Sunday, November 16, 2014

This Fall's Big-Bank Thorn: FX

Banks must now settle FX-market-related charges
Senior management at big, global banks these days operates as if they are shell-shocked.   Or operates as if another debilitating dooms day is on the horizon. Every page they turn and everywhere they look, an apparent crisis looms. Or the apparent crisis becomes the real ordeal, particularly one where the end result is a billion-dollar hit to earnings because of reserves they must take for previous transgressions, legal settlements or massive reorganization.

On top of crisis management, senior bankers must manage (what they perceive) overwhelming regulatory requirements and other priorities of the moment.  Bankers in this decade spend much of their time responding to the lingo of the moment:  "MRA's" or "matters requiring action" (jargon used by regulators to help banks prioritize what they need to do to get on the regulators' good side).

Think about the long list of issues banks must address--minute by minute, everyday, all the time: mortgage-related settlements, derivatives-trading processes, increasing capital requirements, stress tests, equity trading and "dark pools," threats from shadow-banking segments, compensation restrictions, and a Libor scandal (and the related settlements).

In the current year, the challenges continue to mount: cybersecurity, balance-sheet leverage restrictions, and contemplation of what a "SIFI" (systemically important financial institutions) designation implies.

Now comes another crushing headache:  Allegations of cheating, collusion and misrepresentation in one of the biggest markets big banks have controlled over the past four decades--the trillion-dollar market for foreign-exchange sales and trading.

FX sales and trading have been a stable, profitable machine for large global banks for decades. They have controlled markets, trading, processing and clearing, products, and pricing. They are the dealers in the middle of the fray around which all other players, participants and users must operate. Hedge funds, speculators, small dealers, and the treasury teams at major corporations that use FX for hedging and payments purposes must--for the most part--go through the circle of big banks.

Banks control access to and insight regarding FX markets, partly because they have history and experience in FX and partly because they control the deposit accounts and funds-transfer systems that allow the market to operate.

They make markets in currencies of all kinds, establish prices and facilitate actual settlement (receipt and delivery of currency into bank accounts).  Banks also have expertise in specialty products: FX options, long-dated FX trading (trading for settlements at dates in the future), and currency swaps. FX market participants who need, use or even want to speculate in currencies can't avoid banks, unless they choose to do this entirely in futures markets, and even then, they will likely use banks for clearance, brokerage and settlement.

Think of the FX market as a commodity market with foreign currencies traded as if they were products, subject to supply and demand and influenced by the machinations of interest rates and macro-economic factors. Companies that do business internationally (exports and imports, e.g.) will require currencies for payments or receive currencies in sales. They may also engage in FX transactions to hedge balance sheets and earnings statements from the impact of FX volatility.

Because prices fluctuate in predictable and unpredictable ways, speculators are attracted to the market. Price movement will imply opportunities to profit from the increase or the decline in the values of currencies.

Think of banks as operating a the top echelon of this vast market, one that features a shelf of sometimes oddly behaving and sometimes predictably reacting commodities (Euro, sterling pound, Japanese yen, etc.).

Now banks are in trouble in this marketplace in the way they were in the fixed-income arena in the Libor and mortgage-related scandals the past decade.  A bevy of regulators in the U.S. and in Europe has investigated and begun to levy billions in fines and penalties or arrange for legal settlements (over $4 billion in total so far, and over $300 million at many banks).

This fall has become another migraine for big banks (including HSBC, Barclays, JPMorgan, RBS, Citi and UBS). Another quarter with a special loss provision to account for the transgressions regulators claimed banks committed. (Front-running trading--in front of their own clients for their own accounts--is one allegation. Price collusion in setting daily prices is another.)

With banks forced to clean up strings of lingering issues, is this one reason why we haven't seen new products, banking innovation, and new financing ideas in the way we saw financing creativity in the 1990's through mid-2000's?  Has financing creativity been discouraged, because it has been linked often to the financial failures of the crisis?

Or have banks resigned themselves to the notion that innovation and efforts at fancy transactions and novel banking products will eventually lead to market implosion, reputation risks and billion-dollar legal settlements a decade later? Or just as important, will the process of introducing a new product or a new financing method take much longer, as banks decide whether the financial and reputation risks are worth it? Are the risks now perceived to be too overwhelming for the short-term rewards?

A decade or so ago, who would ever have thought that plain-vanila FX sales and trading (not to mention, pegging Libor interest rates) would result in alleged scandal and billion-dollar blows to earnings?

Tracy Williams

See also:
CFN:  Libor in Crisis, 2012
CFN:  Making Sense of Derivatives, 2013
CFN:  High-frequency Trading, 2012
CFN:  Can You Stand Market Volatility, 2011
CFN:  JPMorgan's Regulatory Strategy, 2014

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