The colossal size of the global foreign exchange (“forex”) market dwarfs that of any other, with an estimated daily turnover of $5.35 trillion, according to the Bank for International Settlements ’ triennial survey of 2013. Speculative trading dominates commercial transactions in the forex market, as the constant fluctuation (to use an oxymoron) of currency rates makes it an ideal venue for institutional players with deep pockets – such as large banks and hedge funds – to generate profits through speculative currency trading. While the very size of the forex market should preclude the possibility of anyone rigging or artificially fixing currency rates, a growing scandal suggests otherwise. (See also "Forex Trading: A Beginner's Guide.")

The Root Of The Problem: The Currency “Fix”

The closing currency “fix” refers to benchmark foreign exchange rates that are set in London at 4 p.m. daily. Known as the WM/Reuters benchmark rates, they are determined on the basis of actual buy and sell transactions conducted by forex traders in the interbank market during a 60-second window (30 seconds either side of 4 p.m.).The benchmark rates for 21 major currencies are based on the median level of all trades that go through in this one-minute period.

The importance of the WM/Reuters benchmark rates lies in the fact that they are used to value trillions of dollars in investments held by pension funds and money managers globally, including more than $3.6 trillion of index funds. Collusion between forex traders to set these rates at artificial levels means that the profits they earn through their actions ultimately comes directly out of investors’ pockets.

IM collusion and “banging the close”

Current allegations against the traders involved in the scandal are focused on two main areas:

Collusion by sharing proprietary information on pending client orders ahead of the 4 p.m. fix. This information sharing was allegedly done through instant-message groups - with catchy names such as “The Cartel,” “The Mafia,” and “The Bandits’ Club” - that were accessible only to a few senior traders at banks who are the most active in the forex market.

“Banging the close,” which refers to aggressive buying or selling of currencies in the 60-second “fix” window, using client orders stockpiled by traders in the period leading up to 4 p.m.

These practices are analogous to front running and high closing in stock markets, which attract stiff penalties if a market participant is caught in the act. This is not the case in the largely unregulated forex market, especially the $2-trillion per day spot forex market. Buying and selling of currencies for immediate delivery is not considered an investment product, and therefore is not subject to the rules and regulations that govern most financial products.

An example

Let’s say a trader at the London branch of a large bank receives an order at 3:45 pm from a U.S. multinational to sell 1 billion euros in exchange for dollars at the 4 pm fix. The exchange rate at 3:45 p.m. is EUR 1 = USD 1.4000.

As an order of that size could well move the market and put downward pressure on the euro, the trader can “front run” this trade and use the information to his own advantage. He therefore establishes a sizeable trading position of 250 million euros, which he sells at an exchange rate of EUR 1 = USD 1.3995.

Since the trader now has a short euro, long dollar position, it is in his interest to ensure that the euro moves lower, so that he can close out his short position at a cheaper price and pocket the difference. He therefore spreads the word among other traders that he has a large client order to sell euros, the implication being that he will be attempting to force the euro lower.

At 30 seconds to 4 p.m., the trader and his/her counterparts at other banks - who presumably have also stockpiled their “sell euro” client orders - unleash a wave of selling in the euro, which results in the benchmark rate being set at EUR 1 = 1.3975. The trader closes out his/her trading position by buying back euros at 1.3975, netting a cool $500,000 in the process. Not bad for a few minutes work!

The U.S. multinational that had put in the initial order loses out by getting a lower price for its euros than it would have if there had been no collusion. Let’s say for the sake of argument that the “fix” - if set fairly and not artificially - would have been at a level of EUR 1 = USD1.3990. As each move of one “pip” translates to $100,000 for an order of this size, that 15-pip adverse move in the euro (i.e. 1.3975, rather than 1.3990), ended up costing the U.S. company $1.5 million.

Worth the risks

Odd though it may seem, the “front running” demonstrated in this example is not illegal in forex markets. The rationale for this permissiveness is based on the size of the forex markets, to wit, that it is so large that it is nearly impossible for a trader or group of traders to move currency rates in a desired direction. But what the authorities frown upon is collusion and obvious price manipulation.

If the trader does not resort to collusion, he does run some risks when initiating his 250-million short euro position, specifically the likelihood that the euro may spike in the 15 minutes left before the 4 p.m. fixing, or be fixed at a significantly higher level. The former could occur if there is a material development that pushes the euro higher (for example, a report showing dramatic improvement in the Greek economy, or better-than-expected growth in Europe); the latter would occur if traders have customer orders to buy euros that are collectively much larger than the trader’s 1-billion client order to sell euros.

These risks are mitigated to a great degree by traders’ sharing information ahead of the fix, and conspiring to act in a predetermined manner to drive exchange rates in one direction or to a specific level, rather than letting normal forces of supply and demand determine these rates.

Asleep at the switch

The forex scandal, coming as it does just a couple of years after the huge Libor-fixing disgrace, has led to heightened concern that regulatory authorities have been caught asleep at the switch yet again.

The Libor-fixing scandal was unearthed after some journalists detected unusual similarities in the rates supplied by banks during the 2008 financial crisis. The forex benchmark rate issue first came into the spotlight in June 2013, after Bloomberg News reported suspicious price surges around the 4 p.m. fix. Bloomberg journalists analyzed data over a two-year period and discovered that on the last trading day of the month, a sudden surge (of at least 0.2%) occurred before 4 p.m. as often as 31% of the time, followed by a quick reversal. While this phenomenon was observed for 14 currency pairs, the anomaly occurred about half the time for the most common currency pairs like the euro-dollar. Note that end-of-the-month exchange rates have added significance because they form the basis for determining month-end net asset values for funds and other financial assets.

The irony of the forex scandal is that Bank of England officials were aware of concerns about exchange rate manipulation as early as 2006. Years later, in 2012, Bank of England officials reportedly told currency traders that sharing information about pending customer orders was not improper because it would help reduce market volatility.

Growing repercussions

At least a dozen regulators - including the U.K.’s Financial Conduct Authority, the European Union, the U.S. Department of Justice, and the Swiss Competition Commission - are investigating these allegations of forex traders’ collusion and rate manipulation. More than 20 traders, some of whom were employed by the biggest banks involved in forex like Deutsche Bank (NYSE:DB), Citigroup (NYSE:C) and Barclays, have been suspended or fired as a result of internal inquiries.

With the Bank of England dragged into a second rate-manipulation scandal, the issue is seen as a stern test of Bank of England Governor Mark Carney’s leadership. Carney took the helm at the BOE in July 2013, after garnering worldwide acclaim for his adroit steering of the Canadian economy as Governor of the Bank of Canada from 2008 to mid-2013.

The Bottom Line

The rate manipulation scandal highlights the fact that despite its size and importance, the forex market remains the least regulated and most opaque of all financial markets. Like the Libor scandal, it also calls into question the wisdom of allowing rates that influence the value of trillions of dollars of assets and investments to be set by a cozy coterie of a few individuals. Potential solutions such as Germany’s proposal that forex trading be shifted to regulated exchanges come with their own set of challenges. Although none of the traders or their employers has been accused of wrongdoing in the forex scandal to date, stiff penalties may be in store for the worst offenders. While the balance sheets of the biggest forex players in the interbank market will be able to easily absorb these fines, the damage inflicted by these scandals on investors’ confidence in fair and transparent markets may be longer lasting.