More than a year ago, John Taylor and his team at a hedge fund in New York noticed an intriguing dynamic in the currency markets. They found that they could often make profitable trades in the few minutes surrounding 4 p.m. London time, the moment when a daily foreign exchange benchmark is set.
"We thought it was a little weird," said Mr. Taylor, a veteran currency trader. But he attributed it to the fact that many corporations and institutional investors wanted to do trades at that time, at rates as close to the benchmark as possible.
Now, a brewing scandal is offering a different explanation for the short-lived market moves: possible collusion by traders at some of the world's biggest banks, a scheme allegedly co-ordinated via electronic chat rooms with such names as "The Cartel" and "The Bandits' Club."
The market manipulation, if proved, would be the most significant misconduct to emerge from the world of currencies in decades and would represent a fresh black eye for the financial industry.
With more than $5-trillion (U.S.) in daily turnover, foreign exchange represents the largest market in the world and also one of the most lightly regulated. Now, however, it's facing a new level of scrutiny, as is the technology that supposedly abetted the wrongdoing. On Tuesday, UBS AG – one of numerous banks being examined in the probe – announced a ban on chat rooms used to communicate with friends or traders at other institutions.
No banks or individuals have been accused of any wrongdoing. But authorities in at least six places – the United States, Britain, the European Union, Switzerland, Hong Kong and Singapore – have launched probes of currency trades.
Eric Holder, the U.S. Attorney-General, recently remarked that the manipulation in question "may be the tip of the iceberg" and said that this could be "an extremely consequential investigation."
In Britain, about 15 banks are under the microscope, according to a person with knowledge of the investigation, who said Canadian banks are not part of that group at present. Barclays PLC, Citigroup Inc., Deutsche Bank AG, JPMorgan Chase & Co. and Royal Bank of Scotland Group PLC have acknowledged in regulatory filings that they are being scrutinized in connection with the probes and are co-operating with investigators.
Spokespeople for Royal Bank of Canada and Toronto-Dominion Bank said their firms had not been contacted as part of the currency probe. The other major Canadian banks did not immediately respond to queries.
For currency traders, the investigation is deeply disquieting. Unlike stocks, which trade on an exchange and are governed by securities laws, currencies are traded over-the-counter between banks. While certain types of currency products – futures and options, for instance – are subject to regulatory regimes, the market for trading "spot" currencies and forwards has no such oversight.
"There's not a lot to say: 'You can't do this, you can't do that,' " remarked Mr. Taylor, whose hedge fund, FX Concepts, recently closed amid a difficult business environment for currency funds.
For years, the thinking about the foreign exchange market was that it was too big to manipulate. The reports that have emerged about the investigation, however, suggest that complacency was unwarranted. Foreign exchange trading has grown increasingly consolidated in recent years: Five major banks account for nearly 60 per cent of the total flows, according to an annual survey by financial publisher Euromoney Institutional Investor PLC.
"People were rigging the market, there's no doubt about that," said the head of one London-based hedge fund active in foreign exchange, who asked not to be identified discussing a topic that is under investigation. He said he knows several former currency traders at major banks who are extremely worried about being pulled into the probe.
The alleged misconduct centred on the currency "fixes" – the times of day when the benchmark exchange rates are calculated. Such snapshots are critical because currency markets are open around the clock, with trading sessions migrating from Asia to Europe to the Americas.
The most popular "fix" comes at 4 p.m. London time: Data is gathered on trading rates during a 60-second window to produce a median price, which forms the basis of each day's benchmark exchange rate. The resulting rates, calculated by World Markets Co. PLC, are used by scores of investors around the world to value their portfolios or by companies to account for cross-border transactions.
Using instant messages, traders at banks reportedly shared information about the flow of orders leading up to the fix and carried out their own trades prior to it, a practice known as "front running." They also supposedly worked together to push trades through during the benchmark-setting window in an attempt to move the daily rate up or down.
The shifts didn't need to be significant to pay off. "This is not: 'How do we get a penny stock to be a dollar stock?' " said David Gilmore of Foreign Exchange Analytics, a Connecticut-based research firm. But even very small movements could help a trader's positions to the detriment of clients, he said. Two such customers – a municipal pension fund in Massachusetts and a South Korean electronics firm – filed lawsuits in federal court in New York in early November against seven banks, seeking damages for the alleged rigging of currency trades.
The first casualty of the controversy appears to be the use of electronic chat rooms by traders to communicate with friends or peers outside their own bank. In announcing its ban on Thursday, UBS noted in a memo to staff that "recent events within our industry serve as a serious reminder to be mindful at all times… in all of our communication, no matter the channel," The Wall Street Journal reported. At least five other major banks are weighing whether to restrict the use of such electronic forums, the paper said.
With files from reporter Tim Kiladze