When Regulators go rogue

The credit crisis and various financial scandals of recent years have changed the landscape for U.S. regulators. In was strong regulation and out was warm and fuzzy talk of public/private cooperation. In also was supposed to be interagency cooperation.

While one of the five key objectives of the Obama Administration’s audacious regulatory overhaul proposal was to Establish comprehensive supervision of financial markets and it set as a goal harmonizing regulatory regimes to prevent regulatory arbitrage and gaps in coverage, that hasn’t necessarily been followed through on.

Case in point is the Financial Industry Regulatory Authority’s (Finra) proposed Rule 2380. In its original form the rule would have limited the leverage broker/dealers could offer their customer in forex trading to 1.5-1. That is the customer would have to put up about $67,000 for a standard $100,000 forex position.

Finra has since amended the rule proposal to 4-1, which is still much different than the current standard for retail OTC forex trading of 100-1 for major currency pairs. That had recently been reined in by the National Futures Association. Some forex firms allowed customers to leverage up to 400-1.

Currency future margins are risk based and the initial margin for a standard $100,000 currency contract ranges from $2,500 to $4,500 depending on the currency and volatility levels (roughly 20- to 50-1).  

The rule would appear to be punitive to broker/dealers as customers could simply go elsewhere to trade with much greater leverage. However, on Wednesday the Commodity Futures Trading Commission (CFTC) proposed limiting leverage on retail forex customer accounts to 10-1 (the CFTC now has clear jurisdiction in OTC forex due to the passage of the Farm Bill).

Both measures, if passed, would create clear winners and losers as it stands. Non-U.S. forex brokers and futures markets would be at a distinct advantage.

Perhaps unbeknownst to us there is overarching plan to all of this but short of that this simply seems wacky. It seems to me the problems came from those whole industries who were able to have themselves completely written out of rules, not the rules themselves. Futures industry regulation worked because everyday multiple entities have to back every position. Traders face margin calls from their brokers, brokers answer to the clearinghouse.

In discussing the Finra proposal and the clear differences between the levels they would set for the entities under their jurisdiction and the rest of the market a spokesperson wrote, “FINRA believes that leverage ratios of 50:1, 100:1 or higher are inconsistent with our mandate to protect investors, in particular retail investors. Our submission explains that FINRA does not believe that its regulatory program is bound by limits established by other regulators. Different regulators may pursue their regulatory mandates in different ways.”

This is consistent with the way Finra addressed comment letters received responding to their initial proposal but not really consistent with the spirit of the Administration’s regulatory overhaul, which sought to avoid regulatory arbitrage among other things.

There is a lot of talk of protecting retail investors but at least retail investors can choose to take that risk. They certainly had no choice when it came to the bailout of Wall Street banks and AIG.

It raises an interesting question. Were everyday investors more harmed by the ability to trade with high leverage levels or by the New York Fed arbitrarily deciding that AIG’s imminent bankruptcy represented significant systematic risk and therefore needed to be bailed out? And by the way, force taxpayers to pay AIG’s large counterparties 100 cents on the dollar to do it.

Where was the concern for the retail investor then?

About the Author
Daniel P. Collins

Editor-in-Chief of Futures Magazine, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange. Dan joined Futures in 2001 and in 2005 he was promoted to Managing Editor, responsible for overseeing all the content that went into Futures and futuresmag.com. Dan’s incisive reporting and no-holds barred commentary places him among the most recognized national media figures covering futures, derivative trading and alternative investments.

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