A fix for the financial products market

It isn’t quite cricket. Libor had been fixed and bullion, too. Now, if the UK’s Financial Conduct Authority is to be believed, dollar-pound (WM Reuters 4 pm) and euro-dollar (ECB 1.15 pm) rates have been fixed as well. Of course, we are not talking about the process of setting rates in these asset classes but the process of manipulating them to deflect them away from their true value.

Two things stand out. One, there is the financial community’s obsession with ‘value’ as a notion specific to a point of time, that split-second assessment, if you may. But there is an alternative notion of value that encapsulates a flow of transactions over a 24-hour period into one representative number which could serve the purpose of the financial community and the world of global commerce just as well.

The former may have served a purpose in the past. When all trades were conducted under a banyan tree (as was once the case with the Bombay Stock Exchange) or some such exotic location; where all transactions were manual, a case could be made for conducting a ritualistic trade with a degree of Masonic pomp and secrecy, to serve as a benchmark rate for use by the rest of the trading community.

But in these days of automated and screen-based trading, where orders can be entered and instantly matched against one another based on best available quotes and in the order of time, there is need neither for open-ended (rate to be determined at a later point in time) transaction nor determination of the actual value of the transaction through an episodic exercise at ‘rate’ determination.

The National Stock Exchange, for instance, has effortlessly put together roughly 7.9 million trades in equities with weighted average price disseminated at all times across 1,500-odd equity instruments (data for November 18, 2014). Each of these transactions was matched for a precise price and counterparty clearly identified against each and every trade.

The present ‘clubby’ nature of the market in international financial assets serves the interests of entrenched players but does little to secure the interests of other participants, investors and businesses. The sooner the governments of the G20 nations, which account for 85 per cent of the global output of goods and services, resolve to introduce a new financial architecture for markets across different asset classes, the better it would be for all concerned.

A beginning has been made with countries at least now talking of the possibility of a trade repository for all ‘over the counter’ (OTC) transactions for disseminating information to the general public.

Unfortunately, there is no commitment as yet within the global community for legislative changes to mandate market participants to switch over to exchange-based electronic trading platforms.

The argument that the OTC market provides for flexibility in terms of innovative instruments catering to specific customer needs is no longer valid. There is a fair degree of standardisation as to the products on offer in these OTC markets. In any case, those that have become well established can be made to move over to exchange-based platforms. You don’t really need an OTC market for a plain vanilla euro-dollar spot quotation.

An electronic, exchange-based trading architecture as an international norm is preferable for another reason as well. That brings us to the second issue that the recent scandal in spot rate fixes has highlighted. The phenomenon of proprietary trades coexisting in apparent harmony with client orders is the worst form of ‘conflict of interest’ that one can think of.

Assume for a moment that you spot your neighbour stepping out of his house with a shopping bag. You ask him what he was getting up to, and he replies that he is going to the market to buy half-a-dozen apples. You request your neighbour to buy another six on your behalf.

He manages to get six of the choicest from the first shop that he visits at ₹30 a piece. Let us assume that the shop had either exhausted its stock of apples or that the rest were not of the appropriate quality. Your neighbour has perforce to go to another shop and buy six more apples but at ₹35 a piece.

So what should he declare as the cost of apples that he bought for you? Is it ₹30 or ₹35 or ₹32.50? Mind you, each one of these answers can be defended on some well-grounded moral principle.

Hypothetical or not, this much is certain. Your neighbour would never have had to experience this moral dilemma if he had gone to the market to buy, not apples but something else, or was merely going to fetch his child from the school and along the way bought the apples that you had requested.

Indeed, a moral dilemma or the potential for a conflict of interest is inherent in a situation where you seek to represent a person in a commercial relationship and at the same time engage in the very business of the principal whom you have promised to serve. For then, there is every likelihood that some of the profits coming to you are at the expense of the very person you represent as an agent with all the attendant implications of promising to act in his best interests and to the utmost of your abilities.

The choice is clear. The global financial system can have an OTC market structure and live with conflicts of interests that the arrangement poses for agents in the system. Or declare that such conflicts of interests are unfair to consumers/investors and mandate an electronic, exchange-based market structure.

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