Figure 1. Leverage can quickly put your account balance underwater, but even that may not stop traders at certain foreign-exchange brokers. Photo by Zwiebackesser/Shutterstock.
• Part 2 of a series. Part 1 appeared on May 21, 2019. •
In Part 1 of this series, we learned that individuals who trade currencies are vastly overconfident in their ability to squeeze money out of the world's currency system. About 70% of currency players lose money, although almost every trader thinks he or she will actually make a profit.
The real money-makers in the currency trading business are the "retail foreign-exchange dealers" or RFEDs. These entities charge commissions on currency trades. In addition, the forex business is characterized by titanically risky leverage. Some dealers encourage individual traders to use as much as 1000-to-1 leverage with borrowed money. Many such firms are based outside the United States, according to Broker Cybersearch.
Of course, the RFEDs collect margin interest on the loans they extend, at rates traders may think are insignificant (but are not). And, of course, with 1000-to-1 leverage, a currency move of more than a mere 0.1% against you can wipe out your account and leave you owing more than you put in.
"The average life of a retail forex trading account at an RFED was 4 months regardless of the amount of the initial deposit," according to a letter from the National Futures Association (NFA) to the US Commodity Futures Trading Commission (CFTC).
Keeping the players playing, even when they've crapped out
Even if you lose your entire wad gambling on currencies, the fees and margin-interest payments that traders pay are so important to forex dealers that the firms sometimes forgive the debts in order for the whole game to continue.
One example is FXCM, formerly one of the largest foreign-exchange currency markets in the United States. The firm supported trading in many instruments, but the currency that reveals the most to us is the Swiss franc.
Switzerland has long been known as one of the most stable democracies in the world. The European sovereign-debt crisis that began in late 2009, in which Greece and some other countries threatened to default on billions in obligations, put an international spotlight on the Swiss franc. Fearing that the euro would decline in value, investors far and wide sought to move their funds into the safety of the franc.
This increase in demand caused the Swiss currency to rise in value against the euro. The value of the franc had traditionally been worth significantly less than one euro. But during the debt crisis, the exchange rate approached parity. The soaring franc put pressure on Swiss exporters, whose goods became more costly to foreign buyers — and therefore less competitive — the more the franc rose.
In early September 2011, the exchange rate hit 1.095 Swiss francs to 1.00 euro. That was an intolerable level, in the eyes of the Swiss National Bank. The central bank declared that the exchange rate would henceforth be fixed at 1.20 francs per euro to prevent more funds flowing into the currency. The bank also made its short-term interest rate more negative than it had already been — minus 0.75% rather than minus 0.25% — to discourage European financial institutions from keeping their money in francs.
This fixed exchange rate remained in place for more than three long years. Currency traders multiplied their leveraged bets, predicting — correctly, for a time — that the franc would not rise against the euro. Why, the Swiss National Bank actually guaranteed it! Currency brokers such as FXCM collected commissions on every trade and margin-interest payments on the leveraged accounts.
The Swiss central bank's cost — selling francs and buying euros to keep the cap in place — grew enormously The bank's balance sheet of foreign currency swelled from less than $200 billion to over $500 billion. Suddenly and without warning, the bank on Jan. 15, 2015, once again allowed the franc to float freely. The Swiss currency soared. Instead of a euro buying 1.20 francs, it almost immediately would buy as little as 0.98 franc.
Many of those "it can't fail" leveraged bets on the franc immediately generated huge losses for currency traders. FXCM estimated that day that its customers owed it almost a quarter of a billion US dollars. The company was forced to borrow $300 million at 10% interest from Leucadia National Corp. just to meet the capital levels that US regulators required.
Did FXCM try to collect the money it was owed from the currency traders whose accounts now had negative balances? In most cases, no.
FXCM announced that it would forgive the losses of most of its customers and allow them to continue trading. This declaration affected 90% of the underwater accounts and 40% of the dollar amount the firm had lost. (FXCM said in its statement that it would attempt to collect obligations from larger clients, such as financial institutions and high-net-worth individuals. But for the smaller players, the casino would let bygones be bygones, and the party could keep on rolling along.)
Those who live by leverage die by leverage
The seeds of FXCM's demise had been planted by the firm itself. Currency trading had been largely unregulated in the US until after the 2008 global financial crisis. Congress's 2010 Dodd-Frank law gave the CFTC the power, among other things, to reign in forex brokerages.
The CEO of FXCM and eight other brokerage executives sent a letter to the CFTC in March 2010 bitterly opposing the commission's proposal to limit forex leverage to 10-to-1. Under pressure, the CFTC set the upper limit at 50-to-1. That was better than the amount of risk many forex brokers in other countries allowed, which could be hundreds or thousands of times a trader's capital. But even 50-to-1 leverage was enough to wreak havoc on FXCM and many other brokers when "Francogeddon" struck in 2015.
By February 2017, FXCM and three of its founders were fined a total of $7 million by the CFTC and barred from the US market for "deceptive and abusive execution activities." The firm had misrouted its customers' orders in return for kickbacks, according to a Forbes article.
The brokerage's parent company, FXCM Inc., changed its name to Global Exchange Inc. (GBI), but the new branding wasn't much help. The brokerage subsidiary known as FXCM Group severed its relationship with GBI in October 2017. The renamed corporation declared Chapter 11 bankruptcy that November.
Other forex brokers that let traders ignore their debts included GAIN Capital Holdings and the Canada-based currency house OANDA. Both companies said they would forgive all negative balances, according to Reuters. But smaller brokers from the United Kingdom to New Zealand closed their doors as a result of losses, Fox Business reported.
Because most of its account holders were outside the US, FXCM lives to this day. According to the company, only 13% of its business by volume was from the US, with the rest mainly in Europe and Asia as of 2104 (before the Francogeddon crisis). As a result, despite the fall in FXCM's market share, it still counts as one of the world's five largest forex dealers outside of Japan, according to Finance Magnates.
In the next two parts of this series, we'll look at other ways currency trading affects individual investors and what you might be able to do about it.
With great knowledge comes great responsibility.
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