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A different kind of swindle

In the weeks and months following the subprime crisis, a number of financial swindles have come to light. Perhaps the most famous of these was the Bernie Madoff scandal.

Madoff ran a Ponzi scheme, in which he attracted money from individuals (and institutions) who were hoping that he would provide sound investment management and a healthy return on the funds entrusted to him. Instead, the money ended up in his pocket. The small number of “investors” who did withdraw their funds from Madoff were paid with money from new investors. Because the financial markets were booming at the time, there was a steady flow of funds into Madoff’s coffers and his scheme was not discovered.

The problem with all such swindles is that when the financial boom ends, more and more investors want to withdraw their money while few if any new investors are willing to provide funds, so veteran investors making withdrawals cannot be paid. This is what happened to Madoff, who is now serving a 150-year sentence for a variety of financial frauds.

As tragic as the Madoff scandal was for his victims, it pales in economic significance next to two far less heralded episodes: the Libor scandal, which emerged in 2012, and the foreign exchange (forex) scandal, in which six banks were fined a total of $4.3 billion by regulators in Switzerland, the United Kingdom and the United States last month. Because I have written quite a bit about Libor, this post will focus on the forex scandal.

In 2013 the Bank for International Settlements estimated the daily turnover in the foreign exchange market at $5.3 trillion. Because so much money flows through the foreign exchange market, even small changes in the prices of foreign currency can mean huge profits or losses for market participants.

Bernard Madoff
Bernard Madoff, by United States Department of Justice. Public domain via Wikimedia Commons.

The banks were fined because the authorities found that they rigged the forex market in two ways: (1) by colluding to manipulate the daily “fix”; and (2) by intentionally triggering their client’s stop-loss orders in order to manipulate the price.

The daily “fix” refers to the WM/Reuters benchmark rates, which are calculated by taking the median of actual buy and sell transactions that take place in the 61 seconds between 3:59:30 and 4:00:30 pm London time (the European Central Bank also produces a fix two hours and 45 minutes earlier). These benchmarks are widely used, according to a Bank of England report “…in valuing, transferring and rebalancing multicurrency asset portfolios.” Small movements in the daily fix can therefore have a large impact on the value of asset portfolios—and on the wallets of the traders and their employers. This type of manipulation is reminiscent of the Libor scandal, in which a few traders fiddled with a widely used interest rate benchmark in order to make large trading profits.

Stop-loss orders are instructions placed by clients with their bank to buy or sell a currency when the price hits a specified rate. Clients do this if they are concerned that a large price movement will have an adverse impact on their bottom line: in such a case, a stop-loss order will, well, stop the loss. Traders were found to have manipulated currency prices just enough to trigger clients’ stop-loss orders and move the market for their own benefit.

The Libor and forex scandals have several especially troubling aspects in common. First, unlike Madoff, they did not require asset booms in order to succeed: profits could be made on days when a particular currency rose or fell. That is, no prolonged asset bubble was required for forex manipulation to succeed—nor would the scheme collapse if an asset bubble collapsed. In theory, forex manipulation could have continued indefinitely.

Second, unlike Madoff, who only required his own wits and the gullibility of investors to succeed, the forex scandal was a conspiracy—or rather a series of conspiracies. The efficient operation of all markets—foreign currency included—requires the active participation of large numbers of individuals and institutions. When those participants believe that the market is rigged, they will try to withdraw from those markets. Of course, it would be hard for any major multinational company to completely withdraw from the $5.3 billion foreign exchange market, but it is not inconceivable that they might attempt to find alternative mechanisms for dealing in foreign exchange.

Finally, the forex scandal is especially troubling because it persisted for more than two years after the Libor scandal was exposed. How did the discovery that one hugely important benchmark rate was being manipulated to profit a small group of individuals not lead to a greater scrutiny of other markets?

What other important prices—those set by the London Metals Exchange come to mind—are determined by a small number of traders whose interests might not align with ours? It is time for our governments and financial regulators to be proactive and stop the next episode of manipulation before it happens.

Featured image credit: Foreign money conversion, by McZusatz. CC-BY-2.0 via Wikimedia Commons.

Recent Comments

  1. […] Read my latest OUP blog post on the foreign exchange scandal, and why it is systematically more serious than the Madoff scandal. […]

  2. Carl Henry

    I agree it’s wrong for a few people to conspire to manipulate markets, but it’s also wrong for governments that we all go crying to to manipulate those same markets. Beyond that, these governments obviously aren’t all that good at finding or stopping these issues. Examples: the SEC knew for years there were doubts about Madoff, Libor was known about for years, illegal mortgage derivative sales were known about by the government for years before the bubble burst, and even the wife of the Swiss Fed illegally and habitually made money trading Forex on currency reports before they became public. These same scandels the governments knew about but didn’t stop are the same scandels you want to turn over to the same governments to know about and stop.
    Seems it’s governments and those who run them who are the conspirators…for a fee, for a vote, for more power, and for more bubbles.
    We are humans. We will always have issues. More government is never the answer because the opposite desired results always happen and government prolongs the problems thus producing yet another even larger problem.
    Next Even Bigger Bubble Please!

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