Once again, we have been informed that the world’s leading financial institutions are being investigated for price manipulation.
Hot on the heels of landmark settlements paid by leading financial institutions for manipulating the benchmark Libor interest rates, this time the target is the WM/Reuters benchmark exchange rate.
No fewer than eight banks, including Barclays and Citigroup have announced they are being investigated. The fact that so many banks are involved should not come as a surprise. It takes a concerted effort to manipulate the exchange rates of globally traded currencies. It may be relatively straightforward to move small cap equity prices in a desired direction, but to do so in large volume, high liquidity markets is near impossible for individual dealers or lone financial institutions.
The regulation of currency and fixed income markets has created a cosy network of currency dealers and brokers that know each other intimately. Ironically, the national importance of currency and fixed income markets has led regulators to impose strict conditions on market access to thwart unscrupulous traders, intent on wreaking havoc on monetary policy and trade. That very regulation seems to have spectacularly backfired. At the very least, it did nothing to avoid market manipulation.
Ethical behaviours such as fair dealing, product disclosure and duty to clients are enshrined in banks’ codes of conduct. But the subtle price distortions now under investigation are seemingly outside the scope of such codes.
Is it harder to imagine that someone actually gets hurt when exchange rates are manipulated? An equity trader exploiting inside information would be able to identify the disadvantaged market participants. Likewise, a mortgage broker failing to disclose the risk embedded in investment-linked mortgages understands who will be exposed.
That recognition of a victim is not so obvious when global benchmark exchange rates are involved. The sheer size and global dispersion of currency markets suggests small price movements will only have a very limited impact on individual market participants. Yet these minor price adjustments have enormous profit potential for the banks involved.
Of course, exchanges and regulators take a dim view on market manipulation. Undermining the integrity of the exchange/market erodes public trust in their fairness and transparency of price discovery. If that trust evaporates, markets may shut down with terrible consequences for economic growth and the economy. Not surprisingly, regulators clamp down on the culprits by imposing significant penalties.
While the recent Libor-manipulation settlements were on a scale not seen before, what kind of impact did those penalties have on the culprits? Surely the financial cost to the manipulating bank triggered the disciplining of management by shareholders?
Well, no. Subsequent earnings and profit announcements came in well beyond market expectations, leaving shareholders with little to complain about. Could it be that those settlement penalties were passed on to the banks’ customers (creditors and debtors alike) by imposing higher fees and increasing the interest spread? One should wonder how effective a penalty is in instilling future ethical behaviour if the penalty can so easily be passed on.
If financial penalties do not work to eradicate price manipulation, what hope is there for the future? Perhaps start with the benchmark pricing rule itself – a relic from trading floors past. That could do with a makeover. Following the Libor debacle and other allegations of benchmark price manipulation in commodity derivatives markets, it seems timely to remove the opportunity.
Professor Paul Kofman is the Sidney Myer Chair of Commerce at the University of Melbourne.