Vidya Ram

The new ‘benchmark’ scandals

Vidya Ram | Updated on November 25, 2017

Agencies providing standard quotes for interest rates, forex or energy prices globally are coming under increasing regulatory scrutiny.

If global banks had hoped that 2012 — with its slew of scandals from the manipulation of the Libor benchmark rate to violations of US foreign assets control regulations and sanctions against countries such as Iran — represented a low point for their already tainted image, they were mistaken.

After a slow start, 2013 is gearing up to be a similarly damning year, particularly if the brewing forex scandal proves as big as many suspect.

This one, in a nutshell, is about the foreign exchange market, which, because of its sheer size and scale, was thought to be relatively immune to manipulation. But since the summer, it is facing scrutiny by regulators across the world for just that.

They are looking into whether traders at some of the world’s biggest banks had colluded with colleagues at other banks by attempting to manipulate the WM/Reuters spot forex rates — used as benchmarks for portfolio valuations and settlement of financial derivative contracts — and sought to push through their own orders for profits at the expense of their clients.

A wider examination of the forex market and other potential attempts at manipulation are also thought to be under way. Observers have been quick to draw parallels between these investigations and the revelations about the widespread manipulation of the London inter-bank offered rate or Libor, which engulfed pretty much the whole banking industry last year and led to billions of dollars in fines from regulators globally.

The comparisons aren’t particularly surprising: both scandals have highlighted the yawning gaps that remain in the regulation of the banking sector, despite attempts by various authorities to fill them in the wake of the 2008 financial crisis. Gaps, that when revealed, may seem glaringly obvious to the layperson.

From interest rates…

For, only last year, it had emerged that the Libor — used as interest rate benchmark for some $350 trillion of derivative contracts and trillions of dollars of loans — was based on the mere submission of borrowing rates by a selected group of banks.

These rates were being monitored and gathered by none other than the UK banking industry body, a situation that barely seemed to receive much notice at all until a Wall Street Journal article in 2008 pointed to some anomalies in the rates submitted by those banks.

Subsequently, legal documents highlighting email conversations between traders and pointing to collusion in ‘fixing’ the rates confirmed the public’s worst expectation of hubris in the industry.

But the regulators themselves had to face uncomfortable questions about how such a massive elephant had remained hidden for so long.

…to forex

How widespread and extensive the current ongoing scandal involving manipulation of foreign exchange rates has been — following a Bloomberg story that pointed to the manipulation of the WM/Reuters benchmark rates — remains to be seen.

What does appear to be clear, however, is that the forex industry — estimated by the Bank of International Settlements to be worth a staggering $5.3 trillion a day in revenues and growing — has also had rather light treatment at the hands of regulators.

Even if the manipulation — or attempts at manipulation — remains limited to the WM/Reuters spot rate service, it matters enormously.

After all, this service, a joint venture between the WM Company and Thomson Reuters, is one of the most widely used benchmarks in the forex industry.

Providing hourly (and a few half-hourly) indicators of the rates used by banks — the most important being the 4 p.m. London closing rate — the nearly two-decades old service covers 160 currencies. It is used by fund managers in the valuation of portfolios, compilers of stock and bond indexes, and for derivative contracts, affecting trillions of dollars of assets globally.

To be fair to the regulators, just as with Libor, regulatory action, once initiated has been swift and widespread.

Regulatory lessons

The European Commission, Switzerland’s Finma, the UK Financial Conduct Authority, the US Department of Justice, and the Hong Kong Monetary Authority are among the bodies that have said they are looking into potential improprieties.

And slowly but surely the trickle of banks admitting that they are either “cooperating” with authorities or undertaking their own investigations has been growing. The list includes Deutsche Bank, UBS, Barclays, Citigroup, JP Morgan, HSBC and Goldman Sachs. Some traders have already been suspended.

What do we learn from this whole affair?

“This is fundamentally a benchmark problem,” argues Charles Goodhart, director of the financial regulation research programme at the London School of Economics and a former member of the Bank of England’s monetary policy committee.

According to him, there is no fundamental problem with the regulation of the banking sector: “The problem is to do with how we actually obtain benchmarks. If you have a widely used one, there are incentives to try and manipulate it.”

But unlike Libor, the forex benchmark was supposedly based on actual trades rather than estimated values. It only reveals just how difficult resolving the “benchmark problem” may be.

Certainly, the scale of the benchmark problem is only becoming apparent now. There are an increasing number of such global benchmarks — including those pertaining to crude oil and industrial metals — now being subjected to regulatory investigations.

The wider problem has not eluded regulators: In September, the European Commission said it would be introducing new regulations for a hitherto “largely unregulated and unsupervised” aspect of the financial system, while proposing stricter attention be paid to the actual submitters. In fact, the lack of regulations may make litigation against banks accused of rigging foreign exchange markets harder.

Still, whether such changes will prove enough remains doubtful, given that many believe the warning signs were likely to have been there already.

“I was surprised that you’d get a problem in foreign exchange markets. With so many deals, if there was a benchmark valuation so out of line with surrounding transactions, one would have thought they had seen it and taken steps to prevent it,” says Goodhart.

Whether the gatherers of the data in this case — WMA/Reuters — will come under the same critical eye as the British Bankers Association, responsible for fixing Libor, also remains to be seen.

Since the allegations of collusion between traders across banks have surfaced (in a throwback to the excesses and arrogance revealed during the Libor probes, a recent WSJ article pointed to a number of chat rooms used by top currency traders that were under investigation with bombastic titles such as “the cartel” and “the dream team”), there has been talk of measures such as banning traders from chat rooms.

This, of course, would only be a quick-fix that would go little towards solving the fundamental problems with the industry which, thanks to all the recent revelations, we know are still very much present.

Published on November 17, 2013

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