Rates volatility buoys hopes for currency forwards desks

Libor rigging has been seen as a rates market problem, but it also tainted the foreign exchange market – forcing banks to pick and choose even more carefully as they add extra staff for a surge in currency forwards activity. By Michael Watt

Currency forwards desks have had a quiet time of it since central banks cut interest rates to historic lows, but with rates volatility expected to increase – and the more distant prospect of central bank hikes – trading activity could be reinvigorated. The problem for banks that want to increase their staff in anticipation is that some candidates are now tainted by the Libor scandal.

“Every time we see a candidate, the first thing we want to know is whether he or she has any relationship to Libor fiddling. You want to identify and take on the best traders, but it’s harder to do this now the scandal has leeched into our part of the industry,” says one senior forex forwards trader at a large European bank. 

Evidence of widespread Libor rigging by large, international banks emerged a year ago. Barclays was first to settle, as regulatory investigations uncovered emails and messaging showing traders had pushed for Libor quotes to be skewed for commercial reasons – the bank also submitted numbers that were too low, to avoid the appearance of weakness during the financial crisis. Barclays was fined roughly $450 million by the Commodity Futures Trading Commission (CFTC) and the Department of Justice in the US, and the Financial Services Authority in the UK. Regulatory settlements with UBS and Royal Bank of Scotland (RBS) have followed, with investigations of other institutions ongoing.

While interest rate swap traders were behind many of the requests to manipulate Libor quotes, the CFTC investigation of RBS found forex forwards traders sat at the same desk and were also involved – in some cases pleading with the bank’s Libor submitters in an attempt to pull the benchmark rate one way or the other. The potential rewards were well appreciated: “It’s just amazing how Libor fixing can make you that much money,” one yen trader remarked to a colleague in 2007.

The RBS investigation indicated most of the traders involved were no longer at the bank by the time its findings were published in February this year (see box). Across the Street, the same is true – many have moved on voluntarily or been sacked as the result of in-house probes – shrinking the number of available, untainted staff for banks that are now looking to beef up their forwards teams.

Every time we see a candidate, the first thing we want to know is whether he or she has any relationship to Libor fiddling

“There were a lot of guys let go, even up to a senior level, who will now be looking for work again,” says the senior forex forwards trader. The question is whether anyone wants to take them on.

According to another forex trader, the high-profile nature of the scandal means it is relatively easy to avoid potential bad apples when hiring. “Everyone knows who the big miscreants were among the banks because of the publicity it got. So, all you have to do is look at the firm a candidate used to work for and the time during which they were there. Cross-checking a potential appointee in this manner is pretty easy, and it can bring up an obvious red flag when you’re considering an application,” he says.

Despite the difficulties, some banks are prepared to traverse this minefield, in the belief that changing interest rate expectations will filter through to the currency forwards market. “Interest rates are a key driver of the forex forwards market. The market needs an interest rate yield curve to be able to value currencies over time. The rate of change of those curves, in relation to each other, will then lead market participants to be proactive in hedging their forward currency risk. As these interest rate curves begin to steepen, I would expect to see an increase in market volumes,” says Mark Johnson, global head of forex cash trading at HSBC in London.

Others see it the same way. “In the past year, we’ve been positioning for the upcoming opportunity in the forex forwards market,” says the head of forex forwards at one large US bank. “We’ve hired a number of key personnel in the forwards business globally, and we’ll continue to make sure we invest properly in this area. Over the next few years, we need to have the right people in the right places to take advantage of the growth in the market.”

But the expected increase in activity doesn’t mean everyone will be hiring. “We’re not looking to add to our team. We’ve been putting a huge amount of work into scaling our business to do more with the same amount of people. We think we’re well placed to cope with any sort of pick-up in volumes as we are,” says one head of forwards trading at a large international bank.

Others expect technology to take the strain. “The major banks will trade forwards more and more on electronic platforms. That means you don’t necessarily look to hire traders in the old-style way. Instead, you try to be more efficient with your technology and electronic distribution,” says Eric Duclos, head of short-term interest rate trading at BNP Paribas in London.

Though banks may vary in their response to the changing market, there is little doubt among traders that change is coming. The forex forwards market has been profitable these past few years, dealers say, but not by much. A lot of this has been due to the low interest rates introduced in response to the crisis. “If we go back to late 2007 when the crisis started, it showed up very strongly in the currency forwards market. It was very busy, hugely volatile, with opportunities for individuals and firms to make or lose quite a lot of money,” says Adam Vos, global head of forex forwards at Deutsche Bank. “Since then, we’ve had periods of extreme market volatility due to the euro crisis, but broadly speaking the resulting rate cuts and low interest rate differentials have produced a relatively quiet market for forex forwards.”

The Bank of England dropped its base rate to 0.5% in March 2009, the Federal Reserve settled at 0.25% at the end of 2008 and the European Central Bank dropped its rate from 0.75% to 0.50% in May (see table A).

But this low-rates environment will not last forever. Although actual rate hikes still seem a fairly remote possibility – certainly in Europe – the yield on US Treasury bonds has jumped significantly since Federal Reserve chairman Ben Bernanke suggested at the end of May that the central bank could rein in its programme of quantitative easing later this year (see pages 14–18). That depends on employment numbers in the US and, although few traders expect interest rates to rise within the next 18 months, the market for currency forwards could see the benefits well in advance. “The short-term rates market, and so the forex forwards market, is very anticipatory in nature. If it perceives a change in the rates environment, even if it’s not going to actually happen for a year or two, you’re going to have more speculative interest and more volume. It brings to mind the old joke about the market calling nine of the last five recessions – people are always going to guess when the move will happen, and position themselves accordingly,” says Vincent Delorenzo, global head of short-term interest rates at Société Générale Corporate & Investment Banking.

Deutsche’s Vos explains the thinking process of many clients. “If I’m a buyer of euros, and the one-year forward points fall against the dollar by a hundred points or so, I can arrange a euro/dollar forward in a year’s time that will deliver euros at a far cheaper price than the current spot. That change in the forward rates relative to where spot is tends to get people interested. Clients don’t always have a view on the underlying interest rate, but they know that if they can source euros and sell dollars at a cheaper rate in the future, they should be locking that in,” says Vos at Deutsche Bank. Traders hope to see new business from all types of clients. “In a rising-yield environment, we would expect to see an increase in volume from pretty much every customer sector we have – retail, large and mid-cap corporates, insurance companies, pension providers, institutional investors and banks,” says Johnson at HSBC. 

Duclos at BNP Paribas hopes that, at the very least, the market will regain the volume it has lost in the past two years. “It’s very difficult to estimate the likely increase in volumes in this market. I’d say we have shed around 15% since the market got particularly quiet, and I’d expect to add that 15% back in the future. It’s hard to say though. The increase could be 3%, or it could be 30%. The only thing that could damage the growth is significant regulatory impact, like the imposition of Europe’s financial transaction tax. That would be a killer for forex forwards.”

 

BOX: Misquoting and musical chairs

The Commodity Futures Trading Commission’s (CFTC) February 2013 report into Libor rigging at Royal Bank of Scotland (RBS) isn’t any normal person’s idea of a light, bedtime read. However, it does take one through the looking glass, into the day-to-day conversations between traders and Libor submitters.

The investigation focused on the bank’s Swiss franc and yen Libor submissions, and the instruments that were priced from those benchmarks – interest rate swaps, forward rate agreements, cross-currency swaps, overnight index swaps, tenor basis swaps and currency forwards.

Its findings were clear. “Commencing in at least mid-2006 and continuing through 2010, RBS made hundreds of attempts to manipulate yen and Swiss franc Libor and, on numerous occasions, made false Libor submissions to benefit its derivatives and money-market trading positions... This misconduct involved more than a dozen RBS derivatives and money-market traders, one manager, and multiple offices around the world, including London, Singapore and Tokyo. Sometimes, RBS was successful in manipulating yen and Swiss franc Libor.”

The report also details the manner in which the culture of Libor fixing spread like a virus from the rates desk through to other products and asset classes. In October 2006, the bank decided to seat some of its derivatives traders and money-market traders, of whom some also acted as Libor submitters, at the same short-term markets desk.

Ostensibly designed to improve internal communication, this bout of musical chairs “magnified the pre-existing conflict of interest between the profit motive of traders and the responsibility of Libor submitters to assess honestly RBS’s costs of borrowing unsecured funds in the London interbank market. RBS did not provide any guidance or controls over what constituted appropriate communications between the derivatives traders and money-market traders who were the Libor submitters. The result was an environment where the RBS yen and Swiss franc traders had increased opportunities to attempt to manipulate yen and Swiss franc Libor to RBS’s benefit.”

Stark examples of this collusion were found in transcripts from the firm’s internal instant messaging software, which allowed traders to communicate swiftly without using email. What follows, once you strip out the creative spelling, grammar and punctuation, is a demonstration of just how commonplace Libor fixing became for some of RBS’s traders in both Swiss franc and yen. The transcripts, a small selection of the total found by the CFTC, show traders asking for three-month and six-month Libor submissions in the two currencies to be lowballed or highballed, depending on the specific circumstances of existing trading positions. In all three instances, the person in charge of quote submissions yields to the request.

December 31, 2008:
Swiss franc trader: High 3m libor pls!!!!!!!
Primary submitter: ok if i must
Swiss franc trader: Yes pls
Swiss franc trader: U the man

May 5, 2009:
Swiss franc trader: can we get high 3m, low 6m pls!
Primary submitter: maybe
Swiss franc trader: PPPPLLLLLEEEEEAAAAASSSSEEEEEE
Primary submitter: ok 41 52
Swiss franc trader: perfect perfect

September 23, 2009:
Yen trader: canwe [sic] lower 3mnth Libor by 1 bp if possible
Primary submitter: sure
Yen trader: thanks

Even after the US authorities (referred to by the trader below as the ‘Fed’) became aware of the misquoting and began looking into the matter, RBS traders continued to ask for the submission of false quotes in yen, confident that the investigators would overlook any sketchy activity beyond the US dollar market.

November 22, 2010:
Senior yen trader: hey ... you think we be able to convince [primary submitter] to change the libor today?
Yen trader 1: i can try
Senior yen trader: need to drop 3mth Libor and hike 6m Libor
Senior yen trader: he dropped 6m by 2 bps [basis points] last Friday
Yen trader 1 : at the moment the Fed are all over us about libors
Senior yen trader: thats for the USD?
Yen trader 1: yes
Senior yen trader: dun think anyone cares the JPY [yen] libor
Yen trader 1: not yet[,] i will walk over ot [sic] them