Market participants put alleged DOJ investigation on UBS, Barclays FX notes in bigger context

By Emma Trincal

New York, Feb.9 – The Department of Justice is allegedly investigating UBS Group AG and Barclays plc over “inadequate profit disclosure to clients and counterparties involved in currency deals,” according to a Financial Times article published on Sunday citing anonymous sources.

According to the news report, the products would be based on the so-called carry trade, a commonly used strategy consisting of buying a high-yielding currency and selling a lower-yielding one.

The UBS product mentioned in the report would be linked to the UBS’s V10 enhanced FX carry strategy. No product is mentioned for Barclays.

Calls at UBS were not returned. A spokesman at Barclays declined to comment.

DOJ and not SEC

What first surprised some of the industry participants was which regulating agency was involved.

“I don’t really understand why the DOJ is involved in this,” a New York sellsider said.

“I find it very strange that it would be about disclosure. If there is inadequate disclosure, it should go to the SEC or Finra, not the DOJ.

“And then, you wonder about the clients. There was inadequate disclosure to hedge funds. Hedge funds are big boys. They don’t need the DOJ to look up for them,” the sellsider added.

“Most hedge funds don’t purchase notes. It looks like a discretionary account based on an algorithmic trading strategy.”

Sources were wondering whether the probe originated from complaints from investors.

“It's an investigation at this point, so there is no complaint from anyone. The information is likely coming from inside sources,” explained a lawyer.

V10 strategy

The UBS V10 Enhanced FX Carry Strategy is designed to generate profits from moves in 10 of the most liquid major currencies using opportunities based on interest rate differentials. The algorithm offers a “switch” allowing profits during times of high volatility as well as time of risk aversion, according to a UBS document.

A Bloomberg article on Monday said the UBS V10 strategy was first discussed in 2013 during interviews between the DOJ and UBS employees in 2013 with a focus on meeting fiduciary duties.

“UBS, Barclays [...] the DOJ is focusing on two non-U.S. banks. We saw something similar with BNP when they went after the French bank for $9 billion. All of this stuff looks like potential paybacks that don’t have much to do with any wrongdoing,” the sellsider said.

A spokesperson at the DOJ did not return a call seeking comments.

In June 2014, BNP Paribas agreed to pay $8.9 billion for illegal sales to countries subject to U.S. economic sanctions.

Disclosure

The probe into FX structured products surprised some sources given the small size of the U.S. structured notes market and the tiny market shares captured by the currency asset class.

Last year, FX-linked notes issuance accounted for only 1.3% of the U.S. volume, excluding ETNs, and about 1% of the number of offerings, according to Prospect News.

Retail investors show a limited appetite for this asset class, sources said.

As a result, many doubted that the DOJ investigation had much to do with structured products.

Instead, they said the probes were part of regulators’ broader investigation on price manipulation in the foreign-exchange market.

Global authorities in particular have paid attention to the so-called FX “fixing,” targeting banks they accuse of manipulating the World Markets/Reuters Closing Spot Rates or WM/R Rate. This rate also known as the closing currency fix is FX benchmark set in London each day at 4 p.m.

“It’s not about mismarking or mispricing a structured note. The bigger picture is the role of UBS and banks in the FX market. They’re overreaching. I think they’re putting some pressure on the banks involved in the FX investigation. It’s pure political theater,” said the sellsider.

Six banks in November agreed to pay $4.3 billion for manipulating financial benchmarks across the two sides of the Atlantic.

UBS was one of them, but Barclays pulled out of the negotiations last year, according to news reports.

“FX is a $5.4 trillion-a-day market,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.

“It’s 1,000 times the size of the global export trade, which is $52 billion a day. There’s an effort from the regulators on a global scale to look into this market. The banks are regulated but the FX is not.”

The industry source said the DOJ probe had little to do with structured products.

“They’re talking about currency-linked notes based on the carry trade. But the problem is not the note. It’s the embedded strategy. All those carry trades can be done directly or you can get access to it via a fund or a note,” he said.

“It’s not about the derivative. It’s about the strategy.”

From a legal standpoint, the broader picture explains the role of the DOJ, a lawyer said.

“The issue is that of exchange-rigging, which is a potential criminal offense. It is the underlying FX and the alleged rigging that is at issue, which is why the DOJ is involved. There may be an SEC non-disclosure issue as well for the notes, but criminal investigations trump civil ones,” the lawyer said.

The last SEC-registered note tied to the UBS V10 Currency index was issued in Sept. 27, 2010 for $5.95 million by UBS AG, Jersey Branch, according to data compiled by Prospect News.

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