Manipulation and Regulation of the Forex Market

04 December 2013

Martin Sandler, Michael Brown

1. What elements of the Forex market are open to potential abuse?

In the spot foreign exchange markets, there are several broad areas of potential abuse, which may occur on a stand-alone basis or in combination:

(a) Traders receiving or having knowledge of pending client orders and trading their firm's proprietary positions ahead of such client orders, thereby profiting from market movements caused by the subsequent execution of the client orders (and the client obtaining a worse price than it would otherwise have obtained);

(b) Traders colluding to glean knowledge of pending client orders from other dealers to combine with knowledge of their own client orders, thereby gaining even greater front running opportunities;

(c) In cases of pricing benchmarks which are determined by actual executed trades during a defined window such as the WM/Reuters rate 60-second window, traders executing trades during the window with the intention of moving the benchmark, including splitting such trades into strategic blocks for maximum benchmark impact, thereby making a greater spread where subsequently executing a client order at a guaranteed or limit price;

(d) Traders colluding with traders at other dealers to execute trades during the pricing window at off-market prices where the other trader is the other side of the trade or alternatively all colluding to trade in the same direction but with the combined volume having extra manipulative effect.

It is the markets in the less mainstream currencies which are more open to the types of abuse set out above.

2. What are the concerns in the UK?

With the UK being the largest global centre for foreign exchange trading, the FCA's concerns are around how to tackle potential abuse and make markets safer.  In addition to the various LIBOR investigations, concerns have been expressed by market participants that there may be other potential manipulations of the foreign exchange markets.  In particular, FCA has earlier this year launched a probe into allegations of abuse of the WM/Reuters rates.

3. What sanctions are available if an individual/firm is found to have manipulated the forex market?

One of the difficulties for the Regulator is that spot forex contracts are not in themselves qualifying investments under FSMA and therefore the market abuse regime under that Act and the FCA's Code of Market Conduct does not apply. However various customer duties and principles are applicable and in particular principle 5 (proper standards of market conduct) of the FCA principles still applies,  as well as principle 3 of the Principles for Approved Persons. Principle 5 can impute the standards of the Code to a regulated firm (and principle 3 to an approved person) even where, technically, the Code itself does not apply.  If a firm or approved person engages in any of the activities described in 1 above, the principle may be breached and there may, depending on the facts, also be rule breaches in relation to client confidentiality.  For breaches of rules and principles, the FCA can impose a fine and give public censure. Fines are commensurate with the seriousness of the breach and will be determined by reference to the FCA's usual criteria.

If manipulation in the spot markets turns out not to be the only instance of foreign exchange rate manipulation, and manipulative practices are also used in currency swaps, then individuals may also face censure under FSMA since these are qualifying investments and therefore subject to the market abuse regime.

Whether any manipulation found by regulators will give rise to civil claims by clients of the firms concerned is hard to predict, depending as it does on the specific facts of each case. Depending on fact patterns, there could be potential claims in the tort of conspiracy or for unjust enrichment. 

Where there is evidence of possible collusion between traders at different firms having an impact on any particular market, there is likely to be interest as to whether this involves any anti-competitive/anti-trust conduct.  Indeed the Swiss antitrust authorities are said to be conducting a parallel competition investigation to that recently announced by FINMA into alleged foreign exchange manipulation.

4. What are the challenges in proving manipulation?

For those instances of manipulation involving front running, one difficulty will be linking the trades by a trader to knowledge of the upcoming client trade which is anticipated will have an impact on the market. If there has been collusion or a sharing of information among traders at different firms, there may be a trail of communications, including "chat" on instant messaging, which evidence the conduct. Another difficulty will be in demonstrating that the conduct involves manipulation or some other form of malpractice and not simply concurrent  real trading or legitimate hedging techniques.

What action can be taken by domestic regulators to minimise the risk? Are plans being considered to better regulate forex?

The announced FINMA investigation as well as the less formal probe by FCA indicate a coordinated international approach to tackling abuses in the foreign exchange markets. FCA has as yet announced no plans to bring forex into the regulatory umbrella, though it remains to be seen, following the announced investigations, what action FCA, FINMA and other regulators may take, either against firms or individuals or by way of measures to regulate the market as a whole.

5. What should lawyers do next?

Lawyers should be thinking about how they can advise and assist their clients who operate in the foreign exchange markets in tackling abuses, including improving and strengthening internal compliance monitoring and procedures, as well as advising clients as to how to respond to any formal or informal regulatory probes, particularly in light of the recently-announced enhancement of FCA's powers to investigate competition matters. As an immediate matter, clients should be preparing for a specific investigation into WM/Reuters rates.

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