Here We Go Again: Financial Institutions, Forex and Unregulated Rates

This story first appeared in the Winter issue of Financial Executive magazine.

On the heels of the London Interbank Offered Rate (Libor) scandal, regulators appear to have found a new area of potential improprieties with regard to the foreign exchange (forex) market. The forex market fluctuates, but can reportedly reach a value of up to $4.7 to $5.3 trillion per day. To date, at least 15 banks are reportedly under investigation by various regulators regarding the forex market. Moreover, more than a dozen currency traders have been suspended or put on leave as a result of the ongoing investigations. Some banks have hired criminal defense attorneys to represent employees. While these investigations remain in the preliminary stages, and no wrongdoing has been announced, there are indications regulators and plaintiffs’ attorneys are ramping up scrutiny of unregulated rates.

Background

In essence, the forex market is a global and decentralized system on which currencies are traded. Much like when someone wants to buy foreign currency before international travel, a common method for a company or investor to make a large currency transaction is to review prices posted by various banks for a given currency and pick the best rate. However, as with making a trade in the stock market, banks active on larger currency exchanges will post two prices: the bid price and the offer (or ask) price. The bid price is the price the market would pay for a given currency, and the ask price is the price at which the market would sell the currency. The difference between these prices is how the banks profit on these transactions (commonly called the bid/ask spread). In essence, the banks try to buy currency at a lower rate and sell it later at a higher rate for a profit. There are other pricing issues that can influence whether a person wants to make a currency trade. For example, the banks commonly charge various forms of commission. Further, the price can depend on the size of the transaction, whether the currency is being bought or sold, and even the nature of the relationship between the bank and the client looking to make the trade.

In light of these complexities, companies and investors who are not as concerned with trying to squeeze the best rate out of the banks often seek to use a benchmark rate. For example, forex index funds may use currency benchmark rates to keep their returns in line with the indices. While this may not sound like a particularly significant issue, even small fluctuations may affect these funds’ value. Given that Morningstar Inc. estimates $3.6 trillion in index funds track global indices, there may be a large pool of potentially affected investors.

The most common benchmark rates in the currency market are set at 11:00 am and 4:00 pm London time. This is because London is considered to be the global center of the Forex market, with an estimated 40 percent of trades taking place there. These rates, commonly referred to as “fixes,” are essentially daily rates that can be used to trade currency. The most common fix is computed at 4:00 pm by a joint venture between State Street’s WM unit and Thompson Reuters (Thompson Reuters was also involved with setting the Libor rates). However, at least one recent article discussed potential investigations into “Tokyo fixing”, referring to Japanese currency benchmarks (which are set at 9:55 each morning in Tokyo). The potential attempted manipulation of these fixes appears to be the focus of regulators’ investigations.

For the currencies that are traded more frequently (21 in total), the WM/Reuters fix is calculated by reviewing trade data from various platforms for 60 seconds at 4 pm. Since the currency market is very large, it could be difficult to manipulate these “fixes.” However, with enough coordinated large trades in the one-minute window (in a process known as “banging the close”), it could be possible to manipulate the fixes. Assuming these fixes were manipulated, and the banks knew in advance the direction the rates were going to be fixed, traders could clearly profit from that knowledge.

Investigations to Date

It appears the forex investigations began in April of 2013, when the U.K. Financial Conduct Authority (FCA) asked certain banks for information regarding potential manipulation. From there, the investigations picked up steam, with additional banks being identified as potentially involved or publicly acknowledging they had received inquiries from regulators. The banks that had been identified or made announcements regarding forex regulatory investigations to date include: Barclays, Citigroup, Inc., Credit Suisse AG, Deutsche Bank, Goldman Sachs Group, HSBC, JP Morgan Chase & Co., Morgan Stanley, Royal Bank of Scotland, Standard Chartered and UBS. Regulators investigating the issue include the U.S. Department of Justice, the Commodity Futures Trading Commission, the European Commission, the Swiss Financial Market Supervisory Authority, the Hong Kong Monetary Authority, the Monetary Authority of Singapore and regulators in Brussels. Significantly, over a dozen currency traders located in New York, London and Tokyo reportedly have been suspended or put on leave while the inquiries take place at Barclays (6), Citigroup (1), JP Morgan (1), Standard Chartered (1), Royal Bank of Scotland (2) and UBS (1). Also, Barclays and UBS have reportedly hired criminal defense lawyers to represent employees with regard to the investigations.

For the most part, regulators that have made public statements about the investigations have said only that investigations remain in the early stages. Barclays, Royal Bank of Scotland and Deutsche Bank have indicated they are cooperating with regulators. From various reports, it appears regulators are requesting emails, instant messages and phone records of several employees at these banks. A spokesman for the U.S. Department of Justice has stated the criminal division has started a far-reaching probe, and that they are “responding aggressively and taking it very seriously.”

The Use of Chat Rooms

[pullquote forward=“2”]Several media reports have indicated regulators are, in part, investigating the use of chat rooms that are available via Bloomberg trading terminals. Some of the chat rooms’ names appear suspect enough, with titles such as “the Cartel,” “the Bandits Club” and the “Dream Team.”[/pullquote] In addition, and as can be common in trading chat rooms and message boards, the banter between traders reportedly includes boasts about the ability to manipulate the market, as well as sharing market-sensitive information. Whether those comments are actually true, the potential implications will be taken seriously by regulators given the climate and recent issues concerning rate manipulation surrounding Libor. Several of the traders that participated in these chat rooms are also reportedly past or present members of a Bank of England committee that oversees the currency market (the Foreign Exchange Joint Standing Committee chief dealer’s subgroup). UBS, Barclays, Citigroup and RBS have now banned or significantly limited the use of all chat rooms, and other investment banks are reportedly considering similar options. Further, Deutsche Bank executives are warning employees to be cautious about the words they use in emails and chat rooms, as their comments can be taken out of context.

Forex Civil Lawsuits

Not surprisingly, civil lawsuits are starting to be filed against a number of banks asserting investors have been damaged by the alleged manipulation of the forex market. To date, there have been at least two purported class action lawsuits filed against Barclays, Citigroup, Credit Suisse, Deutsche Bank, JP Morgan Chase, Royal Bank of Scotland and UBS in the United States District Court for the Southern District of New York.˙The first of these, filed on November 1, 2013 by pension fund Haverhill Retirement System, alleges a single cause of action for antitrust violations under the Sherman Act. The second purported class action was filed on November 8, 2013, by the Korean electronics firm Simmtech Co., Ltd. In addition to alleged antitrust violations, the Simmtech action also alleges violations of the New York General Business Law. Despite numerous forex traders having been suspended at many of the defendant banks, neither complaint names any individuals as defendants. The allegations in each complaint are substantially similar and allege the defendant banks traded ahead of client orders and rigged the WM/Reuters Rates by placing large trades before and during the 60-second window when the benchmark is set. By pushing through a concentration of orders during this 60-second window, it is alleged the traders colluded to drive the rate up or down. As a result, the complaints allege the returns that class members received from the currency trades tied to the WM/Reuters Rate were fixed or stabilized at levels lower than the free market would have returned absent the alleged manipulation. Further, the lawsuits assert class members were deprived of the benefits of free, open and unrestricted competition in the currency trading market.

The lawsuits remain in the very early stages, and whether they ultimately obtain class certification remains to be seen. However, damages have the potential to be significant, with some speculating the impact of the alleged forex market manipulation could rival the recent Libor-rigging scandal. Further, as the alleged forex market manipulation becomes more widely reported on, additional civil lawsuits are all but guaranteed to be filed against the banks participating in the forex market. In fact, a lawyer representing Simmtech recently stated that several South Korean companies have inquired about joining the Simmtech action.

That said, to date the plaintiffs’ firms have had problems making the antitrust allegations in the Libor litigation stick. In the consolidated Libor litigation, Judge Naomi Reice Buchwald, who is overseeing the cases pending in the Southern District of New York, dismissed the antitrust claims on the grounds that the plaintiffs failed to allege antitrust injury. Such a claim requires a loss that stems from an anticompetitive aspect of the defendants’ business practices. Specifically, the court found that while the plaintiffs may have suffered a vertical loss (i.e., harm resulting from the defendants’ conduct), they had not plausibly alleged a horizontal effect (i.e., that the process of competition was harmed because the defendants failed to compete with each other). In other words, the court found that no competition was actually harmed as a result of the defendants’ alleged behavior. While that ruling is being appealed, given the size and nature of the forex market, the plaintiffs in the cases filed to date will likely face similar arguments.

Another possible allegation by potential plaintiffs would be violations of the Commodities Exchange Act (CEA). CEA claims were brought by one class of plaintiffs in the consolidated Libor litigation and the district court overseeing that litigation has allowed some of those claims to go forward. One of the key issues the Libor district court reviewed with regard to the CEA claims was whether the plaintiffs could plead “actual damages” on their specific (in that case, Eurodollar) futures contracts as a result of the defendants’ manipulation. If there was manipulation of the forex fixes, it would likely require large coordinated trades. In this regard, it may be possible for an individual investor, or combined group of investors, who made large trades based on the fixes to show damages if there was indeed manipulation. However, much would depend on the size of the trades and level of purported manipulation. Aggrieved investors may also attempt to rescind agreements and/or trades tied to the forex fixes. We have seen this in the Libor arena in the U.K. civil action entitled Graiseley Properties Ltd v. Barclays Bank plc, generally known as the ‘Guardian Care Homes’ case (there is a similar action in the U.K. pending against Deutsche Bank, entitled Deutsche Bank AG v. Unitech Ltd.). In both the Guardian Care Homes and Unitech cases, investors are arguing they would not have entered into financial transactions at issue with each bank had they known that Barclays and Deutsche Bank, respectively, were manipulating the benchmark underlying the transactions (i.e., Libor). If successful, the claimants may be able to use Libor manipulation as a basis to rescind the contracts, walk away from the deals and potentially receive damages.

In this regard, if any index funds or other investors had agreements with any of the banks being investigated for manipulation of the forex market that tied some component of the deal to the forex fixes, similar allegations could be made against those banks if there was manipulation. Similarly, U.S. investors who may have had large investments tied to the forex fixes may make individual allegations of fraud against the banks. This discussion of potential claims that may be brought against the banks involved in the forex investigations is not intended to be exhaustive. Since these investigations are still in the early stages, it is possible other types of allegations of wrongdoing could arise that would lead to different claims being made in civil litigation. However, much has yet to be revealed with regard to these investigations.

The Metals Market and Other Potential Areas of Concern

Other markets have received press concerning potential manipulation including the metals markets, other commodities such as oil, and interest-rate swaps and derivatives. Reports have surfaced that European Union regulators have searched the offices of a unit of McGraw-Hill Financial that assesses the price of “Dated Brent,” which is the benchmark rate for greater than half of the crude oil traded worldwide. Of these other markets of potential concern, the gold market has received more of the press as of late. According to reports, the U.K. FCA has recently heightened its review of the metal markets generally, including hiring outside consultants to assist in its investigations. Germany’s financial regulator, BaFin, is also reportedly investigating suspected manipulation of gold and silver benchmark rates. The gold fix price is used by investors and companies alike to value their holdings, but is also used in derivative markets for purposes of pricing and trading options, swaps and futures.

Insurance Implications

Given the amount of electronic information that is likely being requested from the various banks involved to date, the costs of these investigations are likely to be significant. For example, it has been reported that Deutsche Bank is currently sifting through “tens of millions of pages of transcripts of electronic chats, email messages and other communications to determine whether its employees engaged in improper conduct in the foreign-exchange markets.” That said, costs incurred in connection with the regulatory investigations may not be covered or only provided on a limited basis depending on policy wording.

If regulators determine manipulation did occur and additional civil litigation follows, defense costs could be substantial for many of these banks. However, coverage available under a Banker’s E&O policy could be limited by the claims being asserted. For instance, many E&O policies specifically exclude antitrust claims and similarly exclude fraud (though fraud exclusions now more commonly have varying adjudication provisions). If fines or penalties are levied for wrongdoing, and those fines rival the $3.6 billion levied to date with regard to the manipulation of Libor, it could impact the stock price of a given bank. Moreover, there have been several reports that the suspension of traders at the various banks may cause disruption in the forex market, which could lead to allegations of lost profits. Such circumstances could set the stage for either U.S. securities class actions or derivative actions being asserted not only against the banks, but also the directors and officers. As such, both D&O and E&O policies have the potential to be implicated, depending on policy language and the specific allegations asserted. Finally, employment practices liability policies may also be affected in light of suspensions of senior traders.˙These traders are often highly compensated, and as such are not able to easily find comparable employment. If a suspended trader believes he or she is the “fall guy” for conduct the bank knew about, and possibly even encouraged, employment practices claims for wrongful termination may also be brought against the banks.

The regulatory investigations are still in the preliminary stages, and there has been no admission of wrongdoing by any of the banks to date. However, in light of the ongoing investigations, as well as the suspensions of traders by multiple banks, it appears likely regulators will find some wrongdoing occurred. Additionally, the plaintiffs’ bar is obviously paying attention with the filing of at least two civil cases to date (and more expected to follow). As a result, any issues relating to potential manipulation of the forex fixes and other unregulated rates should be watched closely by insurers going forward.

Eric C. Scheiner and Jennifer Quinn Broda are partners in the Chicago office of Sedgwick LLP where they represent insurers and reinsurers in investigating and litigating claims under various types of professional and commercial lines of coverage.