Barometer of Fear

by Alexis; Stenfors

  The WM/Reuters 4 p.m. fix rate for British pounds against US dollars fixes at 1.6003.

  A client naturally hopes – even expects – that their foreign exchange orders will be executed in a competitive market. Given a turnover of $5.1 trillion per day, it would be difficult to think otherwise. However, during the crucial minutes before and after 4 p.m., HSBC accounted for 51 per cent of turnover in the market in the currency pair above. If one bank is able to exercise such power, even if it is just for a few minutes, it gives the bank a significant advantage in influencing the price in a direction that is amenable to the bank rather than the client.

  According to the UK financial regulator,11 HSBC had a financial motive to manipulate the market, the profit from doing so amounting to $162,000. A large sum, but small when considering that this was only one bank and one currency pair on one specific day. The losses obviously did not disappear into thin air. Instead, they ended up elsewhere – with HSBC’s clients or others involved in the foreign exchange market. Given the vast number of client orders in the FX market, it would be difficult to determine how much has been transferred from clients and other market participants to the large banks systematically in this way. Like any amount in the global foreign exchange market, it would, however, probably be quite substantial.

  Thus, the FX market has never consisted of purely rational traders. Even in the largest market on earth, psychology has always mattered. While this makes the FX market more ‘human’ than many outsiders might think, it also creates an ethical problem. Unless there are rules and enforcement mechanisms for what kind of behaviour is right and what kind of behaviour is wrong, the market can evolve into a culture in which almost any behaviour is tolerated, perhaps even encouraged.

  ‘We self-detected this matter and reported it to the US Department of Justice and other authorities. Our actions demonstrate our determination to pursue a policy of zero tolerance for misconduct and a desire to promote the right culture in our industry.’ This is what UBS Chairman Axel Weber and CEO Sergio Ermotti said in a joint press release after regulators subjected UBS to a large fine for manipulating the FX market. ‘The conduct of a small number of employees was unacceptable and we have taken appropriate disciplinary actions.’12

  The official statement by UBS suggested that it was the bank which had discovered that the FX spot desk had gone rogue. Despite it being one of the most prominent and vocal desks in any dealing room (FX spot dealers can be loud sometimes), up until this point ‘the bank’ had not overheard any of their conversations and had, so it claimed, been totally unaware that the behaviour of its dealers had transgressed the morals, norms and conventions of the market and of society as a whole.

  I have never worked for UBS and therefore cannot comment on the culture of its FX spot desk. However, having done trades worth trillions of US dollars with UBS over the years, and having sat within metres of various FX spot desks for 15 years, the idea that the issue concerned only a few traders seems far-fetched. A scandal of such magnitude rarely evolves in such isolation.

  A trading desk is not an island within a bank. The personal space in a dealing room is minuscule, which means that even in a vast dealing room you sit fairly close to everyone else. The FX spot desk tends to be located very close to the FX options and FX swap desks. This is logical, because even though the traders focus on different types of contracts, they all relate to foreign exchange. The FX spot desk focuses on agreements to buy or sell currencies now (generally in two business days’ time, to be precise). The FX options desk, often located next to the FX spot desk, trades derivatives that give the buyer the right, but not the obligation, to buy or sell currencies at a specific price at some time in the future. The FX swap desk deals with agreements to buy or sell currencies in the future (FX forwards), as well as combinations of FX spot and FX forward transactions done simultaneously, but in the opposite direction (FX swaps). The FX swap desk tends to be located close to the money market or interest rate swap desks, or maybe even integrated into a STIRT desk trading LIBOR-indexed derivatives. Bond trading desks might also be nearby, whereas commodities and equities are situated further away. The seating arrangement in a dealing room is as meticulously organised as a wedding party. And as at weddings, people tend to mingle, switch seats, go out to smoke, powder their noses in the washroom, or listen to rumours told elsewhere.

  Trading desks are also connected to trading desks at other banks. Traders trade with each other, talk to each other, learn from each other. Traders constantly move: in, up or out. The layout of the dealing rooms in the major banks is very similar, regardless of where they are located. It might take traders some time to familiarise themselves with the IT systems and to get to know new people, but everything else follows a logical pattern. Most dealing rooms have around five clocks on one wall, showing the time in a selection of international financial centres such as Sydney, Hong Kong, Tokyo, London and New York. Most dealing rooms lack vast collections of books, magazines and newspapers containing yesterday’s news. Instead, computer screens ensure that the focus is on current and future news. Even though some trading desks can be loud, carpets and a trend towards electronic trading act to reduce the noise levels. Traders are expected to start performing quickly. As in competitive team sports, you are not given a full season to acclimatise to a new bank and a new dealing room; rather, you must find your feet in a matter of weeks. Unless you are a trainee, you are expected to have received your ‘training’ elsewhere.

  There is no official educational background or diploma required to become an FX trader in a bank. Although a degree in finance, economics or another quantitative subject increasingly tends to be desired (and is now often standard), numerous FX traders I used to work with or against had come in via other routes. They had spent their youth studying medieval history or biology or did not go to university at all. Many traders came in from secondary school, the back office, the army or the rugby club. If trading is difficult to learn, it is even more difficult to teach. Diversity is therefore natural.

  There is, however, one kind of foreign exchange trading certificate or diploma that has been around for years. Since 1975, the International Code of Conduct and Practice for the Financial Markets (or simply the Model Code) has worked as an industry standard for the global FX and money markets. It is published by the ACI (more commonly known as Forex), which, since 1955, has acted as the trade organisation for banks and central bank dealers in the FX and money markets around the world. Forex also issues ‘Dealing Certificates’ following an exam process. The following question appeared in the Forex Association London Diploma exam in June 1995:

  You have a position, long of USD [US Dollars] against GBP [British pounds]. The market has moved your way and is being quoted 1.6085–1.6095. A bank calls for a cable [British pounds against US dollars] price and you are thinking of closing your position. Which of these prices would you quote?

  a) 1.6085–95

  b) 1.6080–90

  c) 1.6088–98

  d) 1.6083–93

  The question is directed at a potential FX spot market maker (not a client of the bank). To answer it, you first need to take into account that you are ‘long’ US dollars, which automatically means that you are ‘short’ British pounds. If you are thinking about closing your position, you therefore need to sell US dollars and buy British pounds. (You also need to know that the currency pair is quoted in terms of how many dollars can be bought or sold for one pound, rather than how many pounds can be bought or sold for one dollar.) Because you are the market maker, you want to tempt the other bank to deal at your price, while quoting a price that is as beneficial as possible to you. If you opt for the same quote as the rest of the market, i.e. 1.6085–95, your quote is not tempting enough. If you go with 1.6080–90 or 1.6083–93, you show the other bank that you are keen to sell British pounds for fewer US dollars than the rest of the market. However, you want to show the opposite interest: that you are prepared to pay more dollars for your pounds. T
he correct answer is therefore 1.6088–98.

  Although a real trading scenario would include additional aspects that ought to be taken into account when quoting a price, the question captures one element of market making very well: market makers do not always want to ‘win’ a trade. Sometimes, the status quo can be good, which is why acting like a chameleon and mimicking the others by quoting 1.6085–95 could be an option for a trader who is not thinking about closing their position.

  However, the question also contains an oddity. Why not quote, say, 1.6088–96 or 1.6088–99? Why do all four possible answers contain different prices, but exactly the same bid–offer spread? The figures 85–95, 80–90, 88–98 and 83–93 all represent ten ‘pips’. Why ten pips and not eight, nine or eleven? More importantly, perhaps, does the fourth decimal really matter? Well, currently, the average daily turnover in the global FX spot market for British pounds against US dollars stands at around £175 billion.13 One pip represents $17,500,000 per day. Assuming 252 trading days per year, this figure becomes $4,410,000,000. Expanding the calculation exercise to other currency pairs and types of FX contracts would yield a phenomenally large amount. Even the slightest change in the bid–offer spread matters. On balance, a wider spread is good for market makers (banks) and a narrower spread is good for market takers (everybody else).

  The phenomenon that prices, or bid–offer spreads, often tend to cluster around numbers ending with 0 or 5 more frequently than, say, 7 or 8 is referred to as the ‘round number effect’, whereby human beings put greater emphasis on digits and numbers that are easier to process. Given the numerical system we are used to, ten – or multiples of ten – is much easier to handle than nine or eleven. This observation has also been shown to be prevalent in the FX market.14 A psychological explanation for this kind of behaviour might lie in the desire to look for approximate ‘anchors’ when exact precision might be difficult.15

  Another theory explaining such behaviour is the ‘price resolution hypothesis’. Some researchers argue, plausibly, that volatile markets force market makers to form some kind of grid, or price matrix, in their brains.16 It is simply too complicated and time-consuming to think about which bid–offer spread is appropriate each time you quote a price. The market is too fast and there is too much to think about. Therefore, market makers follow a self-imposed pattern in order to quote and transact faster.

  The third option is that there is some kind of conspiracy.

  ***

  When HSBC was fined by the FCA in the previous example, the regulator pointed out that manipulative practices were not confined to HSBC alone. Confidential information was shared with other banks about the clients and their identities; these clients included central banks, large corporates, pension funds and hedge funds. It was often a team effort, involving traders at banks that ought to be competing with each other.

  Judging by some of the traders’ comments in the chatroom after 4 o’clock, released by the regulators, the tactics worked well for the banks involved in the conspiracy: ‘Nice work gents … I don my hat’, ‘Hooray nice team work’, ‘Bravo … cudnt been better’, ‘Have that my son … v nice mate’, ‘Dont mess with our ccy [currency]’ and ‘There you go … go early, move it, hold it, push it’. The HSBC trader also sounded pleased: ‘Loved that mate … worked lovely … pity we couldn’t get it below the 00 [1.6000]’; ‘We need a few more of those for me to get back on track this month.’

  Sometimes, secret code words were used instead of real names. In fact, not only did traders use secret code words and nicknames for individual clients and other traders in the market, nicknames such as ‘The Bandits Club, ‘The 3 Musketeers’, ‘1 Team, 1 Dream’, ‘A Co-operative’, ‘The A-team’, ‘Sterling Lads’ or ‘The Mafia’ could also be applied to various teams of foreign exchange traders from different banks specialising in a particular currency pair. For instance, a group called ‘The Cartel’ had members from Barclays, Citi, J. P. Morgan, RBS and UBS. Membership in the electronic chatroom was by invitation only, and required particular expertise in euros against US dollars. Information sharing came with benefits, of course, and when a Barclays trader desperately requested to join the club in 2011, existing members pondered whether he ‘would add value’. He received a one-month trial membership, but was told ‘mess this up and sleep with one eye open at night’. (The Barclays trader ultimately passed the test.)17

  In other words, it could also be that banks secretly agreed upon which bid–offer spreads they promise to quote to each other in the FX market – and to their clients. In the stock market, such behaviour would be problematic. For instance, in the US, Section 1 of the Sherman Anti-Trust Act prohibits contracts, combinations and conspiracies in restraint of trade. These can refer to spoken or unspoken agreements. A potential conspiracy with regards to bid–offer spreads in financial markets was brought to light during the 1990s. Two academics found that market makers on the NASDAQ stock exchange tended to quote stocks in increments of one-quarter and one-half dollars rather than, say, three-eighths or five-eighths of a dollar.18 This prompted the question as to whether they tacitly colluded to maintain wide bid–offer spreads. The scandal resulted in a regulatory investigation, significant financial settlements and new rules relating to transparency.19 Following the reforms, savers and investors who bought and sold stocks on NASDAQ were seen as winners. The archives from that scandal reveal that market makers generally treated the convention as a ‘pricing ethic, tradition, or professional norm that other market makers were expected to follow’.20 Some traders even testified that they had been trained by senior staff to follow this convention. A failure to comply with the ‘unwritten rules’ sometimes led to harassment or a refusal to trade by other market makers. In the end, the SEC and the Department of Justice decided not to refer to the convention as ‘an express agreement reached among all of the market makers in a smoke-filled room’. Instead, the behaviour failings were seen as a convention that ‘had anticompetitive consequences and was harmful to the interests of investors’.21

  In 2014, the European Commission fined a handful of market makers for agreeing:

  to quote to all third parties wider, fixed bid–offer spreads on certain categories of short-term over-the-counter Swiss franc interest rate derivatives, whilst maintaining narrower spreads for trades amongst themselves. The aim of the agreement was to lower the parties’ own transaction costs and maintain liquidity between them whilst seeking to impose wider spreads on third parties. Another objective of the collusion was to prevent other market players from competing on the same terms as these four major players in the Swiss franc derivatives market.

  In this case, the collective behaviour of RBS, UBS, J. P. Morgan and Crédit Suisse was classified as a cartel. Joaquín Almunia, Commission Vice-President in charge of competition policy, said in the press release that:

  unlike in previous cartels we found in the financial sector, this one did not involve any collusion on a benchmark [such as LIBOR]. Rather, the four banks agreed on an element of the price of certain financial derivatives. This way, the banks involved could flout the market at their competitors’ expense. Cartels in the financial sector, whatever form they take, will not be tolerated.22

  In competition law, therefore, the bid–offer spread is seen as a ‘price component’ or ‘an element of a price’ – the equivalent of a bicycle chain or computer keyboard, for example. It is illegal for a group of computer manufacturers to conspire and fix prices for their PCs, as it is for their keyboards.

  Legal scholars, therefore, seem to agree that if companies stand in competition with each other (such as computer manufacturers or banks), they should not collude to agree upon a predefined price component or bid–offer spread. Instead, it should be determined competitively. In 2015, the Bank of England, the UK Treasury and the FCA published a joint assessment of the financial markets following the manipulation scandals. In the Fair and Effective Markets Review, the message is clear; it states that ‘no distinction is made b
etween wholesale and retail markets, or between FICC [fixed income, currencies and commodities] and non-FICC markets’ with regards to UK and EU competition law. The report specifically stressed that it ‘also applies to financial markets, including FX spot, which may currently fall outside of the direct scope of financial market regulation’.23

  In fact, a class action has already been filed in the US in which the claimants (a long list of clients in the FX market) allege that the defendants conspired to fix bid–offer spreads for various currency pairs in the FX spot market. Such collusive practices, it is argued, have acted to deprive their clients of active price competition, resulting in higher prices. Moreover, given that FX spot prices are often used as components in a range of other FX instruments, clients entering into, for instance, FX forward or FX futures contracts would also have been harmed. The defendants in this lawsuit are familiar names: Bank of America, Bank of Tokyo-Mitsubishi, Barclays, BNP, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, RBC, RBS, Société Générale, Standard Chartered and UBS.24

  ***

  At the time traders were sitting the Forex exam in 1995, did traders in the FX spot market for British pounds against US dollars actually quote each other ten pips? I cannot remember, but presumably they did. Whoever wrote the exam paper must either have been a dealer or had checked with a market maker that the question was realistic enough. Bid–offer spreads in the FX and money markets not only tend to cluster around a few digits, but are also remarkably ‘sticky’ over time. If ‘10’ is the prevailing spread, it often remains unchanged for weeks, months or sometimes even years. In that sense, some price components in the FX markets are like matrices, which are ‘recalibrated’ over time. However, it is not an automatic process. It always involves human behaviour. And humans tend to interact with each other. From the outside, the FX market might seem too large, liquid, efficient and competitive to be of interest to antitrust authorities. Yet many aspects point towards the complete opposite: a market that is concentrated among very few traders who habitually talk to each other.