The Foreign Exchange Fix

Key Points

• Banks do not manipulate the fix, they manage it.
• Traders could collude, but they have to co-operate to manage risk.
• The fix favours clients not the banks’ traders because traders have to buy or sell currency on the open market – on which rates fluctuate.
• Clients chose to trade at a particular time, for certainty and predictability, not at a particular rate so it is fair to infer that they cannot be too concerned about any potential gain or loss.

Abstract

The coverage of the foreign exchange ‘fixing’ scandal has been rather predictable so far. Predictable media condemnation of bankers, predictable speculation about potential profits and bonuses amassed and a predictable failure to accurately portray exactly how the fixing system works and what really happens in it.

This article focusses on the practicalities and realities of the fixing process, how traders approach it, and who, if anyone, are the winners and losers.

Official ‘fixing’ of benchmark rates for particular currency pairs allows institutions to allocate a daily rate to any business it wishes to transact or to value. It also gives certainty for certain legal issues, for example if a transaction is being negotiated it can be contractually agreed to use the 4pm fixing rate for a chosen day.

Simply put, the rate is fixed with reference to the actual rates trading at around 4pm and then the ‘mid-rate’ of the bid/offer spread at that time becomes the fixed rate. So, to use the most commonly traded currency pair, the Euro against the Dollar as an example, if the spread at 4pm is 1.3848 to 1.3852, the mid-rate will be 1.3850 and that will be the fixed rate.

Clients leave orders with their banks to buy or sell at the fixed rate, sometimes the banks know about the orders days in advance and sometimes only minutes. Often they will have ‘two-way’ interest from a combination of their clients. For example, 15 individual and completely separate clients may want to buy a total of “200 million at the fix and 10 others, equally unconnected, may wish to sell a total of “180 million at the same time. All the orders will be filled at the same rate, and because they net off, the trader’s balance is a mere “20 million. In FX terms, this is a miniscule amount. Of course these amounts of hundreds of millions are simply illustrative and of a size only relevant to a very few market participants.

Manipulation

Obviously the allegations relate to manipulation of the fix in order to make profit out of orders left with banks by their clients. If a client leaves an order to buy 300 million Euros in the fix, it is said that the bank’s trader can ‘front run’ the order by buying the Euros at 3.50 pm at say 1.3840, thus forcing the rate up to 1.3848/52, at 4pm and closing the deal with the client at 1.3850.

Buying that amount at 1.3840 and selling it at the fix to the client at 1.3850 gives a profit of 300,000 dollars to the trader. That, say the complainants, is the manipulation which defrauds clients by artificially inflating the price fixed at 4pm.

This hypothetical scenario, however is so unlikely to occur that it is barely worth considering. It is the type of perfect storm that only happens in newspaper stories or pub anecdotes.

In practice, the client’s order to buy “300 million is unlikely to move the market more than 2 or 3 ‘pips’, particularly in the high volumes at fix time. So if a trader bought at an average rate of 1.3840, the market is only likely to move to 1.3838/42 at 4pm. This means that the trader has a “300 million exposure for the 10 minutes until the fix, and on this scenario, the best price at which he could sell in that 10 minute window would be 1.3838 (i.e. at the bid price rate on the open market, not the mid-rate – see below), 2 ‘pips’ lower than his average purchase price, and this is a $60,000 loss. And 10 minutes is a long time in the FX market. It is entirely possible that the market could fall 10, 15 pips or more. Not to mention the possibility of news coming out that could send it much lower.

Even if the trader were to hold on until the 4pm fix, because the market will not have moved far, the mid-rate at which the client would buy could still be 1.3840 thus giving the trader10 minutes of large risk for no gain whatsoever. In practice, that sort of front-running of an order is simply not worth the risk. Buying against an order in place for 4pm makes it barely more likely that the market will go up than at any other time.

Collusion

Another limb of the allegations is that of collusion; that traders share information about client orders so that they can join forces to use the combined volume of their orders to move the market against their clients just before the fix in a similar way to that outlined above. So perhaps 10 traders each have “300 million to buy in the fix, and in a concerted action they each go into the open market to buy their 300, and the combined weight of their orders forces the market up and they each sell their tranche to their client at the fixed rate, higher than they bought it.

This scenario is predicated upon so many un-likelihoods that it would almost never occur in practice even were those 10 traders minded to participate in such a concerted action. The odds against it are enormous. 10 traders, all being in touch with each other, each having big orders, all to buy, and none having other orders to net them off against. And crucially, no equal or bigger order in the opposite direction going through with another bank that cancels it out. Of course 10 traders could collude without orders, but that would have no relevance to the fix because they would not be working against any client transaction.

It is possible for just one trader with one enormous order, to front run it in the way described, and because of the sheer volume involved, move the price in his favour by a relatively significant amount. To move EUR/USD as much as the 10 pips described above, could take the purchase of several billion Euros, which would be an amount very rarely seen in any FX order in the fix or otherwise. I have known an order of “5 billion that only moved the market 3 pips – and that is a once in a career amount.

Management

In my experience, the usual scenario at almost every fix, is not traders attempting to manipulate the market to make a profit from each client order, but rather to manage the risk and probable loss from each client order.

The reality of the fixing system is not that it makes it worthwhile for traders to be in contact with other traders to get information about orders at fixing time, but that it makes it necessary for them to do so. The fixing system, by definition, leads to traders losing money. Without trader co-operation or taking risks or using market skills, every single client fixing order will cost a trader and his bank money – every single time.

To use the same scenario, if the client leaves an order with his bank to buy “300 million at the 4pm fix rate, and the trader does nothing, perhaps because buying the Euros in advance would lead to allegations of front running, at 4pm he will be forced to sell “300 million to the client at 1.3850 when the best price for him to buy Euros himself is 1.3852 (not the mid-rate – see below) thus incurring a loss of $60,000 if the trader can manage to buy all 300 million at 1.3852, which is no certainty. Clearly, the larger the order the larger the loss.

It is the same for every order, no matter what the size or price. On that example, the client is able to buy from, or sell to, the trader at the fixed price, the mid-rate of 1.3850. The trader though, can only buy at 1.3852 (offer price) or sell at 1.3848 (bid price) in the open market. The client is able to deal at a better rate than in the open market because the trader at the bank has to honour the fixing rate, even though it may not be possible for him to deal at that rate himself.

I am not aware of any media coverage of the fixing system that criticises clients for taking advantage of being able to deal at more advantageous rates than are available in the open market but this is the reality of the system. The FX fix is fundamentally flawed and banks’ clients take advantage of it. By definition, the fix process makes money for bank clients and loses money for bank traders. And of course traders are not employed to lose money for their bank, because if they do, they lose their job.

So naturally, what traders do, is to seek to manage the risk that the client orders impose upon them. One way of doing so, is to use their contacts in the market to find one or more traders who have the opposite client order interest to their own. To use the same example again, as our trader has a client wishing to buy “300 million, it would completely eliminate his risk and prevent any loss if he could find two other traders who each had an order to sell “150 million. They each agree to trade with each other, they then have no risk and the clients get their orders filled at the fixed rate. This is not collusion, this is necessary co-operation.

This is the reality of the fix that does not get mentioned. But then again there is not much public or political clamour for a story about bankers trying to protect themselves from a system that costs them money and potentially their jobs.

Cost To The Client?

If clients really thought that the fixing system worked to their disadvantage all they would have to do is to ask for a price from the trader. There would be no need to give away whether they are a buyer or a seller, they could simply ask for a two-way price and deal on it.

Clients dealing in the fix are, by definition, not price sensitive, because they abdicate all control of the rate at which they actually deal. If they leave an order with a bank to buy that “300 million at 4pm, it is irrespective of the price. They do not know if the prevailing rate will be 1.3800 or 1.4000, because they are choosing to deal at a particular time – for certainty and predicability, not at a particular rate. The difference in profit, or loss, between dealing at those two rates is 6 million dollars. It must be fair to infer that clients are not concerned about that potential loss, because if they were so concerned they would try to sell at the highest price or buy at the lowest price. Instead they choose to buy, or sell, at 4pm regardless of the price.

Commentators claim that traders are routinely manipulating the fix, trying to move the market 5 or 10 pips and thus costing clients such as pension funds money. That pension fund chose to deal at 4pm. It was not concerned with whether it was the top of the day, or the bottom. And they call that fund ‘management’? But thats another scandal.