Foreign currency exchanges (forex) run non-stop across the globe through over-the-counter markets. The global nature of this boundary-less market allows seamless access, e.g., an Australian trader can trade in euros and Japanese yen (EURJPY) through a US-based broker despite geographical boundaries.
Speculative trading in the retail forex market continues to grow. As a result, there can be intermediaries (like banks or brokers) who engage in financial irregularities, scams, exorbitant charges, hidden fees, high-risk exposure offered through high-leverage levels, or other bad practices. Internet and mobile app-based trading allows smooth trading, but also have dangers such as unrecognized firms running sites that may close unexpectedly and abscond with investors’ money. As a result, regulations are necessary and set by competent authorities to ensure such practices are avoided. Regulations are aimed at protecting individual investors and ensuring fair operations to safeguard clients’ interests.
The most important criteria when selecting a forex broker are the regulatory approval status of the broker and which authority governs the broker.
How US Authorities Regulate Forex Brokerage Accounts
The National Futures Association (NFA) is the “premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets” (including forex). The scope of NFA activities is as follows:
- After due diligence, provide necessary licenses to eligible forex brokers to conduct forex trading business.
- Enforce required adherence to necessary capital requirements.
- Combat fraud.
- Enforce detailed record keeping and reporting requirements regarding all transactions and related business activities.
A detailed regulatory guide is available on the official NFA website.
Key Provisions of US Regulations:
- “Customer” is defined as “individuals with assets of less than $10 million and most small businesses,” underscoring that these regulations are meant to protect the small investor. High-net-worth individuals may not be necessarily covered under standard regulated forex brokerage accounts.
- Limits available leverage to 50:1 (or deposit requirement of only 2% on notional value of forex transaction) on the major currencies, ensuring ignorant or uneducated investors do not overstep and take unprecedented risks. Major currencies are defined as the British pound, the Swiss franc, the Canadian dollar, the Japanese yen, the euro, the Australian dollar, the New Zealand dollar, the Swedish krona, the Norwegian krone, and the Danish krone.
- Limits leverage of 20:1 (or 5% of notional transaction value) on minor currencies.
- For short forex options, the notional transaction value amount plus the option premium received should be maintained as security deposit.
- For long forex options, the entire option premium is required as security.
- First-in-First-out (FIFO) rule prevents holding simultaneous positions in the same forex asset, i.e.. any existing trade position (buy/sell) in a particular currency pair will be squared off for opposite position (sell /buy) in the same currency pair. This also implies no possibility of hedging while trading forex.
- Money owed by the forex broker to the customers should be held only at one or more qualifying institutions in the US or in money center countries.
How US Regulations Differ
Care should be taken to verify each ownership, status, and location of each forex trading firm, website, or app before signing-up for a trading account. There are many websites claiming low brokerage charges and high leverage (allowing more trading exposure with less capital), some as high as 1000:1. However, almost all such sites are hosted and operated from outside the US and may not be necessarily approved by the concerned authority in the host country. Even those authorized locally may not necessarily have regulations that apply to US residents. Regulations may slightly vary from country to country in terms of offered leverage, required deposits, reporting requirements, and investor protections.
Here is an indicative list of forex brokerage regulators for a few select countries:
- Australia – Australian Securities and Investments Commission (ASIC)
- Cyprus – Cyprus Securities and Exchange Commission (CySEC)
- Russia – Federal Financial Markets Service (FFMS)
- South Africa – Financial Services Board (FSB)
- Switzerland – Swiss Federal Banking Commission (SFBC)
- UK – Financial Services Authority (FSA)
1) Leverage Restriction
The NFA and CFTC had wanted to cut the leverage down to 10:1 from the previously normal 100:1. If they had gotten away with this, they would have effectively made trading currency futures (at 25:1 leverage) more attractive than trading spot forex. Was this their “secret” intention, even though their stated intention was to protect the greedy trader from himself? After much flak from industry insiders, they conceded to cut the leverage down to 50:1 for the majors, 20:1 for the minors.
When I first learned of the leverage restriction, I was very upset. A 100:1 leverage for forex was a powerful advantage over all other markets, as it could enable the trader to take advantage of higher leverage in cases of opportunity, hardship, or diversification. That being said, a prudent trader should never use more than 2:1 leverage per trade anyway, and no more than 5:1 in aggregate positions, so a leverage reduction to 50:1 should not crimp a professional money management style. A leverage restriction to 10:1 would have been intolerable.
2) Anti-Hedging (FIFO) Restriction
The NFA enacted rule 2-43(b) which effectively eliminates hedging by forcing brokers to close trades on First In, First Out (FIFO) basis. Basically, if you open more than one position on a currency pair, you must close the first before closing the second one. That’s the NFA’s not-so-straightforward way of preventing hedging. Their position is that hedging provides no economic benefit. However, the rule has the secondary impact of preventing a trader from having multiple strategies on the same pair in the same account.
In theory, this anti-hedging (FIFO) restriction would seriously affect you if 1) you are using hedging techniques; and/or 2) you have more than one position on a specific currency. Many traders do hedge, and many more (myself included) have more than one position on a specific currency. I definitely did not like this rule when it first came out.
However, things did play out better in practice. Some of the smarter US brokers managed to escape how this anti-hedging (FIFO) rule affected their clients. Some US brokers were lucky enough to have subsidiaries abroad, so they already bypassed the new rules. Other US brokers found a method of compliance that sorted out the hedging rule in the backend, so you need not worry about it.
Perhaps it was time that US forex firms were obligated to be regulated, as many financial firms in the US already were. While the forex industry was not a cause of the 2007 financial disaster, the forex industry had been growing at an exponential rate throughout the 2000s, and new firms and introducing brokers were popping up everywhere, most decent and good enough but some very bad and very ugly. There have been cases of roguish firms and institutions stealing the fortunes and dreams of innocent investors in different forex related scams and ponzi schemes across the country (First Capital Savings & Loan Ltd, CRW Management LP, Botfly LLC, Yellowstone Partners, M25 Investments Inc., Alpha Trade Group, etc.). Often the CFTC has been the sheriff on the white horse riding into town to put a stop to these bandits. For this they do deserve a salute. We are probably better protected from fraud by such an agency than without.
Nevertheless, I do think that too much power was granted to the CFTC (a regulatory body allied with the futures industry) by the 2008 Farm Bill and Dodd-Frank Act of 2010, and that it misused this power in calling for a severe restriction of forex leverage and hedging. If it had gotten away with what they wanted — 10:1 leverage and absolute No-Hedging– they would have shot out the knee caps of US Forex, forcing many traders back into the futures arena or sneak away to offshore forex providers. In the end, however, the leverage restriction of 50:1, though not ideal, is tolerable when in keeping with sound money management principles. Moreover, there are many clever ways to minimize the No-Hedge rule, such the Back Office compliance procedure adopted by US brokers that effectively makes it invisible to the client.
Ultimately, given that there have been positive push-backs against bad regulation, I am not about to abandon the US Forex Arena just yet. There is still hope. However, if you are not happy with the way that Washington, the NFA and the CFTC have been regulating the US Forex Arena (such as prohibiting spot gold and silver trading, restricting leverage and hedging, prohibiting foreign broker access etc.), and who knows what else they might have in store for us in the future, you can attempt to take your money to a foreign broker where these US Regulatory agencies cannot get you. The Dodd-Franc Act may have already scared many foreign brokers to shut their doors to US clients, but there are still a few that are accepting (e.g., FinFX). Moreover, even with the scared foreign brokers, there are still legal and subtle ways of getting an account set up with them if you think a little outside the box.