To reiterate the obvious, investing is all about risk and reward, but we often tend to focus too heavily on the latter, while easily dismissing most of the former. Many currency traders, however, woke up one morning in March to find their accounts frozen by government officials with little hope that anything would be resolved favorably in the near term. Such is life on the global stage where risk can expand geometrically at a moment’s notice. This time around, it was a banking crisis in Cyprus – tomorrow, who knows?
The time to determine if your broker is protecting your account balances may have passed, but a prudent investor would naturally start asking questions immediately, just to make sure that a Cyprus type situation could not assault his risk mitigating defenses. Recording an investment loss is one thing. We have a say in that outcome, but having your funds suddenly seized is not something a trader typically expects. Preventing this type of action has more to do with performing due diligence when selecting a broker, but in today’s world, global risks require a more continuous due diligence process.
What exactly happened in Cyprus? Since its entry into the European Union (EU) in May 2004, government officials in this tiny island community began touting the nation state as the next global financial center:The island is centrally located in the region, tax incentives were bundled along with flexible incorporation laws to attract financial institutions of all types, and the regulatory environment was known to be one that might look the other way or favor those entities that provided jobs for the local islanders.
All went well for the last decade. To date, over 130 registrations were processed for the right to operate on Cyprus, 80 of those for forex brokers. Foreign exchange trading has garnered enormous worldwide popularity since 2000 and competition is fierce between brokers. One way to get a leg up on the competition is by having total flexibility in product and service offerings, one benefit marketed to a great extent by officials in Cyprus.
But all did not go as well as planned. In March, a banking crisis brought this tiny island to a standstill. The Bank of Cyprus and the Laiki Bank, the two largest banks on the island in that order, had invested heavily in Greek bonds. When these bonds were devalued, both banks suffered staggering losses. Attempts to right the ships failed. A bailout seemed the only way to preserve stability in this new global financial center.
European officials, however, have grown weary of bailout situations. Before committing funds, they demanded that the account and shareholders for both banks share a portion of the losses before additional funds would be forwarded. The Bank of Cyprus would be preserved in a reorganized fashion, but the Laiki Bank would be closed. Accounts over 100,000 Euros would receive a “haircut”, estimated to be roughly 40% by analysts acquainted with the details behind the scenes.
Forex brokers that followed “best practices” and segregated client funds offshore in Tier-1 banks limited their losses to operating account balances over the 100,000 threshold. Many other brokers, the ones that commingled client and operating funds in one account at either of the two affected banks, were not so lucky. Now these banks are in a race to raise additional capital for their survival or be acquired or, worse yet, declare bankruptcy. Clients of these may have to wait years for any resolution or restitution.
This crisis harshly impacted the world of currency trading, yet the source of the problem had nothing to do with this investing medium. The forex community is in a tailspin, trying to repair its tarnished image. Clients are shifting allegiances right and left, and chaos prevails. The sad truth, however, is that this type of risk could have impacted any type of brokerage house on the planet. It is not unique to foreign exchange.
In this modern era of globalization, capital easily can flow to all corners of the globe. Investing across national borders is more prevalent today than ever before. It was not that long ago that a 5% or 10% benchmark was suggested for overseas investment forays, but these figures have trebled in recent years.
Emerging and developing economies are growing at twice to three times the rate experienced in the advanced economies of the world. Profit may not always follow growth, but investors have stampeded overseas to test that hypothesis.
The primary issue, however, is whether your broker has installed the financial disciplines and best practices to protect you from account seizure by foreign officials. The time has come to ask a few penetrating questions of your broker.