The rapidly expanding probe into foreign exchange manipulation has certainly given journalists, pundits and regulators something else about which to write, talk and consider rules.
Near as I can tell, though, these financial benchmark foibles are, by and large, not so much about rooting out pervasive evils so much as moving the inner workings out of legacy structures and into the modern world.
I like to compare it to the evolution of the settlement process in the listed world during my futures trading career. In the olden (and not so olden) days, daily settlement prices were decided by committees made up of members – traders and brokers – closest to the action. Most of the time the process was easy – with transparent prices in highly liquid futures markets, determining prices at the cutoff time was simple.
Less simple was determining settlement for options on these futures contracts, as these were bespoke markets, made by market makers with sometimes imperfect price information, fewer data points, and often differing views on the term structure of volatility at settlement date, as well as the changes in volatility at different strike prices. Plus, since there was open interest in literally hundreds of strikes in each product, it was a cumbersome process, with the work generally divvied up among committee members.
The process required trust – trust that each member acted fairly and objectively when marking the boards, and not skew the settlements to one’s position.
In a perfect world, you want the people in the trenches in charge of daily settlement because they have the most intimate knowledge of where things are actually trading. In our imperfect world, though, such traders have financial incentives to skew in their favor, and the bigger the incentive, the more likely we are to see settlement shenanigans. Although, to be fair, if a trader is long something, it means the trader views it to be undervalued; a short position is viewed as overvalued. Such a trader would quite likely feel that he or she is acting fairly and objectively while marking to his or her position.
As the markets moved to the electronic format, and as streaming quotes became the norm, the issue mostly went away. The exchanges were able to build models to algorithmically determine settlement. Sure, there are still human beings conducting tests for reasonableness, and market participants can still request a review of a specific settlement, but the end result is both more fair and less able to be manipulated.
OTC markets are moving that way as well. The British Bankers’ Association was stripped of its LIBOR responsibilities last year, and the benchmark is moving toward a model based on actual prices. Dodd-Frank is shifting OTC markets onto execution platforms. Technology has made the settlement process much easier to be settled by unbiased algorithms.
I say getting the settlement process into the new era should be a higher priority than taking the old guard to task. If an example must be made of the most egregious instances of chicanery, so be it. But let’s move on to the more important task of unbiased settlements from now on.