Osborne to target foreign exchange manipulation in City clean-up

The obscure and complicated foreign exchange market is to be the next target of Treasury action, I have been told.

The chancellor is working with Whitehall officials and the international Financial Stability Board (FSB) on new regulations which will be imposed on the market. At the moment, foreign exchange (known in City shorthand as "forex") is largely unregulated and left to the bank traders who execute deals on behalf of global companies. Companies use forex deals to move money between different currencies and a large part of the market is dealt through London.

One senior official I have spoken to agreed that the public would be "very surprised" that such a major market was clearly open to abuse. The Treasury is likely to announce a set of measures to "clean up the market", probably in the next fortnight.

The prices in forex are set by traders who are doing the deals. Traders are able to pick a selection of the trades they have been asked to execute, meaning they can choose those most advantageous to their bank. The prices are set at the 4pm "fix", a daily City benchmark against which currencies are priced. I have written a short "How It Works" at the end of this blog on the allegation that forex is manipulated.

Regulators around the world including the Financial Conduct Authority (FCA) in London and the US Department of Justice are investigating allegations of forex manipulation. It has been reported that at least 15 banks are involved and nine are thought to have suspended or fired traders. No allegations have been proved and no admissions of fault made.

Martin Wheatley, the head of the FCA, said the allegations, if substantiated, could be "every bit as bad as Libor", referring to the revelations three years ago that the market which governs how banks lend to each other was regularly fixed.

As forex is an international market governed by international rules, the UK government is limited in what it can do alone. That is why it is working with the FSB - chaired by the Bank of England governor, Mark Carney - which is due to produce a major report on controlling the market at the G20 summit in Brisbane in the autumn.

Options include ensuring that a broader selection of trades are included in setting the price of forex deals; making the trading transparent on electronic trading platforms; limiting the negotiations between traders before the prices are set and changing the trading culture with the possibility of new professional codes of conduct for those executing trades. A single "fix" at 4pm could also be changed, giving a wider range of prices for currencies.

More importantly for Mr Osborne, there is a wider political point he wants to make, I am told. If the public is to regain trust in the financial system, then people must have faith that the markets are operating fairly. Allegations of manipulation around Libor and forex undermine that trust and leave the public believing there is one rule for them and another rule for "insiders", those close to the chancellor believe.

In a passage of his important speech on Inclusive Capitalism last week, Mr Carney laid out some of the key arguments which I am sure will be repeated by Mr Osborne in the near future. "In recent years, a host of scandals in fixed income, currency and commodity markets have been exposed," Mr Carney said. "Merely prosecuting the guilty to the full extent of the law will not be sufficient to address the issues raised. Authorities and market participants must also act to re-create fair and effective markets."

Ever the strategist, Mr Osborne is already looking towards the next general election in May 2015. Before the 2010 election, the then shadow chancellor made great play that Labour had failed on regulation and that the government was asleep at the wheel as the banks made hay (and lots of money) before the financial crisis.

The Coalition's nightmare scenario is that billions of pounds of forex fines are announced in 2015 and Labour accuses the government of a lack of action. Mr Osborne is looking intently at tightening the forex rules to try and head off just such an eventuality.

The allegation - how forex could be manipulated

• During the day, traders receive orders from clients - international businesses which need to buy and sell currencies to run their global operations.

• Traders then discuss, often via telephone calls or electronic message chat rooms, the orders they have.

• They can then trade in the market before the 4pm "fix" - the allegation being that they are essentially front running the market. If they know there are a lot of sterling orders coming, for example, they will buy the currency cheaply in the knowledge that the "fix" is likely to see the price of sterling rise.

• Traders then start buying for their client - again ahead of the "fix". Each purchase pushes up the price.

• The bank then charges the client at "the fix" - a higher price than the bank has actually paid.

• The bank wins twice - it buys the currency itself cheaply and sells at the higher "fix". It also charges its clients more than it paid for the currency.