One of the most popular online trading activities to hit the financial markets in years has undoubtedly been the global foreign exchange market. Replete with trading opportunities “24/7”, this genre vaulted into the 21^st century due to the Internet, more sophisticated trading software, and creative brokers that were willing to aggregate positions to permit smaller trading lots and open the doors to countless consumers across the globe.

And the consumers came in droves. The forex market is already our largest and most liquid market in the world with average daily turnover in excess of $4 trillion. Retail forex traders, the term assigned to this new market of traders, rushed through the door, so to speak, to find a host of brokers aggressively courting their favor with special sign-up bonuses and claims of tight spreads.

Under these conditions, it was like a new “wild west”. Action was fast and swift. Fortunes were won and lost, but beginners became casualties soon enough at such an alarming rate, nearly 70%, that authorities had to step in to bring about a modicum of order. There was another problem, too. Wherever there is money involved, the criminal element in our society is quick to find clever ways to siphon off their share of the booty. The Commodity Futures Trading Commission (“CFTC”) regulates currency trading, and the National Futures Association (“NFA”) oversees the U.S. futures industry.

Both the CFTC and the NFA played a part in policing unscrupulous brokers in the industry, while at the same time, educating and protecting consumers from what could be termed questionable business practices. This yeoman task was successful during the past decade, but the advent of the Dodd-Frank reform act in 2010 addressed a new set of concerns with safety and soundness in the industry.

Restrictions on leverage were adopted that matched major banking formats, but fell far short of the competition outside of our borders. Further restrictions limited U.S. citizens’ usage of offshore brokers, but capital and educational requirements directly attacked domestic brokers. The acrimonious cries from the forex brokerage community could be heard across the land when preliminary regulations were issued for comment. Some modifications were made, but regulators refused to budge on capital requirements.

These capital requirements were set at $20 million, plus 5% of outstanding customer liabilities. There was one “out” – if you opted not to trade with the public, but only with institutions, the capital figure became $1 million. The result has been that two notable firms, Advanced Markets and Forex Club, dropped their public license for capital reasons. There are indications that they may not be the only firms considering this shift, but the NFA has stepped in to suggest that $20 million should apply across the board.

 

Why the big concern over capital? In nearly any new industry, it takes about ten years for the dust to settle and for the stars to survive, rise, and thrive. The ones on the edge tend to bend the rules, adding more systemic risk to the system and jeopardize many unwitting customers due to their poor financial controls. It is at this time that regulators typically force the industry to address safety and soundness issues. The result may be the departure of many smaller firms, but it is viewed as a healthy move from a security perspective.

A cursory review of 116 registered forex brokers as of December 31, 2011 would reveal that 30%, or 35, of these brokers had less than $20 million in net capital. It must be time for consolidation in the industry for the good of all.

Tom Cleveland is an investment analyst for ForexTraders.com and has owned his own consulting business since 2009. Mr. Cleveland has been published in a variety of financial newsletters, with the most notable sources being Business Standard and Financial Post.

 

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