Rigged FX Spot Market: The Tip of the Iceberg?

Originally posted on the TABB Forum, see more here: http://tabbforum.com/opinions/rigged-fx-spot-market-the-tip-of-the-iceberg​.

The major banks are looking to put FX trading scandals behind them after doling out multi-billions of dollars in fines. But regulators plan to turn up the heat on banks with further regulatory actions. Just where will regulators focus to uncover signs of potential market manipulation/abuse and conflicts?​

Though the past few weeks’ headlines may say otherwise, major banks are looking to put FX trading scandals behind them after doling out multi-billions of dollars in regulatory and prosecutorial settlements in recent months. Not so fast, say regulators, who plan to turn up the heat on banks with further regulatory actions, as the FX market undergoes further fragmentation, structural changes, and electronification.

As financial institutions plan for a longer, hotter s​ummer, just where will regulators focus to uncover signs of potential market manipulation/abuse and conflicts? There seem to be three key “rocks” under which trouble usually sits: electronic/high-frequency trading, cross-market manipulation (at both the asset class level and across correlated FX assets) and trading communications.

First, let’s look at how high-frequency trading continues to thrive in a market that is becoming increasingly fragmented and electronic, and which is leading to abusive market practices. Fragmentation, caused by e-commerce, and regulations (think: Reg NMS) already have led to the domination of liquidity by the major FX dealers migrating to other providers of liquidity (in particular, multi-dealer trading platforms).This market structural evolution will create more opportunities for some of the high-speed trading manipulation tactics seen in various markets, such as spoofing, layering, and momentum ignition. 

Undoubtedly set to stoke regulatory fires are the recent allegations concerning rogue trading as a contributor/agent to the 2010 Flash Crash, as it relates to their much warranted concerns regarding the various and significant risks that “high-frequency liquidity” brings to the party. The SEC, the CFTC and their overseas peers are woefully behind in regulating and policing this activity – but eventually, they will find the data and develop the analytics for discharging their “market integrity” responsibilities. One only needs to look at MAD II to understand the contemporary “expectations” of the regulators. 
 
Cross-market manipulation is the second area that will, at some point, capture the attention of global regulators. While the market focus and enforcement actions have for the past two years involved the spot market, it would be naïve or foolhardy to believe that the other two-thirds of the FX market (Forwards, Options, Swaps, etc.) are not a playing field for similar types of fraudulent activities and/or connected to the malpractices witnessed in spot. Barrier option events in particular are easily manipulated, as we have seen in the context of enforcement actions. Consequently, ensuring that an organization’s compliance systems have the sophistication that will establish the nexus between the trader’s spot activities and his/her barrier option risk will be a good starting point. 

Connecting the dots across the FX products and their markets is critical to any effective surveillance program, either that of the regulators or their regulated entities. The FX market not only correlates as an asset class, it also is a causation agent in other asset classes (rates, commodities); therefore, market participants that embrace macro trading will have the additional, and daunting, challenge of surveillance through the prism of multiple products and asset classes simultaneously and not as silos.

Communications surveillance (voice, chat, email, etc.) has been a treasure trove of “smoking guns,” and new technology is coming to bear that allows the integration of communications surveillance into an organization’s compliance risk management systems, in near-real time. While the initial wave of FX market manipulation and abuse may have centered on chat room activity, a very substantial amount of FX trading, particularly non-spot, is still dealt by voice – and this is unlikely to change. Regulators are placing greater responsibility on dealers to establish policies and develop monitoring and enforcement methods that will arrest the exchange of confidential client information and deter tacit collusion. As part of this environment, compliance departments must integrate communications surveillance into their holistic compliance risk management systems/platforms to include all communications surveillance, (chat, IM, social media, email, and voice) as part of a comprehensive monitoring program.

There are indeed different challenges that confront regulators and FX dealer compliance risk stakeholders. The former will find it difficult, if not impossible, to police $5.3 trillion in daily trades without the pipes to the requisite market data to support their surveillance analytics/algorithms. Analytics beg for data, and there is indeed, regrettably, a dearth of FX-related data available to the global regulators.

Sell- and buy-side compliance risk groups, on the other hand, will be less challenged by data (that they have in great abundance), but more challenged by understanding the nuances and idiosyncrasies of the FX market; the absence of mature compliance consortium best practices (FX has long been a compliance orphan); and, the compelling need for developing an effective compliance risk system with the appropriate nexuses that connect the FX risk exposure of the trader/desk – e.g. spot/ forwards/derivatives, across asset classes (FX/rates/commodities). Until then, the more things change, the more they remain the same. 
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