A mounting investigation into the foreign exchange market could be the next black eye for the financial industry.
- By Jamila TrindleJamila Trindle is a senior reporter who covers finance, economics and business where they intersect with national security and foreign policy. Her beat spans everything from the economic underpinnings of conflict to sanctions, corruption and terror finance. Before coming to Foreign Policy magazine, Jamila reported for the Wall Street Journal’s Washington bureau, covering financial regulation and economics. She has also worked as a foreign correspondent in China, Indonesia and Turkey as a freelancer for NPR, Marketplace, The Guardian and others. She moved back to the U.S. to cover the post-crisis economy for PBS in 2009.
At Wall Street’s annual trade conference this week, the common refrain for addressing the industry’s marred public image was "stay out of the newspaper." So much for that. Many of the world’s biggest banks are now caught up in another sprawling inquiry that is likely to keep them in the headlines for months, and possibly years, to come.
J.P. Morgan, HSBC, and Barclays have all said they’re under investigation by authorities looking into possible collusion to manipulate foreign exchange markets. The Financial Times reported Wednesday that 15 banks, including Citigroup, Morgan Stanley, and UBS, have also received requests to turn over information to British regulators, who are among the seven authorities involved in the probe. U.S. authorities are also involved.
"The manipulation we’ve seen so far may just be the tip of the iceberg," U.S. Attorney General Eric H. Holder told the New York Times. "We’ve recognized that this is potentially an extremely consequential investigation."
One of the consequences could be a re-examination of how the foreign exchange market works. Right now, it is an opaque market controlled by the world’s biggest banks without a lot of regulatory oversight. After the financial crisis, policymakers decided certain parts of the financial system should be more transparent, such as previously dark derivatives markets. But regulators decided to leave the foreign exchange market alone, as it was it was seen as functioning well during the chaos of the financial crisis.
If the inquiries are fruitful, banks could be facing another embarrassing, expensive scandal. The global foreign exchange market is worth trillions of dollars, so any manipulation could affect people all around the world. That means banks could face private lawsuits, in addition to charges or fines from authorities in different countries.
The mounting investigation is the latest in a series of regulatory inquiries into benchmarks that are set by a relatively small group of bankers, but affect wide swaths of the financial system. Regulators have already looked at benchmarks that underpin markets in everything from gold to interest rates.
Benchmarks were once a little-considered cog in the financial system, until the banks started paying record-setting penalties to settle the accusations that they were manipulating these rates. UBS paid $1.5 billion, admitted to manipulating the London Interbank Offered Rate (Libor), and two of the bank’s former traders are facing criminal charges. Libor is supposed to be the interest rate at which the 16 biggest banks lend money to each other. Loans and financial contracts all over the world — from large-scale contracts to mortgages — are tied to that rate. But regulators discovered that traders often submitted false rates in order to benefit their positions or make the bank’s credit look better than it was.
Chat room conversations filled with emoticons and offers of champagne made it clear the Libor and other interest rate benchmarks were widely being manipulated. For instance, on March 3, 2010, a Royal Bank of Scotland trader asked the guy who submits the bank’s rate to the benchmark-setter if he could change his submission for "a mutual friend." "If u cud see ur way to a small drop there might be a steak in it for ya," the trader said to the submitter, according to a complaint filed by regulators. RBS has already paid over $600 million to settle charges related to that complaint.
And this could just be the beginning because benchmarks are used in lots of different markets — including metals, currencies, and oil — as a way of gauging a fair price when transactions are private. For instance, if you want to buy a share of a publicly traded stock, you can look at a stock exchange and see what the current price is for the company’s stock that you want to buy. With currencies, for example, it’s not nearly that simple. Currencies are traded in banks all over the world. So, if you want to trade in $500 million for euros, you could call the 10 biggest banks and ask them to quote you a price or you could use a benchmark, where a middleman does the work for you. A company or an organization takes a survey of prices from different bankers or brokers and then takes the average, so that as a buyer you can have a better idea of what’s a good price.
The problem is that the prices are often being reported by a relatively small group of people who stand to benefit if the price moves one way or the other. Traders could also benefit by moving a rate higher ahead of a large customer order they know will be pegged to a particular benchmark. But it’s not just about moving the benchmark higher. Through side bets using financial contracts called derivatives, a very small move one way or the other can be magnified into a large pay out.
And so we’ve got a new, fast-spreading investigation ramping up into currency benchmarks. The Libor scandal rocked the banking world — banks have been fined billions of dollars, executives have resigned. There’s not telling how big of a mess this new probe could uncover. Among other things, regulators are looking at a group of senior foreign exchange traders who were widely known amongst other traders as "The Cartel," Bloomberg reported in October. Regulators are focused in particular on one benchmark which is compiled by the WM Company and Thompson Reuters. The WM Company "currently collects, validates and publishes" benchmark exchange rates for all the major currencies, according to the company’s website. If authorities turn up more chatter of traders blithely manipulating these benchmarks, it will present another black eye for the industry, just as it’s trying to put the Libor scandal behind it.
Manipulation cases in the foreign exchange market could also raise questions about whether the market is properly regulated. It’s a global, decentralized market with transactions taking place in banks all over the world, but there isn’t a global regulator to oversee it.
"National regulators have oversight over national markets, but this has been a global market forever," said Richard Lyons, dean of UC Berkeley’s Haas School of Business. Lyons says that’s part of the reason the market has only seen "light touch" regulation.
U.S. regulators and policymakers considered further regulation for the foreign exchange market after the financial crisis, but concluded that it was unnecessary because most of the players in the market are banks, which are already heavily regulated.
"The market for foreign exchange transactions is one of the most transparent and liquid global trading markets," the Treasury Department said in November 2012, when it decided to exempt foreign exchange derivatives from new rules for derivatives put in place after the financial crisis. "Existing practices already help limit risk and also ensure that the market functions effectively," Treasury said in its determination.
It’s not clear that those rules would have prevented wrongdoing by individual traders, but if a raft of manipulation cases comes down, regulators may decide to revisit the idea of greater oversight.