FX probe shows risks of benchmarks

October 31, 2013

By Dominic Elliott

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

A regulatory probe into allegations of rigging in foreign-exchange markets shows that the benefits of benchmark rates come with risks. Four investment banks – Barclays, Deutsche, Royal Bank of Scotland and UBS – confirmed on Oct. 29 and Oct. 30 that they were reviewing their FX trading practices. U.S., UK and Swiss regulators all said earlier in the month that they were investigating trading in currency markets. In anticipation of a potential backlash, Royal Bank of Scotland emailed select clients last week to reassure them about its FX rates-setting process, according to a person who has read the email.

Benchmarks supposedly offer customers greater certainty and lower costs. But benchmark rates for oil, currencies and money lending – the now infamous Libor – have all been investigated. The common theme is that the price-setting process creates an asymmetry of information, which creates opportunities for traders to profit from unloading positions which were accumulated at the real market price at a distorted benchmark price. In short, end users can be diddled.

Watchdogs may yet give the all clear to official FX benchmarks, the most used of which are calculated by WM, a unit of State Street, using data from Thomson Reuters’ trading platforms. (Thomson Reuters is the parent company of Reuters Breakingviews, which is not involved in the fixing process.) WM takes its rates from a relatively small sample of the average of $5.3 trillion that the Bank for International Settlements calculated is turned over daily in foreign-exchange markets.

It is not that hard to distort a benchmark which is created from quotes offered by traders, as is the case for Libor and many energy prices. The traders merely submit quotes that do not correspond with a realistic market price. It would be trickier for FX, where the benchmark is set entirely by observable transactions. But it could be done if enough traders agree in advance how they would trade the market during the sample period.

International regulators are hard at work to reform benchmark-setting processes. With such a range of different markets now under suspicion, the solutions will need to be nuanced. But if even the most liquid market of all can be rigged, only the toughest rules will do.

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