Trading foreign currencies, or forex, has been a phenomenon for the past decade, garnering popularity across the globe as droves of investors tried their hand at this relatively new medium. Previously the private domain of major banks, hedge funds, and wealthy investors, retail forex is now accessible by the public at large, due to creative brokers in the industry, sophisticated trading software, and the Internet. Forex brokers have generally had a free hand developing the market, but times are changing.
Fraud was a big problem in the early days, but the Commodity Futures Trading Commission (CFTC), the federal agency responsible for oversight in the currency arena, worked along side legitimate brokers to police the industry and educate consumers about the high-risk profile when trading currencies. Currency markets can gyrate wildly at times. Casualty rates tend to be higher than in most other mediums, and overseas marketing schemes can still present problems. As a result, the forex brokerage industry has had to adapt to many changes, mostly of a regulatory nature.
Dodd-Frank legislation and the events in Cyprus have been the big items, but here is a brief recap of the chief areas that are impacting the forex brokerage industry:
- Operational Aspects: Regulators have always viewed their role as the protector of the uninformed investor. In this regard, Dodd-Frank focused on several areas that would change the way that forex brokers in the United States could conduct their business. One area was leverage, the practice of purchasing a much larger position in the market than your account balance would ever allow. Many overseas brokers allow for as much a “100:1” or even “500:1” leverage at no expense. The Bid/Ask spread actually covers the cost, but although larger positions may magnify gains, they also magnify losses. New rules cut back to “50:1” on majors and “20:1” for minors and exotics. New deposit rules would also prohibit credit cards, the most prevalent method for used by beginners to open their account;
- Safety and Soundness: According to the specific language in the CFTC’s press release, the new legislation would also “provide the CFTC with broad authority to register and regulate entities wishing to serve as counterparties to, or to intermediate, retail foreign exchange, or forex, transactions.” The primary requirement for all registered parties would be “to maintain net capital of $20 million plus 5 percent of the amount, if any, by which liabilities to retail forex customers exceed $10 million.” After these rules went into effect last year, three brokers (Forex Club, Advanced Markets, and GFT) exited the retail forex trading space. In the past year, registered entities dropped from 130 to 109, and only 76 of these have the minimum capital level to qualify as a retail foreign exchange dealer (RFED);
- The Crisis in Cyprus: The third bitter pill to swallow occurred recently on the tiny island community of Cyprus, which had over the previous decade become an international financial center and the legal home for many global forex brokers. The nation’s two largest banks were reeling from heavy losses related to devalued Greek bonds. Officials froze bank accounts, subject to mandated reductions if a bailout package was to be arranged. Most brokers maintained their customer accounts offshore in Tier-1 banks, safe from any reductions, but a few brokers were not so lucky. The options for these at this stage will be to raise more offshore capital, be acquired, or close their doors.
These events may appear harsh to forex brokers, but they will serve to ensure the financial integrity of the forex industry.
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