GR investigates why the full cost will top Libor scandal
The foreign exchange market (forex) manipulation scandal has expanded like a mushroom cloud. What started as the suspicions of a few individuals in 2012 is now a global probe involving 15 banks and a dozen regulators.
It is predicted to get worse, and to exceed the cost and severity of the London interbank offered rate (Libor) scandal which it so closely resembles.
The investigations so far have revealed suspected rate rigging and shed light onto the shadowy underbelly of forex trading.
But how bad will the case get, and what will be the impact of forex manipulation on the directors & officers (D&O) insurance market?
Let us start by looking at the alleged offences. Some traders are accused of manipulating the main forex benchmark rate, known as the WM/Reuters rate, which is set at 4pm in London every day and is based on the number of trades placed during a sixty-second window.
The forex market is dominated by big banks, which place trades for their clients and for themselves. Manipulation allegedly occurred when traders conferred to strategically place trades at certain times around the window to manipulate the WM/Reuters rate and maximise their profits. In forex trader slang, this practice is known as “banging the close”.
The investigations are still at an early stage, and so far there has been no proven wrongdoing. There is evidence that traders manipulated the WM/Reuters rate, but proving that this harmed banks’ clients is another matter.
DAC Beachcroft partner Richard Highley said: “Is the client losing? There is still that second step you’ve got to take.
“On the basis that you have got banks being asked to trade for their clients, obviously they are making a profit off the spread. So yes, you would say there must be, because that spread is based on the daily fix. So yes, there would be a likelihood of detriment.
“You’ve then got to work out: what is that detriment? Like Libor, that becomes the more difficult process.”
The forex allegations are very similar to the Libor scandal, in which banks conspired to rig the rates at which they lent to one another. This led to a wave of fines, D&O claims and costly civil litigation.
Perhaps because of the spiralling cost of the Libor scandal, banks are taking the forex allegations very seriously.
Banks including Barclays, Citigroup, Deutsche Bank, HSBC, JP Morgan and UBS have already begun investigations into forex manipulation. The Bank of England has suspended one employee and JPMorgan Chase, Barclays, Citigroup and UBS have also suspended staff.
Highley believes that banks are taking the forex allegations very seriously as a reaction to the costly fallout from the Libor scandal. He said: “They are doing that at a very early stage, and they are doing it, I think, in a similar way to which they are approaching Libor, which is to distance themselves or their management from the wrongdoing. “
Regulators including the New York regulator and the UK’s Financial Conduct Authority are carrying out their own investigations into the issue.
Costly to insurers
So how serious is the problem likely to get, and how worried should insurers be? All the early signs are that the forex scandal could cost banks even more than Libor.
Bank of England governor Mark Carney, testifying to the UK government’s Treasury Committee in March about forex, said: “This is extremely serious.
“As (FCA chief executive) Martin Wheatley has rightly said, this is as serious as Libor, if not more so – time will tell – because this goes to the heart of the integrity of markets. We have to re-establish the principles of fair markets so that people in markets know how to behave.”
Sedgwick Law partner Jennifer Broda says: “It is likely to be more severe than Libor. That is because, in part, the manipulation that occurred was more direct that occurred in Libor, and was actually based on trades.”
The potential for D&O claims arising from forex allegations is clear, and lawyers agree that insurers are very likely to see a raft of the claims.
Pinsent Masons partner Alexis Roberts says that this is a near certainty. He adds that this is a particular possibility in the UK, where the FCA regulator has shown more of a focus on senior management responsibility than its FSA predecessor.
Sedgwick Law managing partner Eric Scheiner said he also thought a wave of D&O claims was likely, but added: “I think those will likely, if they happen, be on the back of any anti-trust liability or large regulatory settlements.”
To add to the problem for insurers, DAC Beachcroft partner Jonathan Brogden believes that the potential pool of D&O claimants is much larger for forex than it is for Libor.
“With forex, you’ve got a much more direct link between those people who can claim to be affected by any allegations of wrongdoing on the part of the banks, who were the people actually making the trades, and therefore also more directly affecting the daily fix,” he said. “For forex, I would suggest they have more cause to bring a claim.”
But will the culprits be senior enough to trigger D&O payments? The banks have suspended traders of all ranks, if that is anything to go by. Of course, the forex investigations are at an early stage, and there is no clarity about which individuals, senior or not, have done anything wrong.
But for many D&O policies, rank no longer matters, because policy wordings cover employees other than directors and officers.
There has also been hot debate in the insurance world about whether D&O policies should pay out when fraud is involved.
Brogden says: “Where the fraud or illegality is obvious, something that has been talked about in the market previously is whether the policy should respond.
“I think the commonly-held view is that this type of policy is intended to advance defence costs, even where insurers are thinking ‘yes, but this individual doesn’t deserve insurance, this is a case of fraud, and we can approve it even if the police cannot prove it’.”
Insurers are, of course, able to claim these costs back after individuals are proven guilty in court, but this is little consolation when these individuals are often unlikely to be able to pay them back.
Unlikely to harden rates
So how will forex rigging affect the future of the D&O insurance market, and is there any good news for insurers?
Firstly, it is unlikely that the forex scandal will lead to rates hardening in the notoriously soft D&O market.
“If losses are great, then for banks we might see a rise, but the market has constant new entrants and has been soft on rates for years,” Highley says.
However, the publicity surrounding forex and D&O could at least increase penetration of the insurance, according to Roberts.
“I would have thought that as soon as we start seeing some profile around enforcement action or civil claims on senior management, that there will be more of an appetite for people to buy these products,” he explained.
For insurers, the full impact of the forex allegations is unclear, because the alleged wrongdoing itself is still unclear. It is almost certain that insurers will face a wave of D&O claims, but the full cost and nature of these claims will only be revealed once the regulatory and bank investigations run their course. But insurers and banks will surely be hoping that, following the unearthing of the Libor and forex scandals in the space of just a few years, there will not be any more costly cases waiting to emerge.