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Take a Breath Folks. Forex Leverage Won’t Be Cut to 10:1

The other day I posted Increasing Regulation of Retail Forex Trading discussing the continued efforts of the CFTC and NFA in terms of regulating retail foreign exchange trading in the US. I came across a discussion on Trade2Win today which made me want come back to the subject, though.

The thread starter asked the question “10:1 could this be the new leverage in the US ?”. This came from a single line in the CFTC’s communique: CFTC Seeks Public Comment on Proposed Regulations Regarding Retail FOREX Transactions, dated January 13, 2009. The line in question comes in the second to last paragraph and says “Leverage in retail forex customer accounts would be subject to a 10-to-1 limitation.” Folks are jumping all over that as meaning the CFTC is going to cut trading leverage to a maximum of 10:1. I disagree.

Firstly, the one line is in a write-up which otherwise focused entirely on requirements of brokers in terms of capitalization, compliance, transparency, and communication. As such, I think it relates to the leverage brokers will be permitted vis-a-vis the balance of customer accounts, not what the customers can actually trade.

Secondly, the NFA only a short while back set a new 100:1 cap on the leverage brokers can offer retail traders (see New NFA Retail Forex Leverage Restrictions). Why in the world would they be coming through with another change at this point? They haven’t had much time to gauge the impact of that adjustment.

Thirdly, this is only a “public comment” thing. Even if the CFTC was contemplating cutting trader leverage to 10:1, there is absolutely no doubt in my mind that there would be way too much negative reaction to that kind of move for them to actually go through with it.

So, in my opinion, all those who are calling for the end of forex trading in the US are seriously over-reacting.

By the way, if you’re interested in see how the various US brokers compare in terms of size, here is the CFTC’s latest financial report including all Forex and Futures brokers. BabyPips member Clint has posted a listing of just the forex brokers, by rank, here.

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Trading News

Increasing Regulation of Retail Forex Trading

There is an article on the Financial Times website on the subject of increased regulation in the US of retail forex trading. For those who have been following along with developments over the last year (No More “Hedging” for Forex Traders, New NFA Rule Impacts More Than Just Forex Hedging, New NFA Retail Forex Leverage Restrictions) there won’t be much new information.

Here’s an interesting point of reference from the article, though.

The rules bring fresh oversight to a small but expanding portion of the $3,700bn-a-day global foreign exchange market, ….

Retail traders make up more than $125bn of that volume, up from $10bn in 2001, it estimates.

There are always a lot of questions about  the influence of pricing and trading within the retail forex trading complex as it relates to the forex market as a whole. These figures – showing that retail trade accounts for only about 3% of daily volume – make it very clear that retail is effectively a non-factor in the movement and determination of forex prices.

The final thrust of the article is that movement is happening to further tighten things up.

The latest proposed rules will strengthen the CFTC’s authority over companies selling currency trading to retail traders, forcing them to register with regulators and disclose more to potential customers, according to a government official familiar with the proposal.

The CFTC would also get clear jurisdiction over most spot currency trades.

“All salespeople and everybody that deals with retail forex have to be registered with the CFTC,” said Larry Dyekman of the NFA.

“That’s going to be a big change to the forex industry.”

Since folks in the rest of the securities markets (stocks, futures, etc.) have to be registered to deal with individual customers, this is basically just bringing retail forex in-line with everything else.

Update: My own employer (Reuters) posted a similar story.

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Trading News

More New Margin Requirements

I posted before about the NFA’s new rules on maximum forex trading leverage permissible for traders with US brokerage accounts (see New NFA Retail Forex Leverage Restrictions). Those went into effect on Monday. Tuesday new leverage rules kicked in for the trading in leveraged ETFs. Darwin’s Finance has a good write-up on the subject.

I find it somewhat interesting that margins on short ETFs is higher than on long ones. Granted, equities do tend to move more rapidly to the downside, but a double long ETF is going to move just as quickly as a double short when the market is falling (considering day time frame moves here, which is what the leveraged ETFs are intended to track). It’s basic math, so I see no real justification for the higher margin between the two.

The other interesting part of this is that even with the new margin requirements you can still trade at effectively 4:1 leverage. That’s a fair amount of leverage when you consider how much volatility there can be in the markets underlying these ETFs. Many experienced forex traders don’t go much beyond 10:1 leverage when they trade, and that’s in a lower volatility market (see Looking at Volatility Across Markets)

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Trading News

New NFA Forex Leverage Limits In Effect Today

I wrote a while back (New NFA Retail Forex Leverage Restrictions) about new rules coming into effect from the NFA which limit the amount of leverage US member forex brokers are permitted to allow their customers. Those new rules start today. If you have a US brokerage account you have probably already received notice about the rules if your broker previous offered more than 100:1 leverage, which is the new cap.

Also, the margin must be calculated from the notional value of the position. I believe this has forced a change among some brokers who previously 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 be posted as margin. If EUR/USD is trading at 1.50, then a standard lot position would be worth $150,00, meaning a $1500 margin requirement.

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Trading News

The Dominant Players in Forex

I see the question all the time about where prices come from in the forex market and who drives them. The answer is that it comes from the market makers in the inter-bank market. Want to know who the big players are there? Here’s the current ranking as per Euromoney (hat tip to Clint at BabyPips).

Source: Euromoney FX survey FX Poll 2009
Source: Euromoney FX survey FX Poll 2009

According to that same survey, the daily volume of forex trading breaks down like this:

  • Western Europe 50.19%
  • North America 26.98%
  • Asia 14.54%
  • All others 8.39%

Here’s something most folks probably don’t realize, however. According to a Financial Times article posted today, about two thirds of the $3.2 trillion in daily forex market transaction volume done each day is derivatives (see Most Active Forex Currency Pairs). That’s heavily in swaps. The focal point of that FT article is on the potential impact of new legislation requiring derivatives to be cleared through central clearinghouses.

It’s worth noting that the only bank in the ranking list above that does retail forex trading business is Deutsche Bank, which has the dbFX platform. The way I understand it, DB is a major liquidity provider to retail forex brokers. So the answer to the question of who is making prices in the forex market is Deutsche Bank.

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Trading News

Someone Else Slamming Forex

I really wish people would get their facts right.

There was an article posted in the ft.com/alphaville section entitled The $100bln FX hustle, which I found referenced in a post on The Business Insider. The two articles basically pick up on the oft-stated “forex brokers trade against their customers” theme. Part of me wants to cut The Business Insider some slack because they were basically just going of the information in the original article, but I won’t. Both post authors are culpable for failing to realize that the marketing making function performed by retail forex brokers varies little from the same function performed by floor traders and bank dealing desks in stocks, bonds, futures, and options.

The FT Alphaville article starts off talking about the rapid growth in daily retail forex trading volume, which they put at $100bln. Information from Gain Capital (they are forex.com) show annual volumes for that group having risen to $1.49tln in 2008 from $120.3bln back in 2004. Anyone who’s been around the forex market for a while won’t be surprised at these figures given how rapidly awareness of and interest in currency trading has been growing. This has happened to the whole of the forex market, with recent estimates over $3tln in daily volume noted.

For some reason, the author of The FT Alphaville article thinks that growth is a reason for concern. I’ve never heard anyone make that kind of complaint about stocks. The rapid growth in forex trading has caused the spreads to come WAY down from where they used to be. When I first got into the markets, 10 pip spreads in USD/JPY were commonplace. The fact that it’s more like 1 pip now is a big benefit to price takers (that’s retail traders).

But that’s not the main gripe. The FT Alphaville article instead focuses on the counter-party element whereby Gain (and other market making brokers) take the opposite side of their customers trades. Specifically, it brings up the subject of stops and how it supposes that the broker gains from stops being triggered:

In its role as counterparty, the firm is taking bets from tens of thousands of customers across dozens of currency pairs. It can maintain a neutral market position while banking the spread between wholesale FX rates and the quotes it offers the Speculators of this world. But it then sweeps up as soon as a client hits a stop loss – which the volatility in FX markets, together with excess leverage, makes a certainty.

First, let me speak to the last statement about the volatility of the FX markets. How exactly is forex volatile? And compared to what? Take a look at individual stocks or commodities. Forex rates are not more volatile than those markets. I’d venture to say they are probably fairly comparable to the major stock indices (maybe in my next post I’ll put up a comparison). Certainly leverage introduces volatility in terms of one’s trading account, but that’s not what’s being discussed here.

Back to the market making. What does the author of the article exactly think is going on when stops are hit relative to their “neutral market position”? It means those customers positioned opposite the ones getting stopped out are making an equal amount of money! It also means the broker is now in an unbalanced position at risk if the market keeps going in the direction of the stop.

The article does bring up the issue of over-leverage, which definitely is a major problem with especially new traders. And of course the various brokers primarily hook people into trading who are thinking more about the potential gains than the potential losses. There are a lot of pitfalls in forex trading (and all other kinds as well). To suggest, however, that market making forex brokers are doing things substantially different from market makers in other markets, however, is naive.

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Trading News

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.