Introduction I. Mechanics of the Foreign Currency Market and Manipulation Scheme A. Brief History of Currency Market B. Financial Instruments in Foreign Exchange Markets 1. Spots 2. Derivatives C. How the Forex Market Works D. Benchmarks E. Incentive Structure F. How the Manipulation Scheme Worked II. Current Regulatory Scheme of the FX Market A. Commodities Futures Trading Commission 1. Commodities Exchange Act 2. Treasury Amendment 3. Dodd-Frank Act 4. Manipulation Laws 5. Charges Brought by CFTC in FX Manipulation B. Department of Justice 1. Sherman Antitrust Act 2. Charges Brought by DOJ in FX Manipulation C. Other U.S. Regulators 1. Monetary Authorities 2. U.S. Office of the Comptroller of the Currency 3. New York Department of Financial Services D. International Authorities E. Internal Banking Regulations F. Repercussions of the Manipulation Scheme III. Implications of Regulatory Proposals A. The Market Should Remain Unregulated 1. Proposals to Maintain Self-Regulation B. Regulations are Necessary 1. Proposals/Solutions C. Criminal Sanctions IV. Shift Toward a Regulated Market A. Regulate the Spot Market Explicitly B. Criminal Sanctions Conclusion "What is the chief end of man?--to get rich. In what way? dishonestly if we can, honestly if we must."
"Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."
--Justice Louis D. Brandeis
On June 12, 2013, Bloomberg published an article exposing a practice by which traders for the world's biggest international banks colluded to manipulate the benchmark for foreign currency exchange rates for their own profit. (1) The article explained, "[t]he behavior occurred daily in the spot foreign-exchange market and has been going on for at least a decade, affecting the value of funds and derivatives." (2) The foreign currency exchange (forex or FX) market is the biggest market in the world, with a daily turnover rate of $5.3 trillion as of April 2013. (3) Yet, there is "no single global body to police the massive 24/7 forex market." (4) "The FX market is like the Wild West," according to a trader who spent twelve-years working at banks. (5)
For two years investigations of this accusation went on, with the market unsure of how to proceed. (6) Although the investigation is still continuing, it has so far resulted in over $10 billion in fines for seven of the world's largest financial institutions, (7) four banks pleading guilty to violations of the Sherman Antitrust Act, (8) and over thirty of the banks' top traders being fired, suspended, or put on leave. (9) The investigation has sparked unprecedented regulatory scrutiny on the foreign currency exchange market. (10)
The impact of foreign exchange benchmark rates on urban economies is profound. According to Joseph Gold, former General Counsel of the International Monetary Fund, "for most countries, there is no single price which has such an important influence on both the financial world--in terms of asset values and rates of return, and on the real world--in terms of production, trade and employment." (11) The benchmark rates are not only pivotal in the FX market, but the "Dow Jones Industrial Average, S&P 500, FTSE 100, and others equity indices all use the WM/Reuters benchmarks to compute the value of stocks denominated in foreign currency." (12) Seventy-five percent of all forex trading takes place in just five cities: London (41%); New York (19%); Singapore (5.7%); Tokyo (5.6%); and Hong Kong SAR (4.1%). (13) Cities have long been centers for commerce, trade, and ideas, and the FX manipulation scheme poses a threat to the economies within these cities and the urban experiment generally.
This Note aims to provide an approachable explanation of the complex FX regulatory scheme and how the manipulation came about, along with an analysis of the future of the market. Part I of this Note outlines the history and structure of the FX market and explains the way the manipulation scheme worked. Part II provides a detailed look at the market's regulatory scheme. Part III provides a discussion of the arguments for and against additional regulation and proposals that have been made. Lastly, Part IV proposes a solution to the regulatory void present in the foreign exchange spot market: to create a reporting requirement for the purpose of monitoring and transparency and to impose more severe criminal sanctions.
MECHANICS OF THE FOREIGN CURRENCY MARKET AND MANIPULATION SCHEME
Part I of this Note provides a brief history of the foreign currency exchange market, explains how the foreign exchange market functions, explains its impact on other global markets, and details the way the benchmark manipulation scheme worked.
Brief History of Currency Market
The stability of exchange rates (14) is necessary to maintain economic growth and financial prosperity, affecting nearly all areas in international markets, including free trade and international investment. (15) To provide exchange-rate stability, major industrial nations have proposed and engaged in a number of monetary systems throughout the twentieth century. (16) The most successful system (17) emerged as a result of the Bretton Woods Accord in 1944. (18) The conference (19) resulted in the creation of the International Bank for Reconstruction and Development (the World Bank) and the formation of the International Monetary Fund (IMF). (20) The Bretton Woods Accord required the international community to scrutinize and control exchange-rate policies for the first time, rather than countries reserving oversight as a matter of national sovereignty. (21) The Articles of Agreement of the International Monetary Fund required that each nation would establish a par-value for its currency, defined in terms of gold or United States currency, and that this rate could only be changed or adjusted with the Fund's authorization. (22) Exchange rates were not to rise or fall more than one percent of the established par-value, necessarily prohibiting the exchange rates from floating against one another freely. (23)
The system was essentially a gold standard, and the U.S. dollar had assumed the role of the key reserve currency by providing necessary liquidity. (24) Eventually, with inflationary pressures, the accounts held in dollars began to exceed the U.S. monetary gold reserves, lowering the value of the dollar and the fixed rate system became unsustainable. (25) The Bretton Woods Accord broke down by 1971 when the United States officially withdrew from the exchange rate system. (26) A Second Amendment to the Articles of the International Monetary Fund passed in 1978. (27) Still in place today, this Amendment created a floating rate system, (28) in which major currencies are allowed to float against one another. (29) According to the Fund, "for want of a better label, the present system might therefore be characterized as a discretionary and decentralized system," (30) as opposed to the previous system directly controlled by the IMF.
During the period of the Bretton Woods Agreement, the stability of currency rates left little room for speculation. (31) The currency market was essentially a cash market, with currency exchanged only for the commercial purpose of doing business internationally. (32) A bank customer would purchase foreign currency because of the actual need to use it in a transaction. (33) The FX market has since evolved with the adoption of a floating rate system, with speculative instruments now playing a substantial role. (34)
Financial Instruments in Foreign Exchange Markets
Currency transactions take place in a number of different forms. The distinction between the spot market and these financial instruments is necessary to a complete understanding of the regulatory scheme of this market. As discussed in Part II, financial legislation and regulation identify and govern each instrument individually. This Part defines spot transactions, forwards, futures, swaps, and options.
A spot trade is the most basic currency transaction, upon which all financial instruments are built. (35) A spot transaction is not a financial instrument at all, but is "simply the exchange of one currency for another currency, at the current or spot rate, or a 'currency pair.'" (36) It is...