A Leaky Fix
Unfortunately, it seems that news about the fixing of trillion dollar markets has become mundane.
First there was the ‘bombshell’ last year that the London Interbank Offered Rate (LIBOR) was being unfairly manipulated, then, there was the announcement that the Commodities Futures Trading Commission (CFTC) was investigating the possible rigging of the interest rate swap rate. And in mid-April this year the European Union announced that it was investigating possible price manipulation in the $165 trillion physical-oil market. That’s three price fixing scandals in the last 18 months, all involving trillion dollar markets. The combined impact of all these markets on consumers, businesses and governments is staggering and has far reaching implications. So what has come of these investigations?
In the case of LIBOR, in late June 2012, Barclays agreed to pay $453 million to U.S. and U.K. regulators. In December of last year, UBS agreed to pay $1.5 billion in fines to international regulators, while RBS faced a fine of $780 million. That’s almost $3 billion in fines and counting. Furthermore, the scandal has claimed the jobs of high-profile bankers at Barclays, including both their Chairman and CEO, and led to the arrest of several others, while more than a dozen financial firms are still under investigation. In both an attempt to rehabilitate the tainted benchmark and to restore the bruised reputation of British banking, the British authorities in July granted a contract to produce the LIBOR index to NYSE Euronext, the company that owns the New York Stock Exchange. Hopes are high that the NYSE Euronext will return confidence to LIBOR as a benchmark interest rate.
Meanwhile, in its investigation of the suspected manipulation of global oil markets, the European Commission on May 14 conducted raids on the offices of three oil giants – Royal Dutch Shell PLC, BP PLC and Norway’s state-controlled Statoil ASA. The EC confirmed the raids by stating, “Officials carried out unannounced inspections at the premises of several companies active in and providing services to the crude oil, refined oil products and biofuels sectors.” They went on to state, “The commission has concerns that the companies may have colluded in reporting distorted prices to a price-reporting agency to manipulate the published prices for a number of oil and biofuel products.”1 Again we have an independently determined benchmark for a huge market that has gone from ‘trusted’ to ‘tainted’.
While the markets for gold and silver are much smaller than interest rates or oil, investigators have decided to take a closer look at the precious metals market. In March of this year, U.S. regulators began scrutinizing whether prices are being manipulated in the world's largest gold trading centre, the London Bullion Market. While no formal investigation has been opened, the CFTC is said to be looking at issues including whether the setting of prices for gold and silver market are transparent. Given the manipulation we know has occurred in the oil and LIBOR markets, could gold and silver be any different? Let’s review how gold and silver prices are ‘fixed’ and some recent research that sheds light on the topic.
The London Bullion Market Association (LBMA) website states that the gold price is ‘fixed’ twice daily according to the follow process: “Five LBMA members (Barclays Capital, Bank of Nova Scotia-Scotia Mocatta, Deutsche Bank AG London, HSBC and Société Générale) conduct the Gold Fixing by telephone twice each London business day at 10:30 am and 3:00 pm. Orders are placed by clients in dealing rooms of members of the Fixing who net all orders before communicating that net interest to their representative at the Fixing. The gold price is then adjusted up and down until demand and supply is matched at which point the price is declared “Fixed” and all business is conducted on the basis of that Fixing Price. Transparency at the Fixing is served by the fact that counterparties may be kept advised of price changes, together with the level of interest, while the Fixing is in progress and may cancel, increase or decrease their interest dependent on this information.”2
Last week a fascinating new study emerged that suggests that the pricing mechanism may not be so transparent and that some market participants could be profiting from information ‘leaking’ during the fixing process. Published in The Journal of Futures Markets by Andrew Caminschi and Richard Heaney is an analysis of the fixing process for gold bullion3. The authors investigated the impact of the London PM gold fixing (held at 3pm London time) on gold futures, and the SPDR Gold Shares (GLD). They found statistically significant return advantages for informed traders in the four minutes following the start of the fixing. They found that trades in the opening minutes of the fixing are significantly predictive of the price direction of the fixings, in some cases exceeding 90%. The authors concluded that, “the London PM gold price fixing does have material impact on the exchange-traded gold instruments, information from the fixing is leaking into markets prior the fixing results being published, and there exist economic returns for trading on these information leaks”. While this study does not analyze or comment on the process by which the gold price is determined, it does provide evidence that information during the process is being leaked somehow to the advantage of some market participants.
According to The Economist, it is a lesson of the past five years that benchmarks in unregulated markets can fall victim to the incentives they create4. From the Caminschi and Heaney study it seems clear that the price fixing mechanism for gold has fallen to its own unique incentives, benefiting only a few market participants who clearly have information before the rest of the market. While the authors only studied the market price of the GLD and futures contracts, the most significant market impact of this ‘leaking’ is likely felt by the outstanding gold derivative contracts which total close to half a trillion dollars according to the Bank for International Settlements5. This study should be enough to prompt regulators to ‘shine a light’ on the gold fixing mechanism and review the process for potential abuses.
3 Caminschi, Andrew and Heaney, Richard. “Fixing a Leaky Fixing: Short-Term Market Reactions to the London PM Gold Price Fixing.” The Journal of Futures Markets September 2, 2013. (Published online)
5 Bank for International Settlements Quarterly Review, June 2013
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