On Monday, the Financial Conduct Authority (FCA), a UK regulator, released a research paper that analysed seven of the major financial benchmarks used by firms to guide a variety of different decision-making processes.
The paper comes three years after the FCA introduced the Benchmarks Instrument. Aimed at improving the robustness of these benchmarks – ie. making them less susceptible to manipulation – the Benchmarks Instrument imposed a set of regulatory strictures on benchmark administrators.
Still in place, they mean that benchmark administrators must be regulated and have FCA-approved persons in key positions before starting operations. They also require firms to hold a set amount of financial resources, maintain record keeping and monitoring arrangements and meet predetermined governance standards.
Monday’s paper examined what effect these rules have had on benchmarks since being implemented in 2013. For the purposes of this article, we’ll only look at the results pertaining to the foreign exchange (FX) market and the WM/Reuters (WMR) benchmark.
FCA rules have no impact
According to the FCA’s report, the Benchmarks Instrument’s rules have actually had a negligible effect on the WMR benchmark. In fact, by examining what impact those rules have had on the benchmark, the FCA found that two other factors had caused a shift in market behaviour.
First off was the scandal surrounding manipulation of the WMR benchmark in 2013. In a now famous investigation, regulators found that individuals at a number of firms – including Barclays, JP Morgan and UBS – had been manipulating the benchmark price for their own gain.
After that activity was exposed, liquidity in the FX market increased by between 10 to 11 percent. According to the FCA, this was due to a “reduction in information asymmetries related to the market abuse.”
An academic paper, also published by the FCA and released on Monday, went into more detail on this point. Looking specifically at the WMR benchmark, academics from Georgetown University, the FCA and BI Norwegian Business School found that, after the exposé in 2013, firms were posting lower quoted spreads. That in turn meant lower trading costs and, one would presume, has helped to drive trading activity in the FX market.
The fix is in
Aside from the 2013 scandal, another major change to the WMR benchmark took place in 2015. Having previously looked at data from 15:59:30 to 16:00:30 – a one minute fix period – benchmark administrators extended the time period to five minutes.
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According to the FCA, that has had three consequences. Firstly, attainability – the ability of firms to meet the benchmark rate during the fix period – declined dramatically.
The research paper released on Monday claims that firms have seen a 7 to 10-fold decline in attainability. Looking at the same scenario, the academic paper researchers found a smaller 2 to 5-fold decline.
For individual firms and the market as a whole, this is problematic. Declining attainability means greater tracking error which, in turn, means greater trading costs for market participants that use the benchmark for rebalancing purposes.
On top of this it can also reduce the liquidity of the market. As the academic researchers noted:
“A reduction in the attainability of the benchmark may also prompt participants to avoid using it or to decide to trade outside of the reference window.”
Though there were likely other factors at play, declining attainability has indeed impacted market liquidity. The FCA claims that since the move to a 5 minute fix period, liquidity has decreased by 6 to 7 percent.
One positive outcome of that extended fix period has been an increase in the robustness of the WMR benchmark. According to the FCA’s research, the introduction of a 5 minute fix period has caused a 100 percent increase in the robustness of the benchmark.
That will likely satisfy the FCA who, understandably, want to ensure there isn’t a repeat of the 2013 scandal. But for market participants the results may be frustrating. Once regulators caught the crooks and restored a level playing field, liquidity increased and fees went down.
Conversely, when regulators then forced benchmark administrators to tamper with the fix time, trading fees went up and liquidity went down. The crimes of a few, it seems, are punishing the many.