With the departure of Forex Capital Markets (FXCM) from the U.S., leadership change, etc., financial reporters far and wide are asking for perspective on these events. Some go as far as probing whether this is the end for the U.S. retail foreign exchange (FX) industry—to which I say, no, it isn’t the death of retail FX in the U.S. since there are still three authorized brokers (Gain Capital, Oanda, and TD Ameritrade/thinkorswim). But why are there merely three viable U.S. brokers for FX when Japanese traders have a good dozen brokers (with 150,000 and more than 500,000 traders each) and another dozen brokers of smaller brokers behind that? Moreover, why did the U.S. and Japan go so far apart over the same (2005 to 2017) period in their regulation of the same industry?
Before tackling that question, I will address the FXCM pickle. Long a dominant force in global/U.S. retail FX outside of Japan, FXCM has been in a slow decline since the Swiss National Bank (SNB) crisis of January 2015. I would venture to say that a series of managerial faux pas (i.e., not insulating FXCM U.S. against SNB-like events, misleading claims regarding no-dealing-desk execution, and lax regulatory compliance compared to peer Oanda) ultimately caused the problems that the firm is still resolving.
The U.S./Japan regulatory divergence started in 2004 or so. Japan began to keep track of retail FX activity in 2005, years prior and much more comprehensively than the Commodity Futures Trading Commission (CFTC). In 2009, Japanese authorities announced plans to lower maximum leverage dramatically, something that required traders to better capitalize their FX accounts. Since then and despite the leverage cut, retail FX trading volume, number of accounts, and client deposits have risen steadily in Japan. That’s not so in the U.S., where active accounts at around 80,000 to 90,000 are an eighth of what they are in Japan.
Under the leadership of Chairman Gensler (and later Chairman Massad), the CFTC began a brokerage cull like no one has ever seen before. Did the CFTC abuse the mandate it received from Congress to regulate that sector’s activity? We will not answer that, but the CFTC and its enforcement arm, the National Futures Association, vilified an industry and persecuted retail FX brokers, bringing their number from almost 40 institutions in 2006 to only three 10 years later. The 2010 Dodd-Frank Act on one hand gave the CFTC more regulatory powers to do its work, but it also gave securities and banking regulators the ability to pass their own retail FX rules (i.e., sanctioning the practice of FX trading as a viable retail asset class).
Some of the CTFC regulatory actions that suggest a certain draconian zeal bias toward retail FX include the following:
- Impacting brokers: Minimum capital requirement to operate in retail FX goes from US$250,000 in 2004 to US$10 million in 2008, then to approximately US$35 million in 2014. Brokers are required to report profitability of accounts on a quarterly basis. Maximum leverage offered to clients drops to 50:1 or lower (roughly in line with futures).
- Impacting retail FX traders: Individuals can’t place hedge trades, can’t open accounts with foreign brokers, and have to fund accounts using only the methods the CFTC prescribes.
The CFTC claimed all along that it was acting with retail FX consumers in mind. This author suspects that since the agency couldn’t carry a straight-out prohibition of retail FX, as it did of contracts for difference (another popular trading product outside of the U.S.), it sought to covertly kill the industry through regulatory means, one measure at a time.
There is no denying that some of the CFTC points regarding retail FX were valid. A lot of people can sustain major losses trading FX. Some brokers do use technology to their advantage and are shady. But conversely, there are consistently profitable retail traders and there are reputable brokers. Poor governance impacts all asset classes (e.g., MF Global and Bernie Madoff), and the blame hits retail and institutional circles (e.g., FX custodians and FX FIX scandal on the institutional side). A 2012 Aite Group research study that focused on the profitability of active traders found that the lowest rate of profitability was among those trading stock indices, and the highest was among options traders (FX was in the middle).
The CFTC could have created a safe environment in U.S. retail FX by working more closely with the industry. It left an indelible precedent for regulators worldwide of how to carry out functions in an adversarial, vindictive manner.
I retain hope that under the presumptive chairmanship of J. Christopher Giancarlo, a new chapter begins for how the CFTC will serve retail FX consumers. Here are positive steps the new CFTC leadership could take: Lower to US$5 million the minimum required capital to attract high-quality brokers from abroad, require regulated brokers to administer a suitability test to ensure that new traders plan to use “at-risk capital” only, ask brokers to offer education to would-be traders without any trading experience before they are permissioned to open live accounts, and allow (at least for the next year or two) experienced U.S. traders to use large foreign-based brokers for greater choice. Above all, the CFTC should adopt a conciliatory position with regard to the brokerage industry and abandon the notion that retail FX as an asset class is any more detrimental than futures or cash equities.
Why does any of this matter? It all goes to the heart of whether individuals have a role in self-directed trading in any asset class. Individuals should trade what they want. It is OK for regulators to set a reasonable set of protective steps and disclosures, but not to such a degree that they nigh kill an industry and dramatically curtail public choice.