The foreign exchange, or forex, market is gigantic and continues to grow. It offers electronic access to a decentralized $1.9 trillion per day market with 24-hour per day liquidity, six-days per week. Combine that kind of liquidity and ease of access with 100 to 1 leverage (in some cases more), and it’s not hard to understand the appeal to traders, who can start trading with very little upfront capital in a league with central banks, hedge funds and professional speculators.
It sounds great, but the retail forex market can be a scary place; horror stories and misinformation abound. Regulation of the off-exchange, over-the- counter spot-market currency trading is uncertain. And some forex brokers offer more than they can deliver, including guarantees on execution, high returns and account safety. Some have engaged in outright fraud, misappropriating customer funds and selling illegal futures and options contracts.
“There is a tendency for some to speak of rags to riches,” says Joel Ward, president of Learn:Forex, an online currency trading institute. And while there are legitimate opportunities to make money in the forex market and many success stories, he says, “There are at least as many about those who have lost everything just as fast.”
And many have been defrauded. Since the Commodity Futures Modernization Act (CFMA) in December 2000, there have been 87 cases of forex fraud prosecuted by the U.S. Commodity Futures Trading Commission (CFTC), $115 million in restitution and $168 million in fines ordered and 24,600 victims of fraud, who have lost a total of $381 million. “And it’s definitely not slowing down,” says Gregory Mocek, director of enforcement for the CFTC.
FUTURES VS. FOREX
There are a number of ways to trade currencies. You can buy and sell foreign currency futures and options on designated contract markets (exchanges), which are regulated by an exchange, the CFTC and the National Futures Association (NFA). Those on exchange opportunities represent about 5% of the total volume of the foreign exchange market and typically require that traders post a 10% margin or security bond. You also trade can off exchange forwards and swaps, or the forex spot market.
The off-exchange forex spot market, also known as the cash, or OTC market, is the largest segment, where more than $1 trillion trades per day. Spot forex trading requires a substantially smaller margin account, 1% and in some cases 0.5% is available. Liquidity moves from nation to nation throughout the course of the day, there are no standard contract sizes and prices vary from dealer to dealer. In some ways, spot forex dealers act as miniature exchanges.
“The [CFMA] did not extend regulation to the CFTC over the (forex) spot market in any way shape or form,” Ward says. “What it did do is address the off-exchange forex market with respect to futures and options. But not the spot market.”
The CFMA attempted to clarify the CFTC’s anti-fraud authority regarding retail forex futures and options trading. Entities acting as counterparties for retail forex futures and options transactions were required to register with the CFTC as futures commission merchants FUTURES (FCM) and join the NFA, although some may be registered as other enumerated counterparties (e.g. brokerdealers through the National Association of Securities Dealers). The requirement however hinged on a definition of ‘futures.’ Platforms that can prove they offer spot and not futures fall outside that rule. Entities only registered as FCMs that act as counterparties to retail forex transactions are required to submit weekly and monthly financial reports to the NFA and are subject to regulatory audits. The NFA also offers a free database, BASIC, which provides registration and membership information and shows regulatory actions brought against CFTC registrants by the CFTC, NFA or exchanges. It also lists NFA arbitration awards and CFTC reparations cases.
But even with this tool available, you must watch out for the mere appearance of registration. “You could have a situation where a company is an affiliate of a registered entity,” says Walter Zuck, director of compliance at FX Solutions. “You may see an NFA ID number that appears to have a similar name, and so you assume that the entity is registered, when in fact it is merely affiliated, which means it basically doesn’t afford you (the protection).”
By engaging unregistered affiliates, unscrupulous brokers are able to trade against their customers, a new trend in abuse and forex fraud, according to Mocek.
LOW MARGINS
Margin requirements as low as 0.5% make forex especially enticing for retail traders, drawing in new and frequently inexperienced traders with dreams of getting rich quick.
“People who are new to the market have a lot of buying power,” Zuck says, but that is a double edged sword. “If you are unsophisticated, if you don’t have the necessary disciplines and risk management, you’re going to lose all of your money.”
Low margin requirements allow traders to hold large positions with little on deposit, a recipe for a quick exit. “If the market moves 2¢ in a single day, that’s a big, big move,” Ward says. A 2¢ move (200 pips) equals $2,000 on a standard $100,000 lot, and now mini ($10,000) lots are available. At a 100 to 1 leverage, that trade required $1,000 to trade a $100,000 lot. “To make $2,000 on that means I tripled my money; but I took huge risk to get there if that’s all the money I had. I could have just lost it,” Ward says.
While high levels of leverage are available, any responsible forex broker will tell you it is not wise to trade with that level of leverage. A $1,000 account should be trading the mini lots and probably only one at a time.
PLATFORMS: GOOD FROM BAD
Choosing a good forex trading platform is like choosing a car, almost anything on the market can get you from point A to point B, so choosing the right vehicle is a matter of finding the best combination of pricing, features and benefits for you and your individual needs.
Test several platforms, open practice accounts and use as much of the functionality as possible. Cross check the price feeds against eSignal or Reuters. “You’re relationship with your broker is the dealing platform,” Ward says, and you will want to test it under real world conditions, such as in fast markets. If possible, look at the platform during a major economic release, such as the unemployment payroll numbers.
The two things that you need to be on the look out for: slippage and requotes, both of which should serve as red flags. Slippage is what happens when the broker couldn’t execute your trade at the price you requested and executes it for a pip or two more; or they stop you out at one or two pips worse than you had requested due to thin liquidity or a fast moving market. Ward says that while slippage can be legitimate, it should happen rarely; more than once or twice per year is too many, and then only if you are trading during highly volatile times. Remember there is already slippage built into the pip spread.
A requote is when you enter or exit the market, and while you can see your price and click your mouse, a screen pops up with a different, worse price and a notice that you have only a couple of seconds to take or leave the worse bid or offer. The only time this is acceptable is in times of thin liquidity, and it should be a function of the market, not just the brokerage. “How often does the market move faster than the milliseconds it takes to send your order in by high speed internet connection?” Ward asks, but he notes that if you are trading exotics or thin markets, these rules are less stringent.
Frequent slippage and requotes demonstrate weak technology or outright dishonesty. Dishonest brokers use slippage and requoting to treat winning traders differently than they treat losers, says Michael Cairns, head of trading at FX Solutions. “What we are hearing is that some of the competition has one basic trading system for people they don’t regard as threats, and a separate platform for those that have a history of making money.” Cairns says that the dishonest brokers send the winners to be requoted or send them straight through to a bank, adding another degree of latency to the pricing and ends up being requoted anyway.
BROKERS: GOOD FROM BAD
The more a broker tries to convince you that your funds are safe, or that the risks or forex trading are minimal, the more skeptical you should be. All trading is risky and any broker who tells you otherwise is lying, not a good sign for any kind of relationship and especially one that involves your money.
“You need to be wary of specific claims about safety of funds,” Zuck says. “Whether it’s ‘your funds are FDIC insured,’ or whether your funds are held in segregated accounts, for all intents and purposes, that’s not true.” Funds deposited in brokerage accounts are not insured and probably would not receive priority in bankruptcy, as Refco foreign exchange customers are finding out.
In addition to verifying that your forex dealer is an NFA member and registered as an FCM with the CFTC, you can find out how much excess capital the company has (see “Five ways to check your broker,” below). “There are really only a couple brokers we feel have the financial wherewithal for our clients to take the risk with,” Ward says. The minimum required by the NFA is $250,000, Ward recommends at least $10 million.
Claims of guaranteed execution should also be a red flag. Because there is not one central market place, these claims are usually followed by an asterisk, “Read the asterisk, read the fine print. It’s important to know how your broker is going to react.” And, Zuck says, they should have a fast market policy as well as a margin policy.
Make certain you know how your broker gets paid. Some forex firms claim no fee trading and make their money by charging a 3 to 5 pip spread on the major currency pairs and slightly more on exotics. Firms that claim to charge less may be making up for lost profits by charging commissions or constantly requoting. Other red flags include pressure to commit more money than you are comfortable with, demanding long term agreements and limiting your access to the account. Make certain that you have real-time access to your account 24-hours per day, seven days per week, and find out if anyone else has access.
Read the account agreement! Make certain you have the right to close a trade by entering an offsetting position, otherwise you may end up purchasing the entire amount of the currency. Brokers are considered market makers and therefore the counterparty on all trades. But, Ward says, “The broker themselves should never take the other side of the trade, that’s when you are going to see the game playing and the slippage.”
Customer service is the other issue you need to research. Call the broker on the phone; send them an e-mail, and use the broker’s chat function to see how responsive the broker is to its customers. Don’t wait until they have your money to find out how they are going to treat you. “When you are in an unregulated market, anything can happen, and has,” Ward says.
