Financial Times (7th of April 2014; page FTfm 14)

Finance briefing: FX market and why it matters

Kate Lander and Rhodri Preece explore impact of rate rigging

In light of the allegations about forex market manipulation, we examine the role and
functioning of the market, why forex fixing is critical and what the implications of rate-
rigging claims are.

What is the forex market?

The foreign exchange, FX or forex market is the market in which currencies are traded.
Currency trading exceeds $5tn a day, which makes it the biggest and most liquid of
financial markets globally.

Britain has the largest share of the forex market, with about 40 per cent of all
transactions taking place in London. The abolition of all foreign exchange controls in
Britain in 1979 was instrumental in the development of the forex market. The strong
infrastructure for currency trading also contributed to the expansion of the forex market
in London.

Why is this market important?

The forex market is the backbone of international trade and global investing. It is critical
to support imports and exports, which are necessary to gain access to resources and to
create additional demand for goods and services. Without the ability to trade in different
currencies, companies’ prospects would be limited and global economic growth would
suffer.

Investors also use the forex market. Those who seek international diversification
benefits need to trade currencies to buy and sell foreign assets and securities. Some
investors view currencies as an asset class and trade currencies to generate alpha.

How does the forex market work? Trading takes place between dealers in a global
network connecting buyers and sellers. Currencies are traded electronically and
bilaterally over the counter. One challenge for investors is to identify “where the market
is” when they want to trade because of limited transparency about forex trades.

What is forex fixing?

Limited transparency about trades combined with the fact that forex rates affect so many
transactions means there is a need for some sort of a benchmark – that is, a single rate
that reflects the value of one currency relative to others at a particular point in time. This
benchmark is called a “fix”.
 While there are many forex fixes, the main ones are determined in London at 11am and
4pm every day. A forex fix is typically created from a snapshot of actual trades within a
narrow window of time, say 30 seconds, unlike Libor that relies on estimated rates. But
concerns have arisen that manipulated trading around the time of the fix may distort the
determination of the forex rate benchmarks.

Why does forex fixing matter?

It matters because of the pervasive role of forex fixes. These rates are used by companies,
investors and asset managers. Forex rates are necessary to value assets, liabilities and a
large number of transactions for goods and services denominated in different currencies.
Some investors even trade on the fix, instructing their broker to buy or sell a certain
amount of currency at the 4pm fix.

Forex rates also form the basis for performance evaluation and risk management. For
example, they are used for hedging against currency fluctuations to manage risk and
they can be used to speculate by assuming risk with the hope of earning a return.

What are the implications of the forex manipulation scandal?

The effect of potential manipulations of rates could spread well beyond the financial
sector, affecting any business with international operations as well as retail customers. If
asset managers or companies discover their orders have not been treated fairly, trust in
financial markets will be further damaged. A likely consequence is an increase in
litigation provisions for dealer banks.

What can be done to fix the fix? Regulatory initiatives to tackle how forex rate
benchmarks are determined are already under way. These efforts focus on governance
and oversight of the administration of benchmarks, greater transparency over
benchmark calculations and supervision. Ultimately, benchmark integrity depends on
ethical behaviour on the part of financial market participants.

Kate Lander is head of education at CFA Institute and Rhodri Preece is head of capital
markets policy at CFA Institute