JOURNAL - VOLUME 2

Front-Running the UK Economy


2019/06/24 - Monocle Journal

On January 17th 2017, precisely 25 minutes prior to the announcement of a crucial statistic relating to UK consumer price inflation, the traded value of the USD to GBP began a sharp and steady rise from its level of USD 1.212 per GBP. The currency had been trading in a range of USD 1.212 to USD 1.213 per GBP for some time. The announcement was imminent and would undoubtedly have consequences on the exchange rate should the UK inflation figure diverge from analyst expectations of 1.4 percent.

Between 25 minutes prior to the announcement for the December inflation figure and the actual announcement, the dollar began an inexorable rise to 1.218, the point at which it peaked, and the point at which the general population of traders, analysts, bankers and investors learnt the truth: that, in fact, the UK inflation figure for the period ending December 2016 had eclipsed expectations and was reported at 1.6 percent. Clearly, a selected number of individuals had had prior knowledge of the diversion of inflation data from expectations, and had then either traded the position themselves, or had leaked the information to others who had traded it on their own behalf. Whilst the actual trade would have at best only yielded a return of USD 0.006 per GBP, this amounts to a yield of 50 basis points – an enormously profitable trade, were one certain of the information about to be announced, and of its obvious implications to the value of GBP relative to the USD. It is also a trade that can be initiated, executed and shut down in the space of 30 minutes or less.

To  stress  the point: in a hypothetical world, had a trader taken a  USD 100 million position, they would have made a virtually risk-free profit of USD 500 000 in the space of half an hour. Several recent studies have been conducted that have pointed out that in the UK in particular – where important statistical data are released to selected individuals, such as Prime Minister Theresa May, up to a day prior to the actual announcement – significant price diversion has been noticed in key financial indices and instruments.  One recalls perhaps the most chilling example of this form of information arbitrage. In the week prior to the September 11th 2001 attacks on the World Trade Centre, the volume of put options acquired on US Airways was many multiples greater than normal trading volumes. In the case of the US Airways put trade, the effect was to strike – physically – at the economic epicentre of the western world whilst simultaneously substantially profiting from the attack itself.

In the case of early trading on the value of GBP versus USD – whilst being less dramatic and terrifying than the September 11th attacks – the persistent and fundamentally undermining nature of front-running the economic data releases, is ultimately undermining and deleterious to the broader economic and social conditions of the western world. It is this nature of insider trading – which continues to persist – that remains a broadly destructive element to the financial markets in general.

These kinds of manipulations of the financial system have been revealed to be ubiquitous across a range of markets – think of the broad extent of the LIBOR rigging scandal, all the way through to the manipulations of the South African Rand. No analyst is yet able to successfully and cogently explain why, on Thursday the 16th of March 2017, at the very moment that the US Fed increased the Fed funds rate, the value of the Rand counterintuitively strengthened against the USD. All logical theory would have it that were the spread between US rates and ZAR rates to narrow, the carry trade on ZAR would be less attractive and the South African Rand should weaken in response.

Naturally, there is a persuasive argument that can be made that the rate increase, given the nature of the fiscal policies being adopted by the Trump administration, was virtually a given and had therefore been priced into the value of the Rand. What is not explainable is that the Rand, in the moments following the Fed announcement, immediately rallied. In the context of the current investigations into the manipulation of the Rand by currency traders in 17 banks worldwide, one is left with little solace in rational economic theory, since, in a world in which information is not shared equally, the reasons for currency moves could be subject to just about anything one could imagine.

This is in fact the real problem: the continued malpractice that seems to go on unabated within the financial markets not only erodes value for the average investor, but also erodes confidence in the body economic itself. This leads to the kind of primal response that one sees in the anti-Davos rallies, in the Occupy Wall Street movement, and in the general apathy that pervades the western democratic system.

Unfortunately, the response from regulators and the response from their masters, the politicians themselves, has been reactionary and counterproductive in nature. Basel III, imposed upon banks post-crisis, has led to several extremely negative effects: increased capital adequacy demands have made banks far riskier, far more difficult to invest in, and less efficient.

Within the world of investment management and sell-side investment banking, the Mifid II directives, expected to be implemented by 2018 – which demand that fees for research and fees for volume trading be clearly delineated – have already led to a substantial reduction in the number of research roles within the broker and investment banking industry, and to a blood-letting of jobs that are critical for the collective good. If there are fewer good minds applied to analysing the idiosyncratic risk within companies, there will naturally be greater scope for distortion and even fraud within financial reporting, rather than less.

Whilst these regulations appear to be necessary given the behaviour of financial institutions, their aggregate effect is negative. It reminds one of a teacher who, rather than isolating and disciplining a particular child, punishes the entire class and thereby erodes the process of learning.

It is remarkable how few individual criminal convictions have emerged out of the raft of market manipulations that have been uncovered over the past decade, and it is uncanny how executives have dodged the bullets. The only way those few who undermine the entire construct of western democracy and capitalism will stop is if one were to treat them as they should be treated, as criminals.

 



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