sterling equivalent to $3.5 billion in two tranches at 1.15pm and 2.28pm. 

When Johnson heard from Scott at 2.28pm that the customer was going ahead with a purchase of the full amount of £2.25 billion he commented: “No, you’re kidding?” followed by “Ohhh, f***ing Christmas”.

The implication was that Johnson knew that he and Scott had an opportunity to make a guaranteed profit by pushing up sterling at the client’s expense. In another call between Johnson and Scott at 2.54pm they are alleged to have discussed how high they could ramp the sterling/dollar rate before the customer would “squeal”.

There are potential weaknesses in the US government’s outline of its case against Johnson and Scott. One is that the traders were not guaranteed a profit. They were trading in what is one of the most active currency crosses (sterling against dollars) in the most liquid of all wholesale markets, where daily volume normally ranges between $4 trillion and $5 trillion. Countervailing flows from other dealers or end users could have pushed prices against HSBC and created a loss on its client execution trades.

The foreign exchange market also has virtually no formal regulation to breach governing execution of client trades (unlike equities), and the affidavit outlining the US case fails to differentiate between profits on trades made before or after the final confirmation of the client order. Demonstrating wire fraud under US law could also be a challenge.

But the US move to tackle front-running of client trades could have a chilling effect on fixed income profitability for banks, regardless of the result of the case against the HSBC traders. FICC (fixed income, currencies and commodities) profits for banks have declined substantially in the last three years. Boston Consulting Group recently estimated that FICC profitability fell from 70% ($59 billion) to 44% ($26 billion) of the total profit pool for investment banks between 2012 and 2015.

Foreign exchange had looked like a rare bright spot in the FICC sector. Market events such as removal of the Swiss franc peg to the euro last year and the recent Brexit vote in the UK generate volatility and volume in FX. 

There were signs of this boosting ailing sales and trading returns in recent second quarter bank results. If banks have to evaluate every potential client trade to ensure that there is no risk of being accused of front-running or gaining excessive profit from execution then this opportunity to put some margin back into FICC may disappear.

Electronic trading and the emergence of new liquidity providers, such as hedge fund group Citadel, have already reduced profitability from flow fixed income market-making for banks. If supervisory authorities police the mechanics of client trade execution more rigorously, then a shift towards an advisory-based fixed income business model for banks will also become challenging.

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