Bloomberg News recently reported that traders at some of the world's largest banks have been in the business of rigging foriegn exchange (FX) rates. An FX rate essentially tells you how much of one currency you can buy with another currency: for example, currently you can buy about 100 Japanese yen for each US dollar. The rates affect "trillions of dollars of investments" according to Bloomberg, since they are used for the valuation of portfolios, derivatives, and even equity and fixed income indexes.
The rates at issue in the current controversy are the WM/Reuters spot rates . The spot rates are calculated via an automated process that involves data streamed from multiple venues. Rate data is collected over a 60 second window centered on the fixing time (e.g. closing rates are fixed at 4PM UK time). The median bid, offer and mid rates then calculated to determine the fix rate. Although certain quality checks are applied, "no guarantee of accuracy can be given."
Typically customers will ask banks to buy or sell at a rate at a particular WM/Reuters fix rate. Since banks trade both customer orders as well as their own orders, the concern is that traders use client orders to get better prices, and therefore higher profits, on their own trades. For example, if a large order comes into a bank that will likely move the market, the trader may time the placement of the order to profit from the subsequent rate change. In addition, traders could ensure maximum impact of their timing by splitting a large order into many small orders -- sometimes through collusion with traders at other banks -- since the published rate is determined by the median rate.
The fact that there could be abuses in the determination of this benchmark is perhaps not surprising given the LIBOR scandal that dominated headlines last summer. This news is already on the radar of international regulators such as the Financial Conduct Authority. Although formal investigations will likely take place, it "may be difficult to prosecute traders for market manipulation, as spot foreign exchange [...] isn't classified as a financial instrument by regulators." Indeed, some sources claim that front-running FX trades is "simply impossible to regulate" and that "'concentration' tactics are normal practice for the industry."
But the consequences for investors can be real. For example, in 2011 several state pension funds sued major banks for allegedly overcharging on foreign currency transactions. Also, some municipalities have cross-border financing arrangements with foreign lenders that could be exposed to this form of manipulation. And if emerging market equity indexes have been affected, that could in turn alter the value of billions of dollars worth of mutual funds and ETFs linked to those indexes.