You Paid How Much for that Foreign Currency?

“If you ain’t cheating, you ain’t trying” were the words of 1 trader working in the foreign exchange market. They belie an attitude that was widespread amongst traders in this market in between 2009 and 2013. Being unfaithful was simply a normal part of the trader’s day job. In fact, not cheating would be to shirk your responsibilities.

Widespread cheating in the foreign exchange market offers turned out to be very costly indeed. Previously six months, six large banking institutions around the world have paid out US$10 million in fines over the adjustment of the global foreign exchange market. There’ve also been fines levied against banks for manipulating additional over-the-counter markets such as LIBOR, the ISDAfix and the gold market.

In add-on, there have been fines for other bad behaviour by banks like money laundering, their own role in the sub-prime mortgage crisis, violating sanctions, manipulation of the electricity market, assisting taxes evasion, and mis-selling payment protection insurance. This provides the total amount of fines, which banks have paid since 2008 to over US$160 billion. To place this in context, this really is more than what the UK federal government spent on education last year.

Cleaning upward their act

As the cost of misbehaviour mounts, banking institutions are under increasing pressure to clean up their act. In spite of widespread public cynicism, much has changed within the banking sector. Banks have beefed up their own risk function and elevated oversight of traders.

They have also changed the “tone from the top”. Bankers who talk much more about ethics, careful risk management and serving the customer have largely replaced senior managers of the boom years who promoted a hard-driving, risk-taking culture. A new legal regime is in place to hold senior bank employees personally responsible for wrongdoings on their watch. Banks are required to hold more equity on their balance linens. There have been new laws which changed bankers’ compensation to emphasise long-term overall performance rather than short-term risk taking. Riskier trading and investment banking procedures is being ring fenced from their more staid retail banks.

Problems with the market

All these changes might be producing bankers safer, but will they do anything to make the markets, which they operate within, any less prone to reward bad behaviour? We usually assume a market such as foreign exchange emerges from millions of individual decisions. Changing this might sound impossible.

However, each of these decisions falls within a particular set of constraints. These constraints would be the product of deliberate policy design choices. Changing conduct in a market like foreign exchange involves looking carefully at the design of the market and requesting whether this actually does the task it is supposed to do.

As it currently stands, the foreign exchange market seems to create opportunities for bad conduct:

* It is huge – US$5.3 trillion passes through the market every single day.

* It is extremely opaque – because it is an over-the-counter market, there is no centralised point where trades are cleared and documented. What this means is that unlike the proportion market, there is no single point of knowledge about how much trades and also at what price.

* It is extremely concentrated. Although millions of people participate in the forex market every day, only four banking institutions control over half the market. This effectively means that a couple of hundred people working for these big institutions trade over $2.6 trillion US.

* It is almost entirely self-regulated. Although there are many laws and regulations which apply in additional financial markets such as shares, regulation is almost entirely absent within currency trading. The main body, which oversees the operation of the market, is a panel appointed by the Bank of England whose membership is comprised of mainly currency traders.

It is difficult to expect that a large and opaque market, managed by a small handful of gamers who self-regulate will produce angelic behaviour.

Changing the design

To change conduct within this market, some of these style choices needs revisiting. If policy makers wanted to reduce the size of this gigantic market, they could place a small transaction tax on each currency trade. This would probably have the effect of driving out much of the speculative trading in forex (and related financial devices) which makes up the great majority from the market.

To make the market more transparent, banks, which operate large trading platforms, could be required to share information about the volume of trades as well as the price of deals they are making. This would lessen the information asymmetries between the large banking institutions (who know what is going on) yet others (who do not).

To make the market less concentrated, maybe create a centralised trade similar to the share market for currencies. This would quickly erode the advantages that large banks trading forex have from their currency trading platforms.

To make the market more stringently regulated, then it is possible to replace weak self-regulation by insiders with increased developed regulation by a completely independent body. This would mean there are obvious boundaries between poachers and gamekeepers.

In the united kingdom, the Bank of England is actually reflecting on some of these style choices. With its “fair and effective markets review”, it is looking at the design of FICC (Fixed Income, Currency as well as Commodities) markets. So far, monetary firms and their representatives have mostly engaged with this, and some policy options are already from the table. For instance, there is little prospect of a centralised currency exchange or a Tobin tax on currency trading.

Many important options remain, however. One big question is whether these essential market design decisions will be ones made by market insiders and technocrats, or whether they calls for some degree of genuine democratic thought. This is an important question to ask. Because my colleague Emilio Marti has recently contended, making decisions about the design of the financial markets in a more democratic method will lead to fair outcomes. Keeping the decisions on how to style the biggest market in the world in the hands of a small number of regulators, economists as well as currency traders may not result in a fairer market.

‘If you ain’capital t cheating, you ain’t trying’ – exactly how forex has changed is republished along with permission from The Conversation