CFTC "Reform" To Kill Retail FX?

Karl Denninger
Market Ticker
Jan 21, 2010

Slithering along in the proposed rule bin is a nasty little ditty from the CFTC that will fundamentally change how retail FX (forex) business is conducted - and, likely, end its appeal.

The proposal does a number of things, not all of them bad. Retail FX shops have been subject to massive abuse and near-absent enforcement, including front-running. While "bucket shops" ("dealers" that don't actually trade but rather have you betting against the house) have been broadly illegal, and whether it goes on these days or not is difficult to discern.

In addition you've all seen the ads - both online and on ToutTV - pumping OTC Forex trading as a means to "make money" in a trading market that is open nearly 24x7.

Chief among the risks is the fact that these products are in fact an over-the-counter market - that is, there is no central party exchange and counterparty. As a consequence counterparty risk exists in these accounts along with the risk of business failure of your broker. These accounts are often marketed and sold to people who have little appreciation for the risk that the extreme leverage (in many cases 100:1 or higher!) offered to clients can pose. The brokerages all claim to be "commission-free" but this is not really true - the fees charged, instead of being in the form of a traditional commission, are in the form of "pips" or a spread, and on a position held open the spread is charged again and again as a "rollover fee." As such, unlike a stock, option or futures trade where one pays to enter and again to exit (but not to hold) a FX position is inherently a short-term trade, as you will be charged simply for the privilege of holding your position open over a period of time.

Indeed, while nearly all OTC Forex brokers use language in their advertising that suggests very low (or absent) commissions in point of fact commissions can be quite high and in order to control those costs you MUST trade on very short time frames. If you short the Euro/USD cross, for example, and expect a 100 pip (one cent) move on your trade, you might pay three pips of spread to enter and another three to exit, for a total "vig" of six pips. That's a 6% commission! Worse, if you hold over a rollover you will get hit with another spread and your commission goes up even more. To put this in perspective I can buy or sell 1,000 shares of a $100 stock (total "notional" value of $100,000) for $10 at many discount brokerages. If I'm playing for a $1 move on that $100 stock I pay $20 (round trip) in an attempt to make $1,000 - a commission of 2% on the expected move. In the futures market I can put on a single /6E contract (Euro/Dollar futures) for under $3 in commissions (each way) with an initial margin of $4,050 and a move per-pip of $12.50. This means I can trade for the same 100 pip move for a cost of $6 on a potential profit of $1,250, or ONE TENTH the percentage cost of commission of a retail FX shop! Most brokerages of course try to quote commissions on the "notional value" of the position you buy or sell - that's an intentional misdirection as the correct way to compute the "vig" (or cost of your action) is the percentage cost on the anticipated profit on the trade. The bottom line: RETAIL FX COMMISSIONS ARE QUITE HIGH COMPARED TO OTHER FORMS OF TRADING AND THOSE COMMISSIONS MAKE IT DIFFICULT TO CONSISTENTLY PROFIT AS A TRADER IN THIS MARKET.

As such OTC Forex trading is NOT suitable for virtually ALL persons. Indeed, it is the ultimate "day trading" vehicle, both due to the severe cost disadvantages that apply to positions that are held open along with the fact that most "FX brokerages" offer leverage of 100:1 or more. That is, a 1% move in the currency pair you're trading can and will, if it goes the wrong way, wipe you out.

In addition to all of the above there is margin risk that is often unappreciated. While all brokers (in all markets) will typically try to protect themselves by reserving the right to close a position that reduces your account equity to zero (rather than generate a margin call and wait for you to meet it) there is no guarantee that a rapid and/or disorderly move will not gap over the "zero line" and leave you with negative equity. This can lead to a situation where you can easily lose more money than you have deposited with the brokerage. Large, unexpected and violent moves in FX markets are relatively common, especially around news events, and even though such moves often reverse quickly they frequently result in accounts being destroyed and liquidated unexpectedly. This risk goes up dramatically as offered leverage increases.

Now you might think from the above that I "hate" Forex.

You'd be wrong.

Forex is a very difficult market to consistently make money in, mostly due to the "pip spread" form of commissions. The spread looks small but in fact when combined with the high degree of leverage offered it is quite large and it is also charged on a recurring, not only on a trade entry and exit, basis.

Nonetheless for those who wish to speculate on an intraday basis, using very high degrees of leverage and accepting the sizable risk associated with this sort of trading, OTC Forex is a reasonable way to speculate on currency moves and, if one has a full and fair understanding and acceptance of the risks I have no quarrel with it.

The CFTC's proposal will tighten up regulatory supervision substantially and to the degree that it stems the abuses, including irresponsible marketing practices, improving capital adequacy supervision and providing a means of addressing the "shark" problem (misleading, abusive and unreasonable acts by some retail FX brokerages) it is a good thing.

The retail FX industry is rather aghast at the regulatory requirements including assigning liability for improper actions or business practices. To this I say "Awwwwwwwww!" The retail FX marketplace has for years been rife with complaints about various FX brokerages with allegations including soliciting people who have no business trading in this market, front-running, spread manipulation and even blatant bucket shop operations. How much of this is true I have no means to determine (I don't trade FX with the "retail folks", preferring instead to use an established real broker that deals in other products and therefore has some generalized skin - and a reputation - to protect) but that some of these abuses have happened is a matter of record. (With that said, many who put on a bad trade and lose due to their own overuse of leverage or simply making a bad decision look for someone to blame other than themselves for their losses, so I am typically skeptical of such claims absent evidence.)

But buried in the proposal is one item that has the potential to kill retail FX as we know it today:

Proposed Regulation 5.9(a) would require each RFED and each FCM that engages in retail forex transactions, in advance of any such transaction, to collect from the retail forex customer a security deposit (in cash or in financial instruments that meet the requirements of Regulation 1.25) equal to ten percent of the notional value of the retail forex transaction, ten percent of the notional value of short retail forex options in addition to the premium received, or the full premium received for long options, as the case may be. Pursuant to proposed Regulation 5.9(b), the RFED or FCM would be required to collect additional security deposit or to liquidate the retail forex customer's position if the amount of security deposit collected fails to meet the requirements of paragraph (a).

That paragraph effectively limits leverage to 10:1 by imposing a hard margin cap of 10% on cash positions (long or short) - or a net leverage reduction of 90%.

Now I'll go out on a limb here and say that most Forex traders, if limited to 10:1 leverage, will leave. They will either trade something else or go somewhere else. Of course the bleating has begun already, with people claiming that traders will move to Europe where they can obtain leverage as high as 400:1.

Well folks, frankly, if you're playing with 400:1 leverage you're juggling nuclear balance sheet destroyers and sooner or later one will explode and blow your fool head off. I simply cannot countenance such a thing.

Is 10:1 a reasonable limit? We seem to think it is in other parts of the market - in commodities and futures generally, most of which offer somewhere between 6:1 and 10:1. As such the CFTC's proposal appears to be in line with other regulated markets, and on its face appears reasonable.

But there's no doubt that this has (and will) anger a huge number of retail FX traders and dealers and will, without a doubt, engender more calls of "you're going to destroy us if you limit things like this!"

Indeed, some of that has already come, including this article from Turnkey Trading Partners (who alerted me to the proposal - it had flown under my radar originally.)

My view on the regulatory proposal is that there is both good and bad contained herein. I believe:

• Regulation of business practices and demanding capital adequacy tests and strict liability for business practices (especially when it comes to solicitations and/or things like front-running and other abusive practices) is a good thing. The Retail FX market has been a shark tank since its inception and muzzling some of the sharks will make the market more fair for everyone.
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• Few people truly understand the commission structure and how much it actually costs to trade FX. I have seen NO retail FX shop that explains the commission structure in a fashion that I consider adequately clear - and that's being polite.
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• The leverage limit may be overbearing. The need for some sort of leverage limit isn't really open to question - there is such a need. Whether 10:1 is the right number is another question.

On balance I agree that it is long overdue to clean up the FX market shark tank and shoot some of the Tiger Sharks that have been devouring retail customers who have an inadequate understanding of the risks they are accepting by playing in this market, the fee and commission structure and its implications, and how this, along with the rollover format of fees and commissions make it very difficult to consistently profit in this marketplace.

Perhaps the leverage limits will trash the retail FX market and drive it offshore. But I believe there's an argument to be made that with the alternatives available for the most-common currency crosses already (e.g. the /6E Euro/Dollar cross futures contract) there are alternative products that have significantly lower costs embedded in their trading and as such the impact of these regulatory changes could be to bring in line with regulated futures contracts the fee and cost structure found in the OTC marketplace. If it instead drives the market overseas or destroys it entirely what have we lost as traders when I can get the same exposure to the market for one tenth of the commission expense?

Finally, why is the retail FX brokerage community whining about this proposal instead of adjusting their cost and business models to bring commissions more in line with the regulated marketplace that consistently provides users with the same exposure to the market at a fraction of the cost? If you trade retail FX maybe it's time for you to investigate the regulated /6(x) futures contracts instead and cut your transaction costs down to a more reasonable percentage of your anticipated profits. Yes, you'll have to post margin and if you're a "very small" trader you probably won't be able to participate. But if you can't post margin on even one contract in that market the better question is "can you really afford to be trading these products - a highly-speculative instrument in which you can lose everything you put up and then some - at all?"

Now there's something to think about.

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Jan 20, 2010
Karl Denninger

source: http://market-ticker.denninger.net/archives/1879-CFTC-Reform-To-Kill-Retail-FX.html

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