By Roy C. Smith and Ingo Walter
Of all the financial markets that should be resistant to manipulation, the foreign exchange (FX) market surely tops the list. With $5.3 trillion traded daily by thousands of buyers and sellers across the world, this should be a hyper-efficient market.
Foreign exchange is traded in a self-regulated broker-dealer market dominated by large, responsible banks and other intermediaries serving financial and non-financial clients worldwide. It has run seamlessly for decades, including during the global financial crisis of 2008-2010.
The FX playing field is a design masterpiece, blending efficiency, innovation stability and robustness. Equals are treated equally and unequals treated unequally in a transparent, competitive framework that extends from massive dealing banks at the center to nonfinancial firms making wire transfers or hedging currency exposures.
FX traders’ live in a fishbowl where gains and losses are taken as they come and there are no rocks or weeds to hide under. As befits such a business, traders must be as tightly controlled as a Pit Bull on a leash – alternately extending or tightening trading limits with changing market conditions and traders’ skills – controlled by experienced supervisory managers who have been there and done that.
So how could six traders in the FX business -- Citigroup, JP Morgan, HSBC, Royal Bank of Scotland,UBS and Bank of America - agree to a $4.3 billion “settlement” to dismiss charges of FX market misconduct by US, UK and Swiss authorities after a year-long investigation? This is the largest group settlement ever, and the first to target the FX business. The specific charges involved failure of the banks to prevent traders’ efforts to manipulate the FX market - irrespective of whether they succeeded, which quite likely they did not.
To many, the settlement seemed just and appropriate, coming on the heels of similar scandals in the Libor, mortgage-backed securities, commodities and retirement savings markets. Years after the 2008 financial crisis, these same banks, and a few others yet to be dealt with, seem still to be out of control and need to be forced to do their jobs properly. This is a sad commentary on the effectiveness of market discipline.
But to others, the settlement seemed to be an example of bullying and over-reaching by regulators to extract disproportionately large payments from banks to settle charges that a few apparently poorly supervised FX traders misbehaved. Instead of punishing the miscreants, their direct supervisors and, in turn, their senior managers, it is the shareholders of the banks who are stuck with the bill – billions that could have been returned as taxable income to shareholders or used to increase bank capital.
The New Normal
Indeed, the FX settlement is the latest in a long line of massive legal actions against banks as corporate “persons” responsible for the actions of those whom they employ. In this connection, prosecutorial efforts to make shareholders liable for problems caused by employees has been aimed at forcing boards of directors to reform their banking cultures to make them more responsible to the public interest, upon which their banking charters are ultimately predicated.
This is the real lesson for bank shareholders, and, fair or not, this is the “new normal.” The legal power to sue banks for infractions, supervisory failure and associated cultural dysfunction is undisputed and here to stay. And the system is stacked against the banks. Prosecutors almost never have to prove their cases in court because bank boards fear the reputational damage of a public jury trial and that a “guilty” verdict would open a floodgate of civil litigation. So, they settle on the best terms they can get
The current FX case also demonstrates how US-style litigation has spread to Europe, where the UK’s Financial Conduct Authority (FCA) and the Swiss Financial Market Authority (Finma) have teamed up with US banking authorities. In all three countries, it is possible that criminal charges against individuals may follow.
Holder Factors In
Charging corporations as persons responsible for the conduct of their employees was unusual until 1999, when Eric Holder, at that time US Deputy Attorney General, wrote a memo to federal prosecutors outlining the criteria for bringing such charges. His memo - which has been superseded by a series of others - set standards that the Government followed in suits against Enron, WorldCom and other corporations caught in scandals during the early 2000s.
The basic idea of the Holder memo was that corporations are expected to provide a culture of good citizenship and appropriate business practices which fully comply with the law. It contained several “factors” to be considered by prosecutors in bringing charges against corporations – these included pervasiveness of wrongdoing within the company, a history of misconduct, timely and voluntary self-disclosure of wrongdoing to regulators, cooperation in the ensuing investigations, and the existence and adequacy of compliance programs, including management efforts to prevent, identify and discipline wrongdoing (italics added).
The test for whether a corporation meets these tough standards is not entirely clear, but the burden of demonstrating that it has in fact done so rests with the corporation itself.
Some of the banks involved in the FX settlements - particularly those with a history of employee misconduct in other markets - may have been uncomfortable demonstrating the ability of their management organizations to spot and prevent trouble. No doubt there have been cases of FX trading desks being pressured to boost their profitability using aggressive tactics, failing to examine new “trading strategies” for compliance shortcomings, or failing to listen to whistleblowers.
A New Standard
Given the Holder factors, it is increasingly hard for banks to plead ignorance or incompetence. No longer will it do to say “we have procedures in place, but we cannot be expected to keep track of everything every employee does.”
The proliferation of settlements across different financial markets makes it clear that banks increasingly will have to show they made credible and persistent efforts to keep their people in line. They must now be able to demonstrate that they have organized themselves into proactively watchful, compliant organizations by training, motivating and rewarding thousands of middle managers for spotting and fixing trouble before it happens. Such a functional approach to controlling behavior is the essence of the missing “cultural” issue in banks. It does however beg the question of how to reward these people appropriately for things that didn’t happen as opposed to things that did.
Even with the best of intensions and commitment of resources things can still go wrong. But if a bank can show it has in good faith done all that any responsible organization could have done to prevent, detect and halt employee misconduct, then it can expect to avoid the kind of litigation that has damages shareholders and undermines its reputation and performance.
Bank boards of directors are beginning to get the message. They appreciate that getting these Holder-type issues wrong can be hugely expensive, and can lead to even worse consequences if their cultures are perceived to be tolerant of misconduct.
The good news is that banks can turn things around. This requires pruning the FX ranks of chat-room miscreants and re-training those who remain. People selected for middle management must be inculcated with the idea that they can and will be be rewarded for how well they play “defense” as well as “offense.” Internal whistleblowers need to be encouraged, not marginalized – itself not an easy thing to do. Department ad hoc committees at the operating unit level need to be able to thrash-out and resolve conflicts-of-interest and compliance issues on the spot as they arise.
This will require a major reworking of middle management responsibilities and accountability for a large segment of a bank’s managerial structure – maybe one in every ten or fifteen employees. But it can be done, and done effectively, if the necessary will and resources are applied.
The latest series of FX settlements make it very clear that the banks have no choice but to do all this, and do it quickly.