This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Ian Lance at RWC discusses the impact of markets being rigged
The book capturing the headlines at the moment is Flash Boys which is an inside story of High Frequency Trading and its impact on financial markets. All of Michael Lewis’s books are highly entertaining but Flash Boys contains some very serious messages.
It reads: “Stock markets rigged. The United States stock market, the most iconic market in global capitalism, is rigged.”
For anyone who doubts the influence of HFT, as far back as January 2011, research from Tabb Group LLC identified that high frequency trading accounted for 77% of all transactions in the UK equity market. Many market participants will have felt its influence for years as they wondered why the share price of any sell order placed with a broker slid away the moment they sent it. The machines are now so prevalent no-one is surprised by unexplained price movements such as the slamming of the VIX index and levitating the S&P500 in the final minute of trading.
Share prices surging ahead of a bid and plummeting ahead of a profit warning with no subsequent action taken by regulators are now the norm. Everyone looks at the spike in AstraZeneca’s share price in the months before the bid and they just shrug.
No longer does anyone kid themselves that fundamentals move the market when the fluctuation of the S&P500 now seems determined either by jawboning of members of the Federal Reserve and ECB or by the move in the JPYUSD rate.
Given all of the above, it is no surprise that people have begun to lose confidence in equity markets. As Lewis points out “Since the Flash Crash in May 2010, the S&P500 index has risen by 65% and yet trading volumes are down by 50%. Before the flash crash, 67% of households owned stocks; by the end of 2013, only 52% did […] It wasn’t hard to see why their confidence in financial markets had collapsed. As the US stock market has grown less comprehensible, it had also become more sensationally erratic.”
And of course the equity market is not nearly the only market that has been hit by scandal.
Foreign Exchange
From the Financial Times, February 12 2014: Seven global banks including Barclays and UBS face new claims of alleged foreign exchange market manipulation in the first US class action lawsuit to include original research that highlights unusual price spikes in euro, sterling and other major currencies.
LIBOR
The Libor scandal was a series of fraudulent actions connected to the Libor (London Interbank Offered Rate) and also the resulting investigation and reaction. The Libor is an average interest rate calculated through submissions of interest rates by major banks in London. The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they were. Libor underpins approximately $350 trillion in derivatives. It is administered by the British Bankers' Association.
Gold
On February 28, 2014, Bloomberg News reported that the same academics who uncovered the Libor manipulation had investigated the gold fixing process and found empirical evidence consistent with manipulation – the study is currently unpublished. The newswire reported that the gold market is worth $20 trillion annually. The Commodities Futures Trading Commission, the U.K.’s Financial Conduct Authority, and Germany’s Federal Financial Supervisory Authority, are all reportedly investigating the manipulation of this benchmark.
Interest Rates and Bond Markets
One can trace the rigging of the bond market back to 1991, when U.S. Treasury Deputy Assistant Secretary Mike Basham learned that Salomon trader Paul Mozer had been submitting false bids in an attempt to purchase more Treasury bonds than permitted by one buyer during the period between December 1990 and May 1991. Salomon was fined $290 million for this infraction, the largest fine ever levied on an investment bank at the time. Last month a Credit Suisse bond trader was fined for similar attempts to rig the market.
Of course the most blatant example of rigging the bond market is that carried out by the central banks. Having hoovered up over $4 trillion of government bonds and mortgage backed securities, the Federal Reserve’s policy of quantitative easing has had far reaching implications across all asset markets.
What also makes this so terrible is that many would regard part of the Federal Reserve’s role as regulating financial markets and yet they are the largest manipulator of markets out there. This is another reason that investors are losing trust in the markets; regulators are seen to be turning a blind eye to many of these controversial practices or at best applying double standards.
So there you have it; most markets are rigged and no-one trusts the regulators to do a thing about it. “I will leave the conclusion to investment strategist Grant Williams.
In order for market rigging to be stopped, the changes have to come from those entrusted with regulation, in the form of stern punishments for those caught rigging them, and there must be changes to the rules to close the loopholes that allowed this kind of activity to occur in the first place. Instead, the bodies which supposedly oversee the markets are involved in the most serious rigging of all.
What chance is there that we will see any change? Get used to it, folks. As anyone who looks at financial markets up close with their eyes open will tell you, they are all rigged — it’s simply a question of degree.
The question is, do you adapt and work around the rigging, or do you simply decide not to play? Central banks and governments seriously hope you choose the former option.”
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