Over the last couple of years, it has become clear that traders who want to be involved in the spot foreign exchange market need to be very careful in choosing their broker. Although finding a broker that is willing to put its customers first can be lot of work, it can take much of the stress out of trading. Unfortunately, the alternative is ending up with a less scrupulous broker that can make trading a chore or even put your money at risk.
Unlike trading on futures exchanges through a futures commission merchant, spot forex traders need to be aware at what point regulatory protections end, says Karen Wuertz, senior vice president of strategic planning and development at the National Futures Association (NFA). “If you look at the disclosure document that is required to be provided to all customers, it basically says that your deposits have no regulatory protections.”
So, how can you be sure that your broker is up to snuff? Just as you should when making any investment, you need to do some research before you even consider making a deposit with a forex broker. To help you, here is our checklist of seven factors to verify as you search for a new forex broker.
1 Check the registration.
All brokers that offer retail spot forex trading must be registered with the Commodity Futures Trading Commission (CFTC) and the NFA. “If they are dealing with U.S. customers, they have to be registered. If they’re dealing entirely with foreign customers, they may not need to be registered,” Wuertz says. “If they’re not registered, that’s a huge red flag.”
The regulators make it very easy to see if a firm is registered by visiting the NFA’s Background Affiliation Status Information Center (BASIC) database online at www.nfa.futures.org/basicnet.
If you are a non-U.S. customer looking to trade with a foreign firm, you may have a little more work to do. Nonetheless, Dean Popplewell, senior currency analyst for Oanda Corp., says traders still should look to see that the firm is registered with a regulatory authority. “The forex market is becoming better regulated, and like anything, regulation is continuously changing,” he says. “What we’re finding is regulation is moving toward global [unification]. Anybody who is responsible should encourage regulation.”
2 Look under the hood.
Now that you know the broker is registered with a regulatory authority, it’s time to dig deeper into its background to get to know the broker better. Again, the NFA’s BASIC system makes a lot of this information very easy to access.
Wuertz lists some of the details the BASIC system makes available. “You can dig down into some details like how long they have been registered, and you can look at their regulatory history. There’s a whole due diligence that a customer needs to do by looking through the BASIC registry,” she says. “How long has the firm been around? Understand their disciplinary history, know who the principal of the firm is and also do background checks on the firm. It’s entirely possible that the firm is brand new, but the principal has a long list of regulatory issues.”
Barbara Rockefeller, president of Rockefeller Treasury Services and author of “The Foreign Exchange Matrix,” agrees that checking the BASIC system is an essential step, but warns that it has its own limits. “[Checking the BASIC system] may not help you because [Peregrine Financial Group] (PFG) was fine until it wasn’t,” she says. “I’m not sure that the CFTC, NFA or anybody can protect you completely from fraud or collapse. However, you do want to make sure that your broker doesn’t have a lot of grievances against it.”
Spot forex customers from MF Global, which declared bankruptcy in 2011, and PFG, which went under in 2012 after fraud was revealed, continue to face an uphill battle in recovering the funds they had on deposit at the two brokers. When Refco declared bankruptcy in 2005, its spot forex customers did not receive any of the funds they had on deposit.
In addition to checking the firm’s regulatory and disciplinary background, Popplewell says that now also is a good time to check the firm’s books and capitalization. “You’re concerned about capitalization because that will have a direct impact on their ability to remain solvent and is a good indication of the size of a particular company, and its ability to remain in business,” he says. “You go to the CFTC [or NFA] to look at a dealer’s capitalization levels. All this is transparent information that is publicly recorded on the CFTC website if they are regulated in the United States.”
3 Kick the tires.
Assuming you still are interested in a broker after doing this background research, it’s time to start considering some of the specific disclosures and services the firm offers.
Wuertz recommends that traders pay particular attention to the risk disclosure that brokers are required to provide every customer. In addition to spelling out the specific risks traders face when trading off-exchange, it also must disclose the broker’s total number of accounts over the last four quarters, as well as the percentage of those accounts that were profitable and the percentage that lost money over those quarters, she says. “Over the last four quarters, if 50% or more of customers have lost money, that’s an important piece of data.”
Additionally, you need to learn how the firm makes its money at this point. Because the spot forex market is off-exchange, that means your trading partner often times is your broker, which is a direct conflict, according to Wuertz. “The terms of the trading system are regulated by the dealer, and it’s not a regulated exchange,” she says.
This directly ties into how a broker handles the bid-ask spread. Because you are trading off-exchange, there is no standard spread that will be offered from all brokers. This means the spread you see for a currency pair may be different from the spread the next trader sees at a different broker.
According to Rockefeller, there are a couple of ways firms generally handle the spread. “Some do matching, meaning that if you want to sell yen, you can only get a price for it if they have a customer on the other side willing to buy it for that price. Then there are true brokers who will go out into the rest of the brokerage universe to find somebody for the other side of your trade,” she says. “[And] there are the market makers who take the other side of the trade themselves.”
At this point in evaluating a potential broker, Rockefeller also recommends that you look for third-party reviews and opinions to see how other traders have fared. “A good practice is to go to Google and just type in ‘critique or review of’ the broker you are looking at, and see what pops up. Then you have to use judgment whether a person has a grievance that is legitimate,” she says.
Popplewell agrees that user reviews can give you a greater insight into a brokerage. “Read what the actual users’ experiences are. Some people undervalue this, but you certainly get honest feedback,” he says.
4 Manual or automatic?
Now it’s time to begin evaluating the aspects of a broker that are important to you. For many traders, this includes things like customer service or education.
Popplewell puts a high emphasis on the services a firm provides. “It’s important that the investor is comfortable and is being looked after. Never underestimate the service aspect of things when you’re looking at a dealer,” he says. “Things like front-of-line customer service, investigative services and whether they provide user-friendly tools that actually help you understand the reporting and administration process of any account.”
Further, it’s important to understand how the broker handles interest rate differentials. Unlike futures contracts that incorporate interest rates into their prices, in spot forex trading, you are either paying or receiving interest when you carry a position, which is based on the differential between the two nations’ interest rates.
Finally, whereas almost all brokers will give you access to the major currency pairs, it may not be as easy to find a broker offering a minor, emerging or cross pair that you may want to trade. “What pairs are offered? Some dealers have 100 different pairs,” Poppelwell says. “You have to look at the product offerings, and they have to fit your trading profile.”
5 Bells and whistles.
Now that you’ve found a broker that appears to have its regulatory act together and seems to offer everything that’s important to you, it’s time to look at the other value-added features.
These features likely will differ from broker to broker, but often show where the broker has tried to place an emphasis. “That would be charting and execution platforms,” Popplewell says. “Are they information-based platforms? Is there a heavy emphasis placed on charting? Or is it on execution speed? All those things should be considered, including latency and reliability.”
6 Take her for a test drive.
Many brokers now offer the option of checking out their system on a demo account using fake funds, or paper trading. This can be an invaluable part of your decision process, but only if the demo account is an accurate mirror image of what a trader is going to get in the tradable account.
Although a demo account can’t replicate the full emotional experience of trading, it gives you an opportunity to learn the broker’s system before any money is on the line. This includes things such as placing market orders and understanding the charting software that is provided.
Even though it can’t replicate everything a trader experiences, Popplewell says taking the product for a test drive through the demo account is very worthwhile. “I’d certainly want to test drive any product I’d want to take home with me,” he says.
7 Sign, drive and maintenance.
Finally, you’ve found a broker that meets all of your criteria. It is registered, has a regulatory history you are comfortable with and offers everything that is important to you in a broker. Although you feel comfortable placing your money with them now, that doesn’t mean your due diligence is finished. As we’ve seen, the situation at a firm can change drastically in just a short time. As such, you need to continue to monitor any disciplinary actions taken against your broker and its capitalization levels. Any sudden changes may be an early warning sign that it is time to pull your funds.
Although it is becoming better regulated, the spot forex market still is experiencing growing pains as retail traders continue to flock to it. As such, it is all the more important that traders take the time to know their broker. A little time spent performing due diligence before opening an account can make all the difference should a problem arise in the future. Keep in mind that these steps should be applied to almost any broker in any field that you are contemplating trading, such as stocks, futures or options. “Buyer beware” has never been so important as today. An educated trader, both in markets and execution, typically is the most successful.