Potential Manipulation of GSE Trades May be Just Fine with FBI

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 through.

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 American businesses."