The four-year anniversary of the signing of the Dodd–Frank Wall Street Reform and Consumer Protection Act will be in July, but, although many of its detailed regulations have yet to be issued, foreign exchange brokers have already been reeling under their new rules for the past year or more. As if accommodating new legislation were not enough, the forex industry was also rocked by the recent crisis in Cyprus, where client deposits were seized and trading operations halted.
The Commodity Futures Trading Commission (CFTC) and its “cousin”, the National Futures Association (NFA), provide regulatory oversight in the foreign currency arena and have been instrumental in making Dodd-Frank live and breathe in the forex realm, so to speak. Many participants in the world of foreign exchange have regarded the last ten years as a modern version of the Wild West. It was only a matter of time before more stringent law and order would prevail.
Over the past decade, regulators have spent an inordinate amount of time eliminating rampant fraud while policing brokers and educating consumers as to the risks they were undertaking. These risks can be exceptionally high when speculating on future currency movements in a very volatile market. Dodd-Frank legislation became an instrument to bring order, security, safety, and soundness disciplines to an area that had been self-regulating at best, with investor casualty rates running as high as 70%.
Most objections from forex brokers centered around leverage, the ability to secure a larger position in the market at no cost. The broker funds the practice through his larger spread premium. Overseas brokers can offer as much as “500:1” leverage, as an easy way to multiply gains of a few basis points into material profits. Leverage can magnify gains, but it can also magnify losses, as well. Banks offering domestic trading services had limited leverage to “50:1” on major pairs and “20:1” on exotics.
The final regs from the CFTC adopted the standard already established by the banking sector, leading forex brokers to cry foul since overseas brokers would have an obvious competitive advantage with higher leverage offerings. New reporting and registration guidelines, however, block many overseas brokers from serving U.S. clients, but all possibilities have not been ruled out.
After a decade of unbridled growth in popularity, the retail forex industry, the place where consumers can trade, is comprised of large banking interests, a number of large and well-established brokerage firms, and a broad spectrum of smaller firms trying to become successful and grow. Regulators, as a rule, begin to focus on capital adequacy after such a gestation period has taken place. The CFTC now requires that forex brokers register, comply with a number of operating standards, and “maintain net capital of $20 million plus 5 percent of the amount, if any, by which liabilities to retail forex customers exceed $10 million.” Over 20 firms have departed the scene, and 25% remain out of compliance.
But the industry’s reputation took a severe hit in March, when government officials in Cyprus seized the operating accounts of 80 forex brokers. The older and more astute brokers had segregated client deposits offshore in accounts with Tier-1 banks, but many others had commingled client and operating funds together. The two largest banks were taken over due to enormous losses sustained when Greek bonds were devalued. Balances in excess of 100,000 Euros became a partial funding source for a bailout.
The sad truth is that the present plight of forex brokers could have happened to other brokers, as well. Regulations and best practices are there for a reason.
About the author:
Tom Cleveland has been researching forex and other investments since 2009 after joining the team at forextraders.com. His most recent work on forex brokers can be found at http://www.forextraders.com/forex-brokers.html.