The Federal Bureau of Investigation
(FBI) is looking into a sophisticated scheme using "unsophisticated tradecraft"
to front run interest rate swaps and thus defraud government sponsored enterprises
(GSEs) Fannie Mae and Freddie Mac. Reuters is reporting the investigation into
unnamed U.S or Canadian traders or banks which it says may have resulted in
profits of $50 to $100 million for those involved.
According to the report written by Richard
Leong, traders may be "conspiring to rig rates on large orders submitted by
Fannie Mae and Freddie Mac, or front running them in the interest rate swaps
market". By front running someone with
advance knowledge of an upcoming large transaction by another party can put an
order in first, profiting from the market move when the large trade goes
Reuters obtained the information from an
FBI bulletin issued to securities officers at financial services firms. The bulletin contained information "from a
former high-level employee at a U.S. bank and an employee at a Canadian Bank,
plus interviews with other bank workers" conducted earlier.
According to the bulletin, swap traders
at the bank may have programmed their phones with different ring tones to
signify calls from certain customers who customarily place large swaps orders. The
Banks may have encouraged traders to listen in on calls to gain transaction information. The traders would then use hand signals to
inform other traders of the details of the planned swaps. Senior bankers were reported to have
encouraged this activity on the part of employees because it led to higher bank
revenues. "GSEs frequently submit
large interest-rate swap trades, making them easy targets for front running and
lucrative targets for market manipulation," the bulletin said.
Interest rate swaps are agreements between two companies to exchange fixed for floating cash flows. In most cases, it's risky for a large firm to be exclusively receiving solely fixed or floating payments. For instance, if a firm receives mostly fixed-rate payments and market rates rise significantly, it will lose money. Instead, a portion of that debt would be swapped with counterparties who have more floating rate payments coming in, thus providing more balance vs risk for both sides of the transaction.
While the FBI was reasonably confident in the information it received, prosecutions are unlikely as the bureau says there doesn't appear to be any wrongdoing. So why is this news? In the words of an FBI Spokesperson: ""It is standard policy for the FBI to share
intelligence information with our private sector partners to help
protect our economy, thwart crime, and prevent threats impacting