Foreign exchange market too big to rig

Market manipulation aficionados have had a field day since the global financial crisis, but short-selling attacks in markets as diverse as equities and gold and the London interbank interest-rate fixing scandal would be put in the shade if reports that currency trading has been rorted were confirmed.

They probably won't be, however. The $US3.6 trillion foreign exchange market is too big to rig, or at least, too big to rig effectively.

The Bloomberg financial news, data and trading group broke the story midweek, with a report that Britain's new financial market regulator, The Financial Conduct Authority, was investigating the manipulation of benchmark foreign exchange rates by traders at some of the world's biggest banks.

Traders may have been rigging benchmark rates set by the benchmark manufacturer, WM/Reuters, by saving up trades and then pushing them through during the 60-second window when the benchmark rates were set, Bloomberg reported. The benchmark rates are set at regular intervals by WM/Reuters, and are used by fund managers around the world to determine the value of assets they own. They are also used as a benchmark for exchange rate settlement prices, in futures contracts, for example.

There are similarities to the allegations about currency market price-fixing and the London interbank (Libor) interest rate-fixing scandal that escalated last year, but there are also important differences.

Barclays last year became the first bank to admit that traders it employed had manipulated Libor rates, initially to boost their financial positions, and after the global crisis erupted in 2007 to present a lower and artificially more upbeat picture of Barclays' own borrowing costs, one of the prime indicators of financial stress or the lack of it.

Barclays paid fines totalling about $US430 million to British and US regulators in the middle of last year. Swiss bank UBS paid fines totalling $US1.5 billion in December, and other banks will follow before the Libor probe concludes.

Britain's FCA has confirmed that it is looking at the currency market allegations, and the world's two currency trading whales, Deutsche Bank and Citigroup, are an obvious place for it to start. Fixing the Libor rate was an easier exercise than fixing foreign exchange rates would be, however.

The Libor rate underpins inter-bank borrowing rates and through that, the pricing of debt in the markets more generally, but during the period of Libor manipulation Libor rates were being set in what was essentially a closed circuit. The rates were published by the British Bankers Association, and rather than drawing on a live market feed, they were based on information the banks themselves periodically supplied. The bankers' association has given up its role as Libor's publisher as a result of the scandal.

Foreign exchange quotes, on the other hand, are live and generated by a continual trading flow. Trading volumes are often strongest around the London exchange rate fixes that are under investigation for major currencies including the Australian dollar, but there is no arcane "off-market" price-setting mechanism to tamper with as there was in the Libor scandal. The currency fixes were "automated and anonymous," Reuters' partner in WM/Reuters, State Street Corp, said this week, and derived from "multiple execution venues," not a "solicitation process".

Trading volumes in currency markets are also immense. It's the biggest market in the world, by a country mile. Average daily turnover in the euro-US dollar market alone in October last year in Britain, the US, Singapore and Australian markets was $US916 billion. Average daily turnover in the $A-$US market in the same four countries in the same month was $US340 billion, making Australia the fourth-largest trading currency. Daily share trading on the Australian Securities Exchange by way of comparison peaked at about $7 billion before the global crisis, and was about $4.8 billion last month.

Influencing the US dollar-Euro foreign currency trade would be next to impossible, given the gigantic size of the flows. Manipulating other major currencies would be easier, but still very difficult. Australia's currency is the fourth largest by trading volumes, for example, and changes hands in amounts that top Australia's annual GDP every trading week.

In a market where prices are continually changing on massive volumes direct and relatively crude price-fixing of the kind that occurred in the arcane Libor rate-fixing market are not available, and the suggestion is that currency traders have instead manipulated currencies by loading trades into the 60-second window that opens when exchange rates are fixed by WM/Reuters. However, it is not unusual for traders to want to trade as close as possible to the rate-setting moment, and all players structure trades as adroitly as possible to try to maximise selling prices and minimise buying prices. If they succeed, it's called good execution.

Stripping suspicious trades out from normal trade execution that may be pushing exchange rates in the same direction is going to be hard to do, as well - and as the Financial Times Alphaville blog also pointed out this week, there is already a very well-funded source of forex market manipulation. It's called central bank intervention. The regulators won't be touching that.

$A's welcome fall

The Australian dollar stopped plunging and started gyrating towards the end of this week, and the Reserve Bank for one will be glad to see it. The currency fell from almost US106¢ on January 10 this year to just under US96¢ on May 31, rallied by almost US2¢ between then and June 3, and then dived again to hit a 33-month intra-day trading low of US93.26¢ last Tuesday. It rallied to US96.6¢ in overseas trading on Thursday night and slipped slightly beneath US96¢ during trading here on Friday.

The Reserve sees a $A decline and the stimulus it delivers as assisting its own cash rate cuts, and would still view the currency as overvalued at US96¢, given the way the commodity price boom has deflated in the past year. It does not want a disorderly retreat, however, and will see the recent bottom-fishing by currency traders as a welcome warning that shorting the $A is not a one-way bet.

mmaiden@fairfaxmedia.com.au