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10:03 AM
Dr. John Bates
Dr. John Bates

In God We Trust: All Others Bring Data

The way FX benchmarks are set and how FX trading is monitored is about to fundamentally change.

"In God we trust, all others bring data." These are the words of William Edwards Deming -- a renowned American statistician, professor, author, lecturer and consultant. In Japan, from 1950 onward he taught top business managers how to improve many aspects of their business through the application of statistical methods. Deming's statistical, data-based methodologies are a familiar concept in this day and age, so one would think they apply to foreign-exchange benchmarks and rates as well.

So you might be forgiven for wondering how, up until extremely recently, a whole range of financial indexes, benchmarks and rates have been fixed simply on the basis of unverified submissions from market participants, or market prices at set time-windows -- without proper monitoring or controls to obviate the most basic strategies of manipulation and abuse.

One possible explanation dates from the era of "My word is my bond." The ability to benefit from inside information was considered the raison d'etre of engaging with financial market professionals during that era, and was not the potentially criminal act it is today. But this era passed at about the time of the "Big Bang" in London's financial markets in the 1980s. Attempts to change this culture have resulted in a steady stream of regulation and control, designed to stamp out practices no longer deemed acceptable in an era of "fair and transparent" markets.

Practices have changed now, of course, and that era is a dim and distant memory. All except for benchmark-setting, it seems!

First we had the LIBOR scandal, where banks manipulated the rate at which they lend and borrowed from each other to either position the bank as being more credit worthy, or to profit from trading instruments linked to Libor. Some 20 banks, 10 regulators and a few billion dollars in fines later we are finding a similar problem with foreign exchange markets.

We are now seeing regulators in London, New York, Switzerland, Singapore and Hong Kong, to name but a few, turning their gaze toward allegations that dealers from various banks pooled information through instant messages and used client orders to move benchmark currency rates. At the heart of the problem is the suspicion that financial benchmarks are being manipulated by the very same firms who have a key role in setting them. 

It appears that some traders, acting alone or in collusion, sought to manipulate the currency benchmark rates by pushing through trades before and during the brief windows when the benchmarks are set. Traders will typically seek to do this to profit from (or reduce loss from) related instruments, such as options, that are derived from a benchmark. Some of the world's largest banks have fallen under the spotlight and some traders have already been suspended.

Rates and FX are big businesses. FX is now traded extensively not only by voice, but also through sophisticated electronic platforms. Whereas previous debate has held that these 'asset classes' did not need to be included into the scope of financial regulations, particularly around monitoring for manipulation and abuse, it is abundantly clear now that there can be no exceptions or exclusions.

Traditional controls and safeguards that relied on human judgment and speeds need to be re-evaluated in light of new market structures -- none more so than FX markets due to the extreme liquidity in some currency pairs. Further, market participants must ensure that regulatory standards and internal controls are calibrated to match both current and foreseeable market technologies and risks.

As a direct result, the technology plan for monitoring and control for major banks and dealers in 2014 needs re-writing. The plan needs to include monitoring that can rapidly evolve to identify new behaviors in previously unmonitored asset classes. Monitoring systems need to learn what is normal from historical patterns, in order to finely tune the identification of abnormal behavior the moment it happens. Furthermore, the plan needs to break down traditional siloed business lines and monitoring tools to detect and respond to all unwanted behaviors from a single platform.

In 2013, I've watched how trading surveillance and monitoring inside banks and brokerages has evolved in the light of major events, such as the LIBOR scandal. The imperative to broaden monitoring from historic to real-time detection has been one trend to try to get ahead of scandal and repetitional damage. I've also seen the scope of surveillance broaden, from a focus on unusual or suspicious trading behavior to also include suspicious instant messaging networks or suspicious trader working patterns. It seems to me that 2014 is going to be the year trading surveillance meets foreign exchange. And the hungry surveillance machine must once again deal with huge amounts of new data.

Dr. John Bates is a Member of the Group Executive Board and Chief Technology Officer at Software AG, responsible for Intelligent Business Operations and Big Data strategies. Until July 2013, John was Executive Vice President and Corporate Chief Technology Officer at Progress ... View Full Bio
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