Oranges, lemons and forex

How to understand the market-rigging scandal

Dan Davies
Bull Market
Published in
11 min readNov 13, 2014

The FX settlement was announced this week, prompting a lot of editorialising about how the banks Don’t Get It, and Are Systematically Corrupt and so on. To an extent this is the default position post LIBOR, post CDO and rightly so. But I think there’s a danger in viewing everything through the prism of previous scandals. Although there was some behaviour that was clearly on the other side of the line, the regulators also made clear that lots of the practices involved were not intrinsically criminal; this was an investigation into a grey area, not a straightforward case of lying. Of course, the industry has less than zero claim to the benefit of anyone’s doubt, and people will be instantly suspicious of claims that “it’s more complicated than that”, so maybe I can explain what went on in the FX market through the medium of a series of examples, all based on someone going down to market to buy oranges.

ON MONDAY: You are on your way to the fruit market, because you want to buy five oranges. Someone you’ve never met before accosts you on your way and says “Hey, you! Could you buy me five oranges please? I’ll give you the money when you come back and pay you ten pence for doing it”. You think what the hell, and say yes.

Down at the market, there is one stall which has five oranges for sale at 50p each, and another stall with five oranges for sale but charging 55p each. You buy ten oranges and head back home.

Your customer is waiting back at your gate. He gives you your ten pence, and asks “How much did my oranges cost?” What do you tell him?

You have three choices really.

a) Tell him “50p each” — ie, you filled his order first and then your own
b) Tell him “55p each” — ie, you bought yours first, and then his
c) Tell him “52 and a half pence” — ie, you give him the weighted average of what you managed to pick up

I’m not sure what the intution about fairness here is. In case a) you have done him a favour and are down on the deal — you paid £2.75 for your oranges when you could have got them for £2.50, and your 10p wages doesn’t cover the difference. Even in case c) you are losing money — paying £2.625 for your oranges, less 10p for an “all in” cost of oranges which is 2.5p more expensive than if you’d never met the guy. A lot of people would say case b) is perfectly fair — this guy clearly doesn’t really care all that much about how much he pays for oranges, or he would have gone to market himself rather than grabbing a complete stranger to do so. Why should you subsidise him?

Of course, I think people’s intuitions about fairness might change if your customer was paying you £10 to go to market for him, or if you had explicitly promised him that you would get him the best price possible. What we’re dealing with here is the concept of “duty of best execution”. In some markets (cash equities, and in almost any case in which you’re dealing with retail clients), there is always a presumption that a broker promises best execution to his or her clients, and these days you often need to be able to prove that you went to considerable trouble to get it. But the wholesale FX market developed in a different way — people tended to assume that it was a professionals-only marketplace, that anyone dealing in it should be presumed to be big enough to look after themselves and that competition and transparency of quotes was all the protection that clients needed. Everyone was, for the longest time, happy to let the market develop this way, for the very simple reason that best execution, as we saw in the oranges example, costs money and nobody wanted to pay it.

ON TUESDAY: the same guy accosts you on your way to market and says “Look here! I read in the Evening Market News that oranges were selling for 48p yesterday!”. You explain to him that prices move around during the day and the Evening Market News only prints the price at 4pm when they go to press, but he doesn’t care. He says “Get me five oranges, and I want to pay you the price that the Evening Market News prints at 5pm. And I’ve decided 10p is too much, I’m only paying you 5p from now on”. You shrug and go down to the market.

That morning, there are a lot of oranges on sale, and you manage to get all ten for 45p. You deliver the oranges and go about the rest of your day. At dinner time, your customer comes around carrying a copy of the Evening Market News, which reports that there was a big truck from the orange juice company in town, sending the price of oranges up to 58p at the close. Your customer pays you £2.90 for the oranges and your 5p wages, leaving you with a 70p profit. You begin to say that the 4pm price isn’t very representative, but he cuts you off. “There! That’s more like it!”, he says, pointing at the newspaper “And 5p is far too much for this work, tomorrow it will be 4p”.

You tell yourself, “This guy really doesn’t seem to be putting much thought into how he buys his oranges”.

The Reuters WM benchmark was basically an administrative convenience. The original idea was to bundle large numbers of small orders, net them off against each other as far as possible and give the small players something close to a fair average, rather than subjecting them to the day’s volatility. But (like LIBOR) it proved so useful that it grew way beyond its original purpose as a participants’ convention. The advantage it had for clients was that it simplified the admin mightily — if you were, for example, a sterling based fund manager buying and selling US shares all day, you could say that you wanted all your currency orders to be transacted “at the benchmark”. That would let you concentrate on what you were interested in — the share prices — and just sort out your books at the end of the day on the assumption that every trade in USD that you had made during the day could be converted to GBP at the same price, and that this price would be the one that you could easily look up in the Financial Times or on Datastream. Compared to keeping a great big ledger of the actual prices which you actually did get, you can see the appeal of this. As early as 2006, people in the market were noticing that while the practice of “sticking a huge order in at the benchmark” was widely regarded as an incredibly stupid and careless thing to do, almost a dereliction of your own duty to manage your own trading book, it was nevertheless becoming quite a common practice. As you can see from the article linked above, people were discussing at the time whether a duty of best execution made sense in the FX market, but of course that would have cost money, and everyone was much more interested in managing the dealing costs that they could see, not the execution quality which they couldn’t.

ON WEDNESDAY: your client gives you the same order for five oranges, specifying again that he will pay the price in the Evening Market News, not a penny more or less.

You walk down to the market and see that oranges are being traded at 50p each. You also see your brother, who owns an orange tree and occasionally goes to market to sell his oranges. It turns out that he has a crochety neighbour too, who has asked him to sell five oranges, and who also wants his trade to go through at the Evening Market News closing price. The two of you sit down for a cup of tea and a gossip with the market traders.

You and your brother tell one of the traders about your respective orders, and he whistles through his teeth. “I don’t envy you two, boys”, he says. “We’re expecting the orange juice truck at a few minutes before 4pm, but we’re expecting Farmer Giles and his bumper crop a few minutes after. Either of them might arrive a few minutes early or late. The price is going to all over the place; you two are going to be very lucky if you get oranges bought or sold anywhere near the price that the Evening News bloke writes down the minute he leaves”.

You and your brother are downcast, but not for long. You come up with a plan. He hands over his neighbour’s five oranges to you, for you to deliver to your customer. You will collect the closing price, whatever it is, and hand it over to your brother who will pay it to his neighbour, and the two of you will collect your wages.

As the FCA report says, and as market participants noted in the Euromoney survey article, “netting off” orders is not intrinsically criminal, and not even necessarily against the interests of customers, even though it involves making off-market deals like this. In some cases, it is probably the only way in which the order could be filled at all, and the intuition of fairness is still there — in the Wednesday example above, the clients are asking the dealers to take a potentially very large risk (associated with guaranteeing a fill at a fixed but unknown price), and the dealers are managing the risk between themselves.

ON THURSDAY: your client asks you to buy five oranges, again at the fixing price. “And no more of this overcharging!” he adds. “I’ll pay you 2p!”.

You walk down to the market and see the trader again. You moan to him about your client’s penny pinching and he, sitting on the back of a truck of oranges, makes you a proposal.

“Look, he says, I happen to have got hold of this truckload of oranges for cheap. And I have a bunch of orders to buy them, at the Evening News price. So I’m basically sitting around all day waiting to find out what that is. Could you please wait until 3.59pm, and then come to my truck with your order, to buy at whatever price I’m posting then?”.

You do as he says — he helped you out on Wednesday after all. The day is pretty quiet, so you wait until 3.59pm, when the truck has “Oranges: 55p” posted on it. You buy your friend’s last five oranges and he smiles at you — the truck next to him is selling “Oranges: 56p” and this is the price that the Evening Market News reporter writes down. You take your 2p wages and charge the client 56p for his oranges, pocketing your 5p profit. Today wasn’t such a bad day after all.

Information is currency. It’s quite normal practice in a lot of markets for traders to recognise that part of the payment for an order is their cash commission or spread, and part of the payment is the order flow itself — if you have more information about the order book, you are better able to make profits or avoid losses. Paying in information is sometimes cheaper for the client than paying in money, and it’s a cost which also tends to be heavily underestimated because it’s much more difficult to calculate how much better a price you could (or maybe you couldn’t?) have got if you had played your cards closer to your chest. Of course, this is an area where conflicts of interest can be rife, which is why regulators have, for the last ten or twenty years (particularly since the dot com crash, which exposed a whole load of bad practices) tended to be pretty hostile to the concept of payment-in-information.

This might be the right thing to do— regulators tend to like to work on the assumption of markets in which everyone has exactly the same information set. But it’s a debate that has never really taken place in public — as far as I know nobody’s ever made a general statement that this longstanding practice is now illegal. So it’s not surprising that we are now getting this series of scandals. The use of a position of privileged information to make money used to be the definition of what it meant to be a trader. At some point in the future, it is going to be the definition of what it means to be a criminal. And right now, we’re in the grey area where the boundaries of what constitutes the use of privileged information are being defined.

ON FRIDAY: Your client rushes to meet you at the gate. “I’ve changed my mind about oranges!” he explains. “I want out. If the Evening News price is below 50p today, I want you to sell all the oranges you’ve bought for me this week, plus the eighty more that I’ve got in this crate! I’m only paying 1p for it mind, I’m tired of subsidising your champagne lifestyle”.

You go down to market, fairly late in the day, to see whether the price is going to be near 50p. At 3.58pm, the market is trading at exactly 51p, and you see your brother and your friend the trader sitting about. It turns out that your brother has a big order to sell a truckload of 100 oranges, while your friend the trader has an order to buy a hundred. Unusually, both of them need to fill at the actual price, not the Evening News benchmark. They are considering netting off their orders and going home.

“Wait”, you say. “Don’t do that”. You point to your brother. “You, make your sale on the market right now”. Your brother unloads his oranges onto the market, pushing the price down to 49p. The Evening News reporter writes down this price and runs off to file his copy. “Now”, you say to your friend the trader, “you can buy your hundred from me”. You agree on a price of 51p, which is where the market has been trading all day apart from the few minutes that your brother was trading.

You go back to your customer and hand him the £49.00 sale proceeds of his hundred oranges at the Evening News price of 49p. He hands over your penny in wages, grumbling all the time as he does so. You take your £2 profit and head off down to the pub to buy your brother a drink.

On Monday, in this example, you were a decent honest citizen. By Friday, you’ve clearly reached into the realm of doing something that’s intentionally robbing your client — running a stop-loss order, it’s called. At some point during the week, you crossed a line, but it’s not at all obvious to me where that line was. And this is a potted and simplified history of the FX market since about the late 1990s. In my view, one of the key features in it is one that I haven’t mentioned so far but which you might have noticed — the client keeps on bidding the visible cost of trades downward, but isn’t prepared to put in any effort at all on his own part to see what consequences this has.

This, in my view, is the real story of the various market manipulation scandals from LIBOR to FX to high-frequency trading — clients got into the habit of pushing big orders out to the sell-side without taking care of them, kept demanding tighter and tighter pricing from their brokers without asking how those businesses would remain profitable, and acted as if they benefited from the protections of best execution without wanting to pay for them. Just as there’s no such thing as a free lunch, there’s no such thing as a <1bp dealing spread.

The fixed income trading markets do need wholesale reform. But that reform has to take place on a sensible and sustainable basis, and while the clients and buyside institutions continue to see this as simply a matter of sell-side perfidy while ignoring their own role in creating the uniquely dysfunctional market infrastructure, it’s not going to go anywhere.



Dan Davies
Bull Market

Senior Research Advisor, Frontline Analysts