Trading News

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.

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.

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.

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.

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.

Trading News

New NFA Rule Impacts More Than Just Forex Hedging

A couple of weeks ago I posted on the new NFA rule which effectively bans the practice of “hedging” in the retail forex market. There’s been considerable discussion on the subject of hedging and several notable brokers have given their customers the opportunity to allow them to shift their accounts to jurisdictions outside the US to permit those who wish the ability to continue hedging.

One of the parts of this new rule (2-43) that I didn’t initially focus much on is the FIFO (first-in, first-out) requirement. Some discussion about it, however, It’s made pretty clear:

Forex Dealer Members may not carry offsetting positions in a customer account but must offset them on a first-in, first-out basis. At the customer’s request, an FDM may offset same-size transactions even if there are older transactions of a different size but must offset the transaction against the oldest transaction of that size.

This FIFO requirement means that you can no longer chose which position you close if you have more than one trade open. If you are long and sell the broker will offset the earliest part of the long first. For example, if you bought a lot of EUR/USD at 1.3000, then later bought another lot at 1.3050, then sold a lot at 1.3100, the initial 1.3000 lot would be the one offset.

I do not “hedge” so the no carrying of offsetting position doesn’t phase me or most forex traders. The FIFO thing, though, is something which will impact a lot of folks. Basically it will mean that you won’t be able to close specific trades (stop or take profit) out of the sequence in which they were entered. Most forex brokers currently allow you to put a stop and/or take profit right on a specific position. This will not be permissible anymore under the new rule because they will be required to close your first trade before closing any others.

Now, if all you do is trade a single trade at a time, this my not be that big a deal. It depends on how you work. What it seems likely to require, however, is having to put on separate stop and take profit orders. This may seem fine, but consider a situation where you’re away from your computer and your stop gets hit, then later the take profit order is hit. You’d end up with a position you’d never intended. This is solved by setting up a One-Cancels-Other (OCO) order, but not all brokers do that at this point. Hopefully they will be pressured into changing that now.

I’ve spoken with someone at FXCM on this issue. It’s one they (and I’m sure all others) are working hard to figure out.

I’ve said from the start that this new NFA rule is just about getting retail forex in line with other markets like stocks and futures – standardizing the accounting for trades and positions. This FIFO thing is just doing that. I’ll admit it creates a bit of a shift in the mechanics of putting orders in and such, but if you’ve ever traded stocks, futures, or any other markets then it won’t be unfamiliar.

Trading News

No More “Hedging” for Forex Traders

The National Futures Association (NFA) has a new ruling which goes into effect on May 15, 2009. It addresses the practice of “hedging” in forex trading, which is the act of holding both long and short positions in the same currency pair at the same time. Here is what the NFA had decided:

Offsetting Transactions

New Compliance Rule 2-43(b) requires an FDM to offset positions in a customer account on a first-in, first-out basis, thereby prohibiting a trading practice commonly referred to as “hedging.” A customer may, however, direct the FDM to offset same-size transactions even if there are older transactions of a different size. Rule 2-43(b) is effective for any positions established after May 15, 2009. Offsetting positions that were established prior to the effective date do not have to be liquidated, but once either position is closed out after May 15, it may not be reestablished as a hedge.

From the NFA’s April 13 press release.

Basically, what this means if you attempt to go long and short the same pair at the same time you will be end up with no position – your broker will offset them against each other and you’ll have no trade left open. For those who trade with brokers like Oanda, this is no change at all as that’s always been the case. Traders with other brokers who have allowed “hedging” will see that change shortly.

If you’re not aware, NFA is the industry organization to which forex brokers in the U.S. belong now that the CFTC has been given regulatory authority over forex trading (FDM stands for Forex Dealer Merchant). It does things like setting the minimum capital requirements for the brokers. The bottom line is that between the CFTC and NFA forex brokers are no longer unregulated in the U.S.

I have long made my feelings about this so-called “hedging” known (see How do you hedge in the forex market?). It probably goes without saying that I am quite happy to see this rule put in place because I have always considered the allowing of this “hedging” by brokers to be nothing more than a way to bilk their customers out of extra pips with zero benefit to the traders.

A forex (and futures) broker contact of mine says he made the following comment about the new rule:

Regarding hedging it is my understanding now that day traders can still hedge but cannot hold overnight yet if one opens a new position after the beginning of a new session that just happens to hedge an open position from the previous session…

Even so I don’t really care, what I do care about is the NFA wanting to convert spot to futures with their FIFO rule for getting out of orders – I have a huge problem with that.

I don’t know if the overnight thing is true or not.