Fight the temptation
Why did the foreign exchange market get into trouble for attempted rate-fixing? That question might sound naïve after an apparently endless stream of banking scandals. But forex should really have been the exception. Swapping one currency for another is an uncomplicated task. The failings of forex trading desks, as detailed by regulators who fined six banks $4.3 billion earlier this month, demonstrate that this business has more weak spots than meet the eye.
Everything about the buying and selling of currencies points to an honest business. To start, it has clear and valuable economic purposes: to facilitate trade, travel and investment. And it is easy to see how financial institutions should fit in. They combine and balance orders, and they can use their own capital to smooth out markets and to offer guarantees on future exchange rates.
If forex is defined in those terms, this is a business where regulators and bosses should find it easy to spot foul play: any forex trading that does not directly serve trade, travel or investment deserves critical study.
Besides, the opportunities for skulduggery are limited in currencies. Unlike the stock market, there is very little inside information (although knowledge of customer orders is clearly advantageous). And unlike most lending businesses, there are no gains from doing business with unworthy customers. What’s more, the currency market is easy to enter and quite competitive, conditions which tend to lead to quick exposure of any collusion.
In fact, forex proved vulnerable to dishonesty. Traders at rival firms teamed up to share confidential information in an attempt to manipulate G10 currency rates, investigators have found.
I believe the real problem was a failure of regulators, banks and lawmakers to consider what function forex serves in the economy. If they had used that as a way of assessing its risks, there would have been a clampdown long ago.
Take the sheer size of the market. There were $5.3 trillion of daily currency market transactions in 2013, according to the Bank of International Settlements. That is roughly 3.5 times more than in 1998 and 15 times more than daily global GDP. It suggests more activity is taking place than the economy really needs. That pace of growth should have worried managers and regulators. It didn’t. Perhaps they decided to believe the standard explanations for the growth: helpful hedging of corporate currency risks, valuable liquidity, free markets in action.
Of course, very little of the expansion was actually driven by any of that. For every ounce of economically merited additional business, there was a tonne of trades created to speculate by taking advantage of cheap leverage, ample liquidity and market adrenaline. It was a place for gamblers.
Everyone should know that gambling and speculation come with a strong temptation to cheat. The lure explains why governments, even when they allow games of chance, generally fight hard to keep them honest. But in forex, the authorities were insufficiently suspicious. The clampdown only began in earnest last year, but the recently exposed failings in systems and controls date back to 2008.
Some market insiders managed to overcome all the forces which pushed to keep the business honest. They were helped by the formulaic approach of many of their counterparties, whose processes demand that they get a particular exchange rate at a particular time.
Penalties have been agreed – with more likely to come – and reforms have been announced. The flurry of activity will presumably help straighten up behaviour, at least for a while. But the underlying problem remains as big as ever. This market should never have been allowed to wander so far from what I see as its core functions – facilitating trade, travel and investment.
As long as the business is so much bigger than the provision of those services would imply, it must in some way be an economic drag – even without scandalous behaviour. The drag can take many forms. Where forex activity is really just gambling, it occupies skilled people who could do something more valuable. Speculation always distorts pricing, leading to inefficient decisions in the real economy. The common forex strategy known as the carry trade, borrowing in one currency and lending in another, is particularly harmful. The fact that much of the speculation takes place in institutions which are supported by governments adds insult to injury.
The scandal is a perfect illustration of the dual nature of finance. There is a good side. Exchanging currencies is vital in any developed economy. But finance also involves trading and speculation. At best, these activities can do a tiny amount of economic good. At worst, they encourage greed.
The good and the bad of finance are not always easy to tell apart. However, it does not take the wisdom of Solomon to determine that little of the expansion of the financial system over the last three decades has been helpful.
A winnowing is in order. Regulators, banks and politicians should decide what should be saved, what should be banned totally and what should be cast out of the protective net of governments. Unfortunately, they are not even asking the right question: what purpose does any particular financial business serve in the economy?