Notes From A Scandal
Making Sense and Sensibility About The Foreign Exchange Legal
Settlements, Root Causes and The Way Forward
Edward Talisse
Financial Instructor, Fitch Learning
27 May 2015
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Educating the Quantitative Finance Community
The Bottom Line…So Far
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Oddly enough, final FX legal settlements, regardless of their size and severity, are a
positive for the large US and European banks
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Five banks pleaded guilty, at the parent level, to criminal charges
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However and somewhat surprising, no bank charters or bank licenses were impacted
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The banks say that the fines have already been reserved for, so there is no hit to earnings
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Total FX fines, split between the DOJ and Federal Reserve totaled $4.63bn, about $1bn
less than consensus expectations
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The settlement calls into question the further use of Deferred Prosecution Agreements (DPAs)
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The same group of banks still face penalties for the yet to be resolved LIBOR scandal
Educating the Quantitative Finance Community
Theoretical Background
Competition Law
FED,
ECB,
OPEC
IVY
League,
BIG 4
Recognized
Interdependencies
Cartel
Key Question: Does behavior lead to resource allocation inefficiency
and loss in consumer welfare?
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Price Fixing and Oligarchy Pricing
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Rational – absolutely, even when considering adverse consequences
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Illegal – No, but collusion is
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Unethical – perhaps; it depends on who is fixing what
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Consistent – absolutely not, ex ante and ex post standards are very different
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Financial Markets already have many built in guards against price fixing
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Don’t trade or decrease overall level of activity
Find substitute investments
Trade at a different time and with different counterparties
Price takers with market power can collude as well
Trade against the fixes
Amazingly, many traders insist that the Bank of England officials said that sharing
customer order information was allowed!
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What’s On The Line?
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FX markets transact over five trillion notional per day
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Outstanding FX derivatives (forwards and swaps) exceed $75 trillion
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The issue is even bigger than you think. Global bond and equity portfolios, that include
positions denominated in non domestic currencies, are marked and valued at the FX fixings
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The FX fixings in turn lead to margin calls, collateral substitutions and VaR model changes
that are hard to foresee and quantify
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A small number multiplied by a very large number is a very large number!
Example
1 pip = 1/100 of 1% or 1/100*.01 = .0001 i.e. one basis point
The value of 1 pip on a $1,000,000 EUR/USD FX rate is ~11 euros ((.001/1.09)*1,000,000).
1.09 equals today’s EUR/USD cross rate. Now imagine the FIX is artificially moved each
day by just 5 pips… manipulation has the potential to be an enormous drain of fair
value drained from the system
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How Does The FX FIX Work?
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The FX fix is executed and governed by WM/Reuters. The WM company is owned and
operated by Sate Street – a large U.S. Trust Bank
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The FIX is based upon actual transactions during a 60 second (30 seconds each side) window
at 16:00 GMT
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The FIX is executed for most major CCY pairs (about 21) and includes spot, forward and non
deliverable price points
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Unlike LIBOR, most FX fixings do not include solicitations for submissions i.e. it is
transaction, not quote, based
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WM/Reuters employ standard deviation and tolerance logic to smooth outliers
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The source of the transaction data is Reuters FX trading platforms
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Who’s To Blame? The Usual Suspects
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Poor product and index designs
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Incentive compensation structure and short termism
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Lack of supervision, guidance and training
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OTC nature of the market and lack of transparency
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A few bad apples
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Remember, FX is not a security… and it falls outside of the remit of the SEC and FED.
Think about that… The FX market is the largest and most liquid financial market in the
world and remains largely unregulated!
There are a number of deeper, more technical issue that need to be explored as well
Educating the Quantitative Finance Community
A Typical FX Derivative Term Sheet
Example of how a participating forward contract works:
The buyer protects against a strengthening euro by executing a participating forward
contract with a 1.30 cap and a 50% participation level expiring June 29. If at expiry
the EUR spot is:
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Above 1.30, the buyer can purchase 100% of EUR at 1.30
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Below 1.30 (for example, 1.20), the buyer can purchase 50% of EUR at 1.30
and the balance at 1.20, creating a blended rate of 1.25.
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The Trades are usually structured so that there is no upfront premium.
There are two worrying aspects about this trade: Point in Time (PIT) fixing and no
exchange of premiums (unlike in options trading)
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Point In Time Trading
Many large institutional investors demand Point in Time trading or PIT. Why?
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Reduces the need for execution staff
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Reduces administrative costs
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Reduces operational and execution risks
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Simplifies transaction cost analysis (TCA)
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Execution strategy is easy to explain to clients
Of course, this has opened up the law of unintended consequences such as manipulating
the FX fixes…
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Formalization of the Problem
Flow Weighted Average Price equals:
𝑀
𝑊𝑚 𝑆𝑚
𝑀=1
where Wm the size of the transaction during the
period and period WS is the mth observed price
The buy side should attempt to minimize execution regret where regret is defined
as Min(Actual – FWAP) for a buy and Max (Actual – FWAP) for a sell. In other
words, you want your executions to beat the flow weighted average price. Its hard
to see how a Point in Time strategy facilities the desired outcome.
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More On Point In Time Trading
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The Point in Time trading strategy ignores the random distribution of intra-day prices
and systemically biases trades AWAY from best execution
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Empirical research suggest that a Point in Time strategy is the most costly and most
volatile of typical execution strategies
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It is estimated that a Point in Time Strategy could cost a portfolio 5% annualized
regret (regret = best available fill versus actual fill)
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Most worryingly, Point in Time trading is an open invitation for manipulation, misbehavior
and abusive algorithmic trading programs
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It is similar to playing Texas Hold’Em with all your cards facing upward!
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How Do Traders Influence the Fixings?
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Preposition the market by observing the order book for the period immediately
preceding the fixing time
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Sharing order book detail with other interested parties to gain market power
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Unleashing algorithmic trading strategies to paint the tape with actual or fictitious orders
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Leaning on customer stop orders to manage risk
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Executing wash trades with friendly market counterparties
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Spread rumors of large impending market orders
At a minimum, it requires a contemptuous disregard for republican pieties!
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What Is To Be Done?
1. Move FX and related derivative markets onto an exchange
2. Move to an order driver rather than quote driven market
3. Need an industry wide Code of Conduct
4. Need an industry examiner in charge or EIC
5. No more Deferred Prosecution Agreements
6. Accountability is yet to be directed at the top of the house
As a free market practitioner, I generally do not subscribe to the need for additional layers
of regulation. However, I do believe that items #5 and #6 are valid.
Educating the Quantitative Finance Community