Lawsuits Bring Renewed Attention to FX Transaction Costs
Despite the promises of better behaviour by banks after their fines for past abuses in the foreign exchange markets, investors should subject their currency transaction procedures to a thorough review to ensure best execution.
On 20 May 2015 six global banks (Bank of America, Citigroup, JP Morgan Chase, Barclays, UBS and the Royal Bank of Scotland) were fined a record US$5.7 billion by US and UK regulators for manipulating foreign exchange rates. In particular, the banks admitted they had colluded in setting the 4pm (London time) WM/Reuters “fix” to benefit their proprietary positions.
The WM/Reuters fix is widely used by investment managers in valuing the foreign currency-denominated holdings in their portfolios. The fix is also used to calculate many equity and bond indices, incentivising some types of client (for example, index-tracking fund managers) to transact FX transactions at or as close to the fix as possible.
Other types of market abuse admitted by the banks included adding undisclosed mark-ups to FX transactions: for example, if a client had requested to be connected via an open line to the bank’s FX trader in order to obtain reassurance that they were dealing at the best wholesale market rate, the salesperson involved in handling the call could suggest by hand signals to the trader that hidden mark-ups could be added to the rate.
The fines bring the total penalties levied in connection with FX market rigging to over US$10 billion, a sum that exceeds the fines for the more widely publicised LIBOR scandal.
Separately, custodial banks have been compensating clients and paying government agencies for a different form of FX market misbehaviour.
In March this year the world’s largest custodial bank, BNY Mellon, settled two class action lawsuits and agreed to pay US$714 million in fines to the US Department of Justice, the New York State Attorney’s Office, pension funds and other clients.
BNY Mellon accepted that, while promising to provide best execution in foreign exchange for clients, including clients for whom it acted as custodian, it often transacted at or near the worst interbank rates of the trading day, pocketing the difference between the rates it received for itself and the rates it charged clients.
State Street announced in April 2015 that it had set aside US$335 million in provisions in connection with ongoing lawsuits over its foreign exchange operations for clients. The bank has previously settled a number of client lawsuits of this type without admitting liability.
In a final report on foreign exchange benchmarks, published in September 2014, the G20 Financial Stability Board (FSB) suggested an immediate reform to procedures for determining the daily WM/Reuters FX market fix, with the intention of reducing the scope for market manipulation: widening the “window” during which the fix is calculated from one minute to five minutes.
For major currency pairs this change took effect in February 2015. Though it may have reduced the scope for manipulation, the reform also appears to have decreased the market liquidity available at the fix.
One consultant, NewChange FX, estimated in April that the widening of the WM/Reuters fix window has pushed up average trading costs at the fix by about 37%, as banks widen bid-offer spreads in response to the greater uncertainty over the fix level.
Considerable challenges therefore remain for investors who wish to ensure that they transact FX business at the best rate possible, particularly if they have relied on passive transaction methods in the past (for example, at the daily fix or by using their custodian’s rates for standing instruction FX deals).
The FX market remains a decentralised network of largely bank-based traders, implying that there is no single correct measure of currency rates.
In its October 2014 Fair and Effective Markets Review, the Bank of England pointed out that bilateral markets, such as those for wholesale fixed income and currency, have inherent structural weaknesses. These include the greater ease of manipulation by market participants, conflicts of interest, limited transparency, poor benchmark design, market concentration, and a reduction in the effectiveness of market discipline.
And on the day that its FX market fines were announced, JP Morgan Chase reminded clients that when transacting for them in currency markets it was acting as a profit-seeking, arm’s length counterparty and not as a fiduciary or financial advisor.
In particular, the bank said, its client trades may continue to include a mark-up over the rates at which it which it transacted itself. Nor, said JP Morgan Chase, was it obliged to disclose to clients in future how much it was earning itself from any particular deal.
According to Henry Wilkes, formerly global head of FX sales and relationship management at Brown Brothers Harriman and now an independent consultant, one useful change investors and asset managers could make is to become less focused on the daily fix, even after the recent reforms to the WM/Reuters calculation methodology.
“In the major FX pairs the bid-offer spread during most of the trading day could be 1-2 basis points, but during the fix it could have been as wide as 5 or even 10 basis points at times,” said Wilkes. “With the widening of the fix window to 5 minutes the risks to the banks have increased and therefore bid-offer spreads have been widening,” says Wilkes.
“Transacting at the fix without questioning how the banks were being compensated for providing the quotes was always a naïve approach,” Wilkes argues.
It’s possible that the LIBOR and FX market trading scandals uncovered over the last few years lead to an uncomfortable conclusion: a single, reliable benchmark for interest rate and currency transactions may simply not exist.
Large investors and asset managers should therefore subject their FX transaction process to a thorough review. A revised process could build in increasing flexibility in transaction timing to reflect the changing liquidity dynamics of the currency markets. It could involve the increasing use of FX trading algorithms, which are commanding an increasing share of market turnover. And there is likely to be increasing demand for FX-specific transaction cost analysis (TCA) from independent market participants.
Clients of custodial banks can use statistical models such as Thomas Murray IDS’s Foreign Exchange Cost Benchmarking Service to measure their past FX execution rates with peer group averages and compare costs with the peer group, using the results to check how efficient past deals have been and, where necessary, negotiate better rates from the FX provider. Brian Ward, Director at Thomas Murray IDS, suggests that there is empirical evidence that clients who benchmark, negotiate and continue to monitor the costs involved benefit most from improved pricing. “Clearly, greater transparency in the market has contributed to more competitive pricing being available, but unless a client monitors the benefits, there remains the possibility of long term upward creep particularly when FX pricing forms just a part of the overall cost of a banking relationship.”
As pricing arrangements between the banks and their clients are becoming more sophisticated, the focus is moving towards how a client can assure itself that its bank is providing best execution. Where it can be provided, time stamping of trades to allow comparison to rates gathered independently from providers such as Bloomberg, Thomson Reuters and FX electronic communication networks (ECN’s) can meet governance requirements. However, the continual change in prices in the market means that some tolerances in price movement need to be accepted.
The underlying message is that the industry continues to have a need for foreign exchange. Clients need to meet the increasing wave of regulatory requirements around the efficiency of third party service providers and the market providers are increasingly put under the microscope.