How Investors Bet On The $5.3 Trillion Currency Market

photo by Allan Ajifo via Flickr 

The $5.3 trillion-a-day foreign exchange market (Forex) is the biggest market in the world, and at one point, one of the most manipulated.

But, what exactly is the Forex and how was it so easily manipulated?

What is Forex?

According to Investopedia, Forex is:

“The market in which participants are able to buy, sell, exchange and speculate on currencies.”

While Forex does attract international corporations who need to hedge their risk by buying and selling different currencies, most market trading in Forex is dominated by financial heavyweights like banks and hedge funds, who use the markets to conduct speculative trading on the same currencies (i.e. wagering whether a currency will go up or down).

How Forex works

Everything in the Forex market starts with what Forex traders know as “the fix,” which refers to the once-per-day 60 second period in which foreign exchange rates are set.

There are many fixes, but the main one occurs every day in London at 4 p.m., and is meant to set a going exchange rate with which Forex traders can value 21 different currencies around the world against each other with.

Specifically, this is done by calculating the supply and demand through tallying the trade of all currencies which take place in this one-minute window. The fix is crucial to Forex since it sets a bar for the rest of the days trading.

While “the fix” in and of itself isn’t necessarily nefarious, what the banks and their traders did to manipulate it certainly was.

How Forex was manipulated

In 2014, after what is now known as the Forex scandal, banks like HSBC, J.P. Morgan, and their biggest Forex traders were swept up in a plot to manipulate the valuation of currencies around the world to their advantage.

During a process that Forex traders dubbed “banging the close,” referring to a last minute push to slide a currency up or down before the fix is over, banks and traders were able to make a profit off of their clients’ trades.

Traders, by using information gleaned from their respective banks’ clients, (i.e. a multinational company wants to buy or sell a large sum of one currency) they were able to stockpile orders, and send the price of a currency up or down.

Put more simply, traders from different banks were able to use their built up trades in tandem during the fix. These trades were in aggregate so large, that they were actually able to influence the final valuation of a currency.

They colluded via instant messaging systems with ominous names like “the cartel,” and “the mafia,” in order to orchestrate such trades together.

After manipulating a currency valuation, traders were able to make their own trades using the fixed rates to their advantage.

Some traders made as much $513,000 in just one of these trades.

The results

After the scandal was uncovered in 2014, a number of prominent banks around the world would bare the brunt of a $4.25 billion fine for their traders’ collusion in the Forex market.

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Since the incident, the amount of time used to determine foreign exchange rates–the fix–has been increased just slightly from one minute to five minutes, a change which regulators hope will make it harder to influence a currency’s value.

The takeaway

The Forex market still remains the biggest in the world, playing a crucial role in multinational corporations ability to hedge risk.

The confidence in such a market, however, has suffered a major blow following the Forex scandal in 2014.

While regulation and some fairly pricey fines have been levied against banks and their traders, investors in the Forex can only hope that such collusion has been handled.

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James Pero