"Banks don't have to beat the market to make money. They just have to beat their customers."
So says Caspar Marney, a foreign exchange trader of about 20 years' experience, including spells at major City banks such as UBS and HSBC.
The former paratrooper has been playing those markets using his own statistical methods on behalf of private clients since 1999, and gives lectures to others keen to learn how this impenetrable scene really works – which seems to be in a very different way to how most of us imagined.
On Tuesday, Bank of England governor Mark Carney admitted that allegations of exploitation in foreign exchange markets could prove to be a bigger scandal than the manipulation of Libor, following last year's revelations that the £3tn-a-day global trade in currencies might have been rigged.
"A bank's spot [currency trading] desk doesn't generally beat the market," Marney adds. "They extract profit from their orders. Orders are information. Every bit of information stacks the deck. And the closer you get to 4pm, the less the risk [of the price moving against you]."
That time is crucial in currency trading and it is where investigators are said to be focussing. The market uses a benchmark price at 4pm – ironically called the "fix" or the "fixing" – which is the price many clients request, chiefly because it is considered to be transparent.
That seems clear enough, but how can a few traders manipulate "the fix" when the currency markets are so huge? The answer, according to Marney, is that the trade is rigged, but not in the way you might think.
Traders cannot really command prices to go higher or lower – as was ostensibly the case in the Libor rigging scandal when a few bankers manipulated benchmark interest rates. But in foreign exchange, the market is heavily biased towards the professionals sitting on trading desks, who gain an edge by automatically receiving information far superior to that used by outsiders.
Marney's example involves a trader who gets a call from a major corporate client wanting to exchange US dollars for £600m in sterling. "That's big, but not absurdly huge," he says. "You perhaps get one of those a month but when you do, all other things being equal, you know the price is going up as you have an order for a market moving amount."
Knowing that there is going to be a large order for dollars against the pound, the trader could buy some pounds for the bank's own trading account (unlike in equity markets, this is not against the rules in foreign exchange). He might also stage the purchases of the £600m so that the bank is likely to pay less for the pounds than the price at 4pm – which is what the client ends up being charged for.
While Marney says he has no evidence of collusion between foreign exchange traders at different banks; he adds that many of them know each other as they have frequently worked for several banks. He speculates that if a few of them did speak and discovered they all had large orders likely to push the market in one direction, it might prove too tempting an opportunity.
Even so, Marney has some sympathy with his foreign exchange colleagues – who have not been shown to have broken any laws. "A bank has no choice but to trade before 4pm – otherwise they'd lose money [as they'd be paying a higher price than at the fix]," he says. "Did the banks do something terrible? If you think that, then you have to ask yourself: how else should they execute [their trades]?"
A step-by-step scenario
3:45pm An international client calls the foreign exchange desk of a bank to convert some of its US dollars into £600m of sterling. It asks if the trade can be settled at the market benchmark price – established at 4pm each day and dubbed by the markets as "the fix" or "the fixing".
3.48pm The trader immediately buys £50m for the bank's own trading account at the market price of 1.6000 pounds to the dollar. He does this as he knows he has a very large amount of pounds to buy over the next 12 minutes meaning there is a good chance that the price will rise.
3.50pm The trader has now made sure that his bank has been looked after. His £50m trade has caused the price of pounds to tick up to 1.6010 and the trader buys £100m at that price. He repeats this trade every two minutes, which drives the price higher each time. He stops when he has bought a total of £600m for his client by 4pm at an average price of 1.6035.
4pm The "fixing" states the price of the pound to the dollar is now 1.6060. The trader has filled his client's order and can also sell the £50m he bought for the bank. As the client has asked to pay the fixing price, he receives his £600m at a cost of $963.6m (£600m x 1.6060). But the bank has paid $962.1m (£600m x the average price of 1.6035), meaning it has made $1.5m out of the client's transaction. Add in the $300,000 won on the £50m side bet, and the trader has just made $1.8m for his bank in 15 minutes. Give the boy a bonus.
guardian.co.uk © Guardian News and Media Limited 2010