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Sunday, July 26, 2009

Smarter forex regulation

An important aspect of trading spot forex is the fact that the price the trader sees is an artificial creation of the firm the trader is trading with. In a currency futures contract, and in an equity trade, the price at any given moment that is listed can be confirmed anywhere in the world. As a result, there is great precision in technical trading tactics.

In contrast, in spot forex the price of any given cunency pair on a trading platform, is what the firm wants you to see. Spot forex is a negotiated market with a stipulated bid and ask price. The buyer pays the ask price and the seller pays the bid price. But how the bid and ask is arrived at is decided by the particular forex firm that you are trading with. The spread shown between the bid and ask of the currency pair represents an algorithm averaging the bids and asks of different banks, which is then widened by the forex firm based on how much of the spread it wants to keep.
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The question of what the price of a currency pair is therefore always imprecise. This price ambiguity also reflects an enduring feature of the retail forex trading industry: the essential characteristic that one is trading against the firm. It therefore makes sense to examine the forex firms that populate the current market. What are their financial conditions? What does a beginning trader need to know about how to choose a firm? Does the current regulatory environment provide the customer the needed information?

The Commodity Exchange Act empowering the Commodity Futures Trading Committee (CFTC) provides in its purpose section that one of the missions of the regulators is to promote financially secure trading facilities. Also, in a recent speech to the Federation of European Securities Commissions, CFTC Acting Chairman Walter Lukken said the policy direction of the CFTC was characterized as adhering to a "smart regulatory" concept, which in his words, "seeks to promote the adoption of regulations that are effective, less costly and tailored to specific risks and societal outcomes. The smart regulation approach does not necessarily mean more regulation or less regulation."

The CFTC requires that a trading firm, including forex firms, report their net capital. The forex trader has an ability to gain insight into the financial stability of the firms. This list can be found at data0704.pdf. It provides a reporting of the actual amount of capital a forex firm has and how much excess capital there is above the CFTC imposed minimum, which is $1 million, $5 million if the firms are trading options.

The CFTC report tells you which firms operate on the margins and which firms are relatively stable. Firms having less than $1 million in excess capital certainty are driving towards the red zone. If a regulatory problem is detected, or a fine occurs, these firms will be vulnerable to a flight of capital. Perhaps more important, when firms operate narrowly above the net capital requirements, sales staffs may be pressured to open more marginal customer accounts.

The CFTC, while still struggling over the breadth of their authority in forex, could do more to protect the forex trading customer. For example, an important measure of a firm's health, not directly available to the public, is the size of the customer base at a forex firm. It would be invaluable for a trader to know the average account size and the mid-point account size of a firm. Two firms with an equal amount of capital but different size accounts generate a very different message to a potential trader.

If the net capital requirements increase beyond $1 million, smaller firms will face insurmountable barriers to entry. The goal of the regulators, of course, has been to make it harder for the unscrupulous forex firm owner to be in the industry. Yet, by increasing the net capital requirements, it also makes it harder for start-up companies to enter and favors the existing larger futures commission merchants (FCM). As net capital requirements increase, more futures FCM's, which are already regulated and have larger capital assets, will start offering more spot forex. They can avoid the initial hurdles of the high net capital requirements. Ultimately, equity firms will consider spot forex as an alternative service product line.

In choosing a forex firm it is worthwhile to look beyond the advertising sizzle. The next time you choose to open an account at any firm ask these questions: How many retail forex accounts are at the firm? What is the average size account at your firm? What percentage of accounts are above $25,000? Are sales staff paid a salary or part of the spread? If the responses are vague or unavailable, consider another firm. The bottom line is that trading forex is challenging enough without costly add-ons. A rule that would require reporting not only the net capital a forex firm has but the number of accounts and its distribution by size would help new traders in their due diligence. It would further the public interest by making the financial stability of forex trading firms more transparent.

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