— Paul Amery's Blog

Banks’ clients bear some responsibility for benchmark abuse

The column inches devoted to castigating bankers for benchmark abuse pile up. But the clients who gave banks the fixing orders in the first place bear some responsibility too.

There’s a common theme running through the benchmark abuse cases: Libor and FX. Banks were given orders to execute client trades at levels that referenced these market benchmarks, while also contributing to the benchmark-setting process.

Clearly, banks should not have been using advance knowledge of clients’ orders to push fixing levels one way or another: this kind of behaviour happened on a large scale, involving collusion between traders at multiple banks.

But what of the clients who gave the order to “trade at the fix” in FX? Were they innocent victims?

If a large corporation or fund manager wants to (say) sell a billion dollars for euro he can trade it in the market in a single order, split it into smaller orders or use an electronic algorithm. All these methods threaten a degree of market impact; in other words, the FX rate moving against the manager as a result of the size of the order.

But (in the past, at least) the fund manager could also hand the order to a bank and instruct it to conduct the whole deal at the day’s 4pm fixing rate.

Although the fixing rate had a bid-offer spread to compensate the market maker for making the trade, the spread was always the same, regardless of the size of the client order and the state of the markets.

There’s a good reason why a fund manager might want to trade at the exact fixing price in a market like FX (or, for example, at the closing index price in an equity market). The fund manager is incentivised (often, formally, via his contract with a client) to minimise tracking error against his own performance benchmark.

Trading at the fix (or at the equity market close) is therefore safer for the fund manager, since it reduces the risk of an unwelcome divergence in performance between fund and benchmark. In some cases clients appear willing to trade at a specific point in time even if this costs money.

It’s unsurprising and no secret that the more money following a particular index or market benchmark, the greater the likelihood of distortions in the index’s or benchmark’s price behaviour.

Fund managers, and other users of the FX fixing, had a right to expect that information regarding their orders would not be abused by the banks.

But the existence of a set spread for “fixing” trades should have raised suspicions that the banks were making money on the side from client orders.

And, unfortunately, by the very act of requiring the banks to commit to execute orders at an (as-yet unknown) fixing rate, irrespective of size, clients acted as the enablers of abusive behaviour.

While the banks are rightfully being brought to task for their role in benchmark abuse, those who “fed” the fix should also recognise they got things wrong.