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New NFA Retail Forex Leverage Restrictions

The National Futures Association (NFA) is not well liked by many retail forex traders because of restrictions they put in place earlier this year.  You may recall my posts NFA rule which effectively bans the practice of “hedging”, NFA Justifications and Reasoning for Killing Forex Hedging, and New NFA Rule Impacts More Than Just Forex Hedging and all the discussions that went on around them (literally hundreds of comments). They forced some changes to the way brokers handle positions and transactions, and the way some traders did their thing (or forced them to switch their account to non-US regulatory coverage).

Well, in case you haven’t heard yet, the NFA is back at it.

Effective November 30 they will be requiring US-based retail forex brokers to cap available leverage at 100:1. To quote the notice to members:

“…beginning on November 30, 2009, all FDMs must collect a customer security deposit of at least 1% for the currencies listed in Section 12 and at least 4% for all other currencies.”

The Section 12 currencies are the majors and some of the big European regional ones: British pound (GBP), the Swiss franc (CHF), the Canadian dollar (CAD), the Japanese yen (JPY), the Euro (EUR), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), the Norwegian krone (NOK), and the Danish krone (DKK). The US dollar (USD) is not specifically listed, but obviously it’s included.

As I understand it, any pair which includes at least one of the above currencies is covered by the 1% margin rule (100:1 leverage). In other words, the Mexican peso (MXN) isn’t on the list, but USD/MXN would fall under the 1% margin rule because the USD is part of the pair. All other currency pairs fall under the 4% (25:1) rule.

Value vs. Size
Note that according to the proposed rule change that was sent by the NFA to the CFTC for approval (the latter regulates the former) the margin must be calculated from the notional value of the position. I believe this is going to force a change among some brokers who have set their margin based on the size of a position rather than its value. For example, they would require $1000 margin on a 100,000 EUR/USD trade. Under the new rule they would have to require 1% of the value of the position. If EUR/USD is trading at 1.50, then a standard lot position would be worth $150,00, meaning a $1500 margin requirement.

It’s Actually More Leverage
This rule is actually an expansion of permissible leverage over what the NFA had proposed back in 2003. At that point they wanted 2% for the Section 12 currencies. That would have only permitted 50:1 leverage, which is closer to what the futures market margin rates are at (though still well short). The members put up a fuss at that point, however, and got them to put a hold on implementation of the rule.

Higher Leverage Means More NFA Action Against Brokers
The rules change proposal noted above also indicates that brokers permitting higher than 100:1 leverage were more apt to be the subject of NFA and/or CFTC enforcement action. At the same time, the two NFA member brokers capping leverage at 50:1 were never the subject of such action. Oanda is one of those brokers. I don’t know the other.

The NFA has indicated that it is concerned about an increased account burn-up rate at higher leverage points. While leverage is only a tool, it’s clearly that it is a dangerous tool in the hands of many new traders, even more so when you consider that those brokers offering the higher leverage seem more apt to engage in shenanigans.

Actually, the NFA proposal letter notes that one broker who offers 700:1 leverage (yikes!) actually claimed that it allows customers to employ tighter stops. I know this may sound like a contradiction, but I’ve long held that tight stops are a trap (see Close stops do not lower your risk). This 700:1 broker should be shut down if it honestly believes that higher leverage is required for tight stops. What are they smoking over there? I’d love to hear the logic. It would no doubt be quite humorous.

My Reaction
I’m perfectly fine with this rule. In fact, it really has no impact on my own trading. I have long traded through Oanda with their 50:1 maximum permissible leverage and never found myself constrained. A great many experienced forex traders will likely have the same response as they tend not to trade at much more than 10:1 or 20:1 actual leverage.

Also, I think the 100:1 leverage keeps the spot forex market in a good competitive position vis-a-vis the currency futures market.

By John

Author of The Essentials of Trading

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