You hear again and again that the foreign exchange market is the fastest growing and largest market in the world, and that $2 trillion changes hands through the course of each 24-hour trading day. But there is no single, centralized foreign exchange market. The vast forex market is in fact composed of the cash or spot market, the international banking market, also called the interbank, and the forex futures and options markets. There are also forwards and swaps markets, which we won’t address because retail traders don’t get to trade there.Forex trading platforms around the world sell access to pools of liquidity, very much like small-scale exchanges, but there are many important differences. Because there is no single centralized marketplace or central clearinghouse to mitigate counterparty risk, regulation of this sprawling, international marketplace is uneven, local and sometimes subject to interpretation. The local regulators have different mandates and offer different levels of protection to market participants. Anyone interested in trading forex needs to understand these differences and know what questions to ask before committing any funds to any trading account.
The spot forex market is really a diverse group of over-the-counter (OTC) markets, and retail customers, meaning those of you with trading accounts of less than $10 million, do not enjoy the same customer protections offered to U.S.-based futures, options and equities traders.
When vetting a forex broker, you will want to find out where your broker is located, where the firm is incorporated and who the firm’s regulator is. Don’t discount the importance of this just because it sounds simplistic. You cannot assume that a forex trading firm is regulated just because it is associated with a large, well-known or regulated firm.
Thousands of traders who had accounts with Refco FX Associates (RFX) were locked out of their trading accounts when Refco Inc., the regulated U.S.-based parent company and more than 20 of its subsidiaries, filed for bankruptcy in October 2005. RFX was in fact an unregulated offshore entity, and the customer protections that were afforded to retail customers of the U.S.-based corporations, which were registered with the Commodities Futures Trading Commission (CFTC) and the National Futures Association (NFA) and other regulators, such as the Securities and Exchange Commission, were not given to RFX customers.
More than 15,000 RFX customers were shocked and angry to find that the firm’s creditors committee had legally appropriated their trading accounts, totaling $150 million, and through the bankruptcy process used the money in their trading accounts to pay Refco’s secured and unsecured creditors. More than one year later, RFX customers would get a scant 18¢ for each dollar they held in those trading accounts.
While many spot forex trading companies have registered voluntarily with the CFTC and the NFA, some firms operate legally without this regulation. The Commodity Exchange Act stipulates that the CFTC has the authority to regulate forex futures and options sales to retail customers when the counterparty is a regulated entity, such as a bank, broker dealer or a futures commission merchant (FCM). However, also according to the CFTC, “entities that introduce retail customers solely to trade off-exchange foreign currency futures and options with registered FCMs that act solely as counterparties are not required to register under the Act as IBs (introducing brokers), but may do so voluntarily.”
This leaves OTC forex trading in a regulatory gray zone, and some OTC forex firms are adding additional customer safeguards to differentiate themselves from their competitors, lure customers and offer additional peace of mind. One such firm is the EFX Group, which is not registered with the CFTC or the NFA. EFX is an “affiliated introducing entity” for MB Trading Futures Inc., which is registered with the CFTC and the NFA. While not regulated, EFX voluntarily offers some customer safeguards, such as Fidelity 14 Bonds, which would insure customer funds in the event of fraud by an employee of the firm. EFX also keeps customer funds in accounts separate from the trading firm’s operating funds. While these safeguards indicate sensitivity to customer needs, separate accounts are not “segregated funds” as defined by the CFTC, and in the event of a bankruptcy it is possible that customer funds, even those in separate accounts, could be appropriated, even if the account was FDIC insured.
Some traders, intrigued by the foreign exchange markets but looking for belt-and-suspenders customer protections, opt to trade on-exchange forex futures, such as those offered by the Chicago Mercantile Exchange (CME), the New York Board of Trade or on-exchange forex options, such as World Currency Options on the euro, offered by the Philadelphia Stock Exchange.
“The CME is the world’s largest regulated market when it comes to foreign exchange,” says David J. Schultz, director of CME FX products, adding that all orders are executed on a first-in-first-out basis, offering equal access to all traders.
FEES AND THE DEALING DESK DILEMMA
All forex trading platforms act as access points to pools of liquidity, but there are two main models that spot forex trading firms follow, the dealing-desk model and the ECN, or non-dealing desk, model.
With a dealing desk model, the forex trading firm offers a trading software platform and access to its liquidity pool, and the forex firm acts as the market maker for all of the customers who access that liquidity pool. By acting as the market maker, the forex firm acts as the buyer to every seller and the seller to every buyer, and charges a fee, typically in the form of a fixed pip spread. The pip spread for the major currency pairs is usually between 2 and 5 pips. A pip is 1/100 of 1%.
In the non-dealing desk model, the firm offers a trading software platform and access to its liquidity pool, which may include several potential market makers such as banks and other financial institutions.
Firms marketing themselves as “non-dealing desk” also may describe the firm as an ECN (standing for electronic communications network) and tout the benefits of straight-through processing (STP), in which orders pass through the forex firm to the market, are visible to all participants and executed on a best-price basis without intervention by the forex firm itself. Some of these firms charge on a fixed percentage basis.
Proponents of the ECN model say that the dealing desk presents a conflict of interest, and in the same way that the odds always favor a casino over the gambler, over time customers always come out as losers because they are trading against the house. Proponents of the dealing desk model counter that the real issue is the accuracy of the prices quoted, that there is always a market maker in the mix and that multiple market makers introduce the possibility of inconsistent commissions and a lack of accountability.
Proponents of both models agree that accurate pricing, liquidity and transparency are the most important things for a retail trader to look for, and that if you are having difficulty getting into or out of trades, or are experiencing slippage, or frequent re-quoting, you probably need to find another forex platform.
On-exchange markets typically host multiple market makers and the quotes at the CME are only one-tick wide, comparable to a single pip. Also, Schulz says, the commission per round turn, meaning to enter and exit the trade, is about $10.
And because on-exchange markets are centralized marketplaces, liquidity could theoretically be more concentrated, and the transparency of a regulated exchange should be a non issue.
WHAT DO YOU GET?
At first glance, most trading platforms look very much alike. You will see bids and offers for several currency pairs, charts, a deal log and streaming prices. One of the reasons that so many of the trading software applications look the same is because they were created by the same manufacturer and “white labeled,” meaning that the forex dealer has licensed the product from the manufacturer for customer use. This is a common practice and while it is not a problem, it is a good thing to know so that you can compare apples to apples, or MetaTrader 4 Client Terminal to MetaTrader 3, for that matter.
Other forex dealers will have created their own software, but regardless of the creator, the important factors are always the same: intuitive design, ease of use, speed and reliability.
From the trader’s viewpoint, things should make sense and be easy to use. In an intuitively designed trading platform, the most important functions and features will be easy to identify and locate. Drop-down menus will be context sensitive, eliminating the clutter of irrelevant features and functions and reducing the number of clicks to enter trades.
Speed is a little bit more subjective and can depend on the speed of your computer and Internet connection. But screens should display quickly with a minimum of waiting. The actual technology that the software is constructed with, such as Java or MicroSoft’s .Net, is probably less important than knowing who will pick up the phone, and how fast, should you have a problem with the software and need to get out of a trade.
Other valuable differentiators are practice accounts, newsletters, seminars and trader education.
“Tools I would look for in a platform are trailing stops to lock in profits, real-time news, wireless trading, charting, pattern recognition and indicators,” says Todd B. Crosland, chairman and president of InterbankFX LLC.
Things he says to avoid are trading restrictions, such as those on scalping or during economic announcements. “When non farm payrolls are announced, this market really moves. You need to be informed in real time; having access to real-time news is really critical.”