Trading is changing in the minutes before currency benchmarks are set as regulators shine a light for the first time on alleged misconduct in the $5.3 trillion-a-day foreign-exchange market.
Sudden fluctuations in exchange rates ahead of the 4 p.m. London close, cited by market participants as indicative of potential manipulation, have become rarer and less pronounced in the past six months, according to data compiled by Bloomberg.
The shift reflects an industry in flux as authorities on three continents examine instant messages and phone records for evidence of collusion and senior traders are suspended or fired. Banks including Citigroup Inc. and UBS AG have curbed the use of chat rooms, and some investors are shunning the WM/Reuters benchmarks set at the close that are now the subject of probes.
“Wherever we are in a position to do so, we are moving away from trading at the WM/Reuters rates,” said Jasper Steger, treasurer at Dutch fund manager MN Services NV based in The Hague, which manages about 85 billion euros ($116 billion). “Clients see the news reports and want to know what we are doing about it. We need to respond to that.”
Investigators from Switzerland to Hong Kong are probing currency markets after Bloomberg News reported in June that dealers said they shared information on client orders with counterparts at other banks and timed trades to influence prices at the close. The 4 p.m. benchmark, known as the fix, is used by managers of $3.6 trillion of funds that track international indexes. At the center of the inquiries are instant-message groups with names such as “The Cartel,” “The Bandits’ Club” and “The Mafia.”
The probes come at a time when currency dealers are battling shrinking margins and increased competition. While trading reached a record high last year, the banks’ share of that business is being eaten into by institutional investors, hedge funds and high-frequency trading firms.
The biggest dealers had a 39 percent market share last year, down from 53 percent in 2004 and 63 percent in 1998, according to Bank for International Settlements data. Years of record-low interest rates are squeezing profits, which are also being eroded by the rise of electronic-trading platforms.
Bloomberg News first reported in August that trading patterns in the 30 minutes before the fix on the last working day of the month, when funds that track indexes typically transact most, exhibited one-way price surges. Spikes of at least 0.2 percent for 14 currency pairs were found 31 percent of the time over a two-year period from July 2011 through June 2013, data compiled by Bloomberg show. To qualify, the moves had to be one of the three largest of the day for that pair and have reversed by at least 50 percent within four hours.
Since June, the surges have been less frequent. From July through the end of December, qualifying jumps on the last working day of the month occurred only 10 percent of the time. For several currency pairs, including U.S. dollar to Japanese yen and U.S. dollar to Canadian dollar, spikes have disappeared altogether. In dollar-euro, the most widely traded pair, the frequency has fallen to 17 percent from 50 percent on the same six days in 2012.
Some spikes ahead of the fix are inevitable because a large volume of business at that time comes from tracker funds balancing portfolios to reflect stock-market movements, according to two senior currency traders who asked not to be named while an investigation is active.
Even so, such frequent and dramatic moves are unexpected and may occur because dealers are sharing information about what trades will be made during the window when the benchmark rates are set, according to Rosa Abrantes-Metz, a professor at New York University’s Stern School of Business who advises the European Commission and the World Bank on market rigging.
One possible reason for the decline is that traders are now executing large orders over a longer period of time using computer algorithms, rather than pushing them through at the fix manually, according to David Woolcock, chairman of the committee for professionalism at ACI, a Paris-based group representing 13,000 currency and money-market traders in 60 countries.
Diminished price fluctuation also may be contributing to the drop, according to one former trader who asked not to be identified. Deutsche Bank AG’s Currency Volatility Index, which measures the market’s expectation of future price swings for nine currency pairs, slumped to 8.36 percent on Dec. 31 from 10.61 percent on June 28. That’s a 21 percent drop. It was as high as 15.8 percent in September 2011.
For Abrantes-Metz, the changes have more to do with the behavior of markets.
“There is strong evidence to suggest that when news becomes public about something wrong in a market, such as collusion, there is immediate and often permanent change in market outcomes,” said Abrantes-Metz, whose 2008 paper “Libor Manipulation” helped spark a global probe of attempted rigging of interbank borrowing rates. “What you are finding seems to be consistent with this evidence.”
If it lasts, lower volatility at the fix could reduce transaction costs for tracker funds that use WM/Reuters rates. Trading at the close instead of a daily weighted average could erase 5 percentage points of performance annually for a fund tracking the MSCI World Index, according to a May 2010 report by Paul Aston, then an analyst at Morgan Stanley.
WM/Reuters rates, based on a median of trades during a one-minute period beginning 30 seconds before 4 p.m., are collected and distributed by World Markets Co., a unit of Boston-based State Street Corp., and Thomson Reuters Corp. Bloomberg LP, the parent company of Bloomberg News, competes with Thomson Reuters in providing news, information and currency-trading systems.
“WM continually reviews recommended methodology and policies in order to ensure that industry best practices are considered,” State Street said in a statement.
Thomson Reuters “would co-operate with any inquiries by regulators” into market manipulation and “provide information if asked,” the New York-based company said in a statement. It supports “any measures that create more robust benchmarks.”
The U.S. Department of Justice, the U.K.’s Financial Conduct Authority and the Swiss Competition Commission are among agencies that began formal probes into currency rate-rigging in October. Since then, at least 17 traders have been fired, suspended or placed on leave at firms including Deutsche Bank, JPMorgan Chase & Co. and HSBC Holdings Plc.
That’s been disruptive, according to a fund manager at one of the world’s five largest investment firms, who said there was a lack of experience in the market now that many chief dealers aren’t around. While pricing and liquidity haven’t been affected, the individuals executing trades might not be as proficient in managing risk, said the manager, who asked not to be named because of the probes.
Banks also are overhauling rules governing how traders execute client orders and communicate ahead of benchmarks. Goldman Sachs Group Inc., Royal Bank of Scotland Group Plc, UBS, JPMorgan and Citigroup banned employees from taking part in chat rooms involving other banks. The move put an end to the multi-dealer conversations used by traders to agree on transactions, share gossip and exchange tips on business flows.
Spokesmen for HSBC, Citigroup, Deutsche Bank, JPMorgan, Barclays, UBS and Goldman Sachs declined to comment.
While traders are prohibited from discussing specific client orders with counterparts at other firms, they have in the past been free to talk about potential transactions that may move prices -- known in the market as providing “color.”
Two bank employees interviewed by Bloomberg News said the probes had created such a sense of paranoia about what they could and couldn’t discuss that they were now avoiding having any discussions about client flows. That caution has spread to conversations traders have with their clients, the dealers said.
“Several of the banks we deal with are telling us, ‘We’re not going to show our book anymore, we’re not in a position to do that while there are investigations going on,’” said MN Services’ Steger. “They’re disclosing less information about upcoming flows at the fix.”
Foreign-exchange sales employees at RBS in London have written to clients pledging that traders at the bank won’t share details of their orders or use them to make proprietary bets, according to an Oct. 23 e-mail read to Bloomberg News.
“We are currently considering processes around the benchmark service,” Sarah Small, a spokeswoman at RBS, said in a statement. “The e-mail does not reflect final policy and we have clarified this with our clients.”
Some investors are taking the investigations as a cue to move away from trading at the WM/Reuters rates. Seattle-based Russell Investments Group, which buys and sells currencies for its own funds and other institutional investors, is advising its clients to avoid the fix where possible, according to Michael DuCharme, head of foreign-exchange strategy.
Steger at MN Services, which trades about 200 billion euros of currency a year, said his firm no longer was using benchmarks when buying and selling securities. The rates were still suitable for amending rolling currency hedges, he said.
At a meeting of the ACI last week in London, senior traders and investors said they detected a drop in business being transacted at the fix, according to Woolcock.
Investors aren’t placing as many orders, and banks are “probably a little bit more wary at the moment of taking very large orders for the fix,” he said.
Unlike sales of stocks and bonds, which are regulated by government agencies, spot foreign exchange -- the buying and selling for immediate delivery as opposed to some future date -- isn’t considered an investment product and isn’t subject to specific rules. Instead, banks sign on to voluntary codes of conduct, which outline best practices and standards.
At the November meeting of the Federal Reserve Bank of New York’s foreign-exchange committee, bank executives said the probe probably would result in changes in the way traders are taught to handle client orders. ACI also is looking into amending its code of conduct to include guidelines for trading around fixes, Woolcock said.
For some money managers, the changes in practices are too little, too late.
“I find it shocking that some professional investors seem uninterested in this matter,” Russell Investments’ DuCharme said in a telephone interview. “If one knows there’s a problem, persisting in the behavior is surprising, especially if these investors have a fiduciary duty to act in their clients’ best interests.”