No matter how bright the lights on a street are, there are always those places that remain dark and inaccessible, where shady characters meet to transact their crooked deals. And the financial markets are no different.
While most exchanges are bathed in light from plenty of regulatory flood lamps, the FOREX markets remain so poorly scrutinized that devious characters ranging from individual rogue traders to investment dealers to gigantic trading houses have been transacting illicit deals for years.
Even while the Libor rate fixing scandal is still fresh on our minds, Bloomberg has revealed evidence of new trading “patterns [that] look like an attempt by currency dealers to manipulate the rates, distorting the value of trillions of dollars of investments” as “dealers shared information and used client orders to move the rates to boost trading profit.”
Given the notoriously loose regulation of currency markets, are currency trades no longer safe?
They Left Their Shoeprints
These recently discovered illicit currency trades leave behind a distinctive trading pattern, which Bloomberg describes as “a sudden surge minutes before 4 p.m. in London on the last trading day of the month, followed by a quick reversal”. They have been occurring with such regularity – from 31% to 50% of the time over the past two years – that they cannot be attributed to normal trading activity.
The timing of these currency spikes is another tell-tale sign of conspired manipulation among dealers. “The recurring spikes,” Bloomberg discerned, “take place at the same time financial benchmarks … are set”, known as the WM/Reuters Closing Spot Rates.
As described by its designers, The WM Company, this benchmarking service “collects, validates and publishes Closing Forward Rates, Closing NDF Rates, hourly Intraday Spot rates, hourly Intraday Forward rates, hourly Intraday NDF rates, and Historical Data as well as the Closing Spot Rates.”
How important and influential have these currency benchmark rates become? They have been “adopted by major stock market indices, the Financial Times and investment clients” as a “standard for the valuation of global portfolios”.
These WM/Reuters currency rates are the foundation upon which numerous banks and investment houses base the values of many of their indices and funds. “Benchmark providers such as FTSE Group and MSCI Inc base daily valuations of indexes spanning different currencies on the 4 p.m. WM/Reuters rates...Index funds, which track global indexes such as the MSCI World Index, also trade at the rates to reduce tracking error.” They even “determine what many pension funds and money managers pay for their foreign exchange,” Bloomberg informs.
That 4 p.m. reading – known as the “London Close” and the “WM/Reuters Fix” – is so important to banks and currency dealers that they “may be executing a large number of trades over a short period to move the rate to their advantage, a practice known as banging the close”. Why? “Because the 4 p.m. benchmark determines how much profit dealers make on the positions they’ve taken in the preceding hour.”
Michael DuCharme, foreign exchange chief at Russell Investments of Seattle, confirms to Bloomberg that the pattern is all too out of place to be attributable to just normal trading activity. “We see enormous spikes,” he reports. “Then, shortly after 4 p.m., it just reverts back to what seems to have been the market rate. It adds to the suspicion that things aren’t right.”
When Tools Become Weapons
It’s the way the WM/Reuters readings are taken that gives these dealers the ability to manipulate the rates.
The WM/Reuters rates are published hourly for 160 currencies and every 30 minutes for the 21 most heavily traded monies. Most readings are an average of each currency’s value over a one minute span, running from 30 seconds before the labeled time to 30 seconds after it.
Anyone wishing to bump up the exchange rate would simply wait until 30 seconds before the top of each hour and flood the exchange with orders within that 60 second window for the reading. Since the average rate for the entire hour preceding it is based on just those final 60 seconds, the dealers now get a lot more money for the entire preceding hour’s trades, even if those preceding trades were filled at lower prices. That 60-second average is what dealers quote back to their clients, and they simply pocket the difference for themselves.
James Cochrane, a former foreign-exchange salesman at Deutsche Bank who has worked at Thomson Reuters, explains, “What started out as a simple benchmarking tool has become something incredibly large,” currently estimated at $4.7 trillion each day. “Every basis point is worth a tremendous amount of money… And there’s no regulatory body looking after it,” Cochrane scorns.
A recent survey shows that some 50% of currency trades are executed by just four large banks: Deutsche Bank AG (NYSE: DB) at 15%, Citigroup Inc (NYSE: C) at just under 15%, and Barclays (NYSE: BCS) and UBS (NYSE: UBS) at 10% each. “All four banks declined to comment” to Bloomberg.
The banks have also been accused of comparing clients’ FOREX orders prior to execution. It is suspected that during the hour between readings, they coordinate trades and even “make their own additional bets”, according to five dealers interviewed by Bloomberg.
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Caution with Currencies
The manipulation of the WM/Reuters rates by banks and currency dealers certainly infuriates many self-directed currency investors. But it is likely not going to dissuade them from trading FOREX, nor should it. There are steps currency traders can take to mitigate any possible adverse affects on their portfolios.
First, now that we know about these hourly and half-hourly times when spikes can be expected, try to direct your currency buys away from those times, and maybe even direct your sells at those times. Monitor your favorite currency pairs to see if you can spot those spikes yourself and maybe even use them to your advantage.
Second, avoid those currencies that trade in low volume, as their lack of liquidity can increase the bid/ask spread substantially, causing you to pay too much when you buy and collect too little when you sell.
Third, listen carefully to the U.S. Federal Reserve’s announcement on September 18th for more direction over any reduction to the Fed’s monthly bond purchases. Currencies all over the world, especially in emerging markets such as Turkey and India, have been reeling over the past couple of months – and even more so over the past couple of weeks – on the speculation of a stimulus reduction. Yet once the Fed makes its plans clear, many currency traders expect something of a rebound rally in emerging market currencies, as well as U.S. bonds.
Just don’t expect any such rallies to last for long. Even if U.S. bond tapering is slow getting started, bond purchases will be phased out eventually, strengthening the USD, weakening emerging market currencies, and felling all bonds – American and foreign.
Extra Nugget: Current Account Deficits
Here’s an interesting conundrum for currency traders, centering on a nation’s current account balance. Typically, a nation with a budget deficit is heavily reliant on foreign investments to help fill its budget gap and finance its expenses.
But as talk of stimulus reductions in the U.S. has been strengthening the USD, investors have been moving their deposits out of foreign currencies into the USD, leaving nations with large budget deficits with little hope of funding their budget gaps.
In turn, this lack of foreign investment leaves them unable to finance economic growth, resulting in stagnation or even recession. Since holding a nation’s currency is an investment in the nation itself, you might want to stay clear of those with unmanageable deficits, because they just won’t grow, and neither will their money.
On a list ranking nations by the size of their current account deficits, the largest deficits in reverse order from 10th place to 2nd place are: Egypt, Japan, Italy, Hong Kong, Spain, Turkey, France, India, and the UK.
Want to know what nation holds the largest budget deficit? The U.S. And therein lies the conundrum, since budget deficits imply insufficient inflows and not enough income to keep the nation moving ahead. So technically, the USD should be hurting as are the currencies of other nations with large account deficits.
What is helping the USD is its status as the world’s reserve currency. And traders are willing to overlook account deficits if they perceive economic growth ahead.
On the other side of the line, the top 10 nations with current account surpluses could make fine currency investments. In reverse order these are: Netherlands, Nigeria, Norway, Qatar, Kuwait, United Arab Emirates, China, Russia, Germany, and first place Saudi Arabia.
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