Aim! Fire! Why media focus on FX price rigging misses the target
Bloomberg posted a story last night alluding to price fixing by foreign exchange traders around the month-end at the 4 pm London close ( in Canada, it is known as the 11:00 am fix) implying that the pattern is similar to the Libor price fixing scandal. I think it's bogus.
Stirring the pot
I have been an active participant from both the sales and execution sides of these transactions while working for leading global banks and I can say from experience that this story is merely an attempt to create controversy where none exists.
The month-end London close (for book keeping purposes, determined to be 4 pm) is when the WM/Reuters rates for 160 currencies are published. According to the Bloomberg story, the methodology is that the prices for the 21 most active currencies are derived from an average of all transactions for one minute, beginning 30 seconds before the hour.
The reason that this is important is that many fund managers all over the world use these rates to "close their books" at month, quarter and year end. Portfolio's are rebalanced as FX price fluctuations during the period can result in a portfolio manager being under or overweight a currency, necessitating an FX trade to bring the portfolio bank into line with their internal parameters.
What makes it interesting is that there are literally thousands of portfolio managers in this position resulting in some very large, market moving rebalancing trades. The Bloomberg story insinuates currency manipulation trade in the Canadian dollar on the last Friday in June.
Source: Saxo Bank
I am pretty sure that they are wrong based on over 20 years of executing the fix transactions and working directly with some of the biggest portfolio managers in the business. The trading around the "fix" is less an example of price fixing but more of an example of profit preservation in what is a pure supply and demand environment. The following is a simplistic example of a typical fixing trade using USDCAD.
Due to a rise in US equities and the US dollar in June, a mega Canadian pension fund with hundreds of billions of dollars under management, finds itself underweight US dollars and to bring the portfolio back into line with its benchmark needs to buy US dollars and sell Canadian dollars. In this case, this pension fund needs to buy USD 1.5 billion. The pension fund FX desk knows in advance, at least the day before, of the size of this trade. To avoid any FX accounting losses, the pension fund needs to acquire the US dollars at the benchmark rate or the WM/Reuters 4pm closing rate (London time).
So far so good. However liquidity and supply and demand are key factors affecting intraday FX trading. A good rule of thumb for intraday USDCAD trading is that the US dollar will rise or fall about .0100 points for every billion dollars traded. The effect is more pronounced when the execution window is narrow.
Can of worms
Wholesale USDCAD generally trades on a two-three point price spread which is usually good for USD 10-20 million at a time. If a pension fund merely needs to buy USD 20 million USDCAD for rebalancing, achieving the WM/Reuters fix price is relatively easy and there is no "slippage" However, if you need to buy a USD 1.5 billion, it is a different can of worms.
The FX manager at the pension fund cannot wait until the WM/Reuters rate is posted as he/she would get crushed on the slippage and perhaps get fired in the process. To avoid these dire consequences, the FX managers at many pension funds, delegate the slippage risk to their favourite FX banks. In exchange for a guaranteed fill at the WM/Reuters fixing rate, the give the FX banks buy (or sell) orders ahead of 11:00 am. The size of their FX requirement would dictate how much time in advance of 11:00 am fix, the orders would be placed.
So once again, assuming the Canadian pension fund needs to buy USD 1.5 billion, the bank FX trader now has the profit/loss risk of executing the order at the WM/Reuters fix rate. If he/she buys dollars better than the fix, they can be sold to the Canadian pension fund for a profit. Happy Days!
However, if they cannot buy the dollars better than the fix, the bank takes the hit. To put it into perspective, slippage of a mere .0005 points on USD 1.5 billion equates to a nasty CAD 750,000 penalty.
To mitigate this risk, the savvy FX trader starts accumulating dollars as fast as he can, depending upon various factors including his view of market, existing orders etc. In addition, the FX rumour mill is in full tilt and even traders without any fixing orders of their own are alert for any and all directional gossip, perhaps adding to the US dollar demand. In this environment, the USDCAD rate would rise.
After the WM/Reuters fixing rate is posted, the USDCAD would drop for many reasons but the key one would be that demand has dissipated. If the currency pair rose significantly, say 100 plus points, experienced traders may elect to start shorting US dollars in the hope of scalping a quick few points as they catch other day traders still long, which goes a long way in explaining why a fixing rally is usually shortlived.
There are other reasons why the insinuation of FX market price fixing (at least among the G-10) is hard to credit. These include the vast number of fund managers, the sheer size of the FX trades, the number of FX trading banks and the permutations of the FX trades. Not only could you have demand for USDCAD, you could also have sizeable demand to sell EURCAD, GBPCAD or CADJPY, to name a few. It is not a stretch to assume that they could easily offset or even swamp the USDCAD demand, increasing the risk of loss to the FX trader.
The real issue is that hundreds of billions of dollars are marked to market at a price where the actual dollar supply at that price is so small as to be inconsequential. The fund managers have no complaint against the banks for price fixing, as they are responsible for transferring their individual FX slippage risk to their FX bank, whose trader is obligated to protect his bank's shareholders by not losing money on the trade. If the regulators decide to investigate this allegation of price fixing, they should come to the conclusion that it is just a pure demonstration of supply and demand theory in action in a narrow window.