Trading News

NFA Justifications and Reasoning for Killing Forex Hedging

Marjorie, who has been commenting on the No more hedging for forex traders post, dug up the NFA communique in which the reasons for the rule change are outlined from when the proposal was put forward to the CFTC after the comment period. You can find the full text here (including the part about price adjustment). I’m pasting below the relevant parts having to do with hedging/offsetting.

The other trading practice NFA believes must be addressed involves a strategy that FDMs refer to as “hedging”, where customers take long and short positions in the same currency pair in the same account. NFA is concerned that customers employing this strategy do not understand either the lack of economic benefit or the financial costs involved.

Ten of 17 FDMs surveyed offer the strategy to their customers, although for most it is a very small part of their business. Of these ten, six actively promote it on their web sites, while another one merely indicates that it is available.

Several of the FDMs told NFA that they had not offered the “hedging” strategy until their customers requested it. Although many of the FDMs admit that customers receive no financial benefit by carrying opposite positions, some FDMs believe that if they do not offer the strategy they will lose business to domestic and foreign firms that do.

NFA has two major concerns about this strategy. First, it essentially eliminates any opportunity to profit on the transaction. Second, it increases the customer’s financial costs in several ways. One way it increases costs is by doubling the expense of entering and exiting the transactions. In the on-exchange markets, a customer who carries opposite positions will normally pay twice the commissions. Similarly, a forex customer will pay the entire spread twice (buying at the high end of the spread and selling at the low end) rather than paying half on entry and half on exit.

Additionally, the customer pays carrying charges that always exceed the funds it receives. In a normal transaction, a customer receives interest on the long position and pays interest on the short position. Since the two transactions are mirror images, you would expect the receipts and payments to zero out. In practice, however, the amount a customer receives on a long position is always less than the amount a customer pays on a short position. Since these transfers occur daily when the positions roll over, the loss increases continually over time.

The costs described above are integral to the strategy, but there is an additional cost that could occur in certain circumstances. FDMs typically determine the equity balance in the account by calculating the liquidation price of the individual positions using the bid rate for long positions and the offer rate for short positions. If the customer holds contemporaneous positions long enough, the carrying charges will bring the equity below the required security deposit. Furthermore, if the bid-ask spread on the currency pair widens, as may happen when volatility increases or the FDM anticipates major market events, the customer’s account equity may fall even faster. If the account falls below its security deposit requirement while the spread is wider than normal, the account could be liquidated at unfavorable prices even though the customer has no currency exposure risk.

The strategy also creates significant potential for abuse. An FDM could promote the strategy to unwitting customers with an eye to collecting the additional spread and carrying costs. A knowledgeable customer could use it to launder money by using the carrying charge to take intentional losses. For a managed account, the practice could be used to disguise losses and inflate the manager’s performance by, for example, directing the FDM to offset a winning position and then entering into a new transaction in the same direction while letting the losing position run.

NFA solicited comments on banning the practice, and two commenters agreed with the proposal, stating that the practice serves no economic purpose. A third supported the ban without discussing the reasons behind it. One commenter that operates an institutional forex platform as well as a retail one indicated that institutional investors never use this strategy. Most commenters stated that the practice results from customer demand and generally felt that NFA should not dictate what strategies customers choose to use. Some were also concerned that customers will simply take their business to foreign counter-parties who can accommodate them.

A number of commenters argued that the practice provides a trading strategy benefit. Specifically, they argued that it allows customers to pursue both a long-term and a short-term trading strategy in the same currency. Some commenters also stated that the practice provides an economic benefit because it allows customers to maintain a directional position by lowering their margin requirements when the position goes against them. The proposed rule would not prohibit customers from pursuing long and short-term strategies in separately margined accounts, and it is not clear that the benefits of maintaining a directional position justify the costs.

Several commenters also recognize the financial costs of maintaining two positions but noted that these costs could be alleviated if FDMs treat them as a single position for calculating interest charges and allow customers to offset positions against each other when exiting both at the same time. In fact, at least one commenter seems to suggest that NFA should require this treatment. None of these FDMs have chosen to do so voluntarily, however. Furthermore, this approach would be equivalent to dictating how or how much Members can be compensated.

NFA believes that the potential for misuse outweighs any perceived benefits from allowing customers to carry long and short positions in the same currency in the same account. Therefore, Compliance Rule 2-43(b) bans the practice and requires FDMs to offset positions on a first-in, first-out basis (FIFO). It does, however, allow customers to direct the FDM to offset same-size transactions.

One commenter who supported Compliance Rule 2-43(b) said that NFA should provide sufficient lead time so that firms now offering the “hedging” strategy could change their systems. NFA agrees with this comment and will consider systems issues when setting an effective date.

One of the big gripes people have with this NFA rule change is the “nanny state” aspect of it whereby the regulators are going to protect the traders from themselves. There’s definitely a fair bit of that in here. I did, however, find the parts about avoiding abuse by money launderers and those running managed accounts interesting. Having seen some really deceptive ways people promote trading systems I can definitely see how a money manager could use hedging to create an illusory performance record.

All the parts about increased transaction costs are well known and have been discussed at length, so there’s no need to dwell on that again. The one argument that the NFA did include, though, was the potential for a situation where a customer could get margin called on a hedged position because of an expansion in the spread. This is something which can only happen to a trader who is running at basically maxed-out leverage, but definitely does present the potential for broker abuse.

Aside from that, I think the most telling line in the whole justification is this: “…many of the FDMs admit that customers receive no financial benefit by carrying opposite positions.” The brokers themselves are saying that hedging doesn’t actually benefit trader performance at all, but being good business people they are giving the people what they want.

By John

Author of The Essentials of Trading

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