FCA holding secret confabs to discuss leverage while industry adapts

Published: 15 February 2017
By: Tom Cleveland

The UK forex brokerage market is still reeling from the dramatic December broadside delivered by the FCA regarding new rule proposals, especially those related to leverage. Yes, the proposals were directed primarily at Contracts for Difference (CFDs) and spread betting, but there were also hints that binary options and spot forex might receive additional future scrutiny, as well. CySEC, the FCA’s “partner in arms” in Europe, had followed suit in a similar fashion, without a discussion period or confinement to the CFD market alone. The FCA requested comments before its self-imposed March 7th deadline.

The word now on the street is that FCA officials have reached out to major forex and CFD brokers as a group to hold a private meeting to review the issues at hand. If the regulator definitely wants a smooth transition to a new operating environment, then it is wise to gain as many perspectives as possible from as diverse a set of industry participants as can be accommodated. December was about shock therapy. The first quarter of 2017 is about determining what is fair to the entire market without overly favoring one sector over another.

Leverage

The big battle will be over proposed limits on the use of leverage

Experienced forex traders understand what leverage is, what it is not, and how to use it prudently to magnify the possibility of position gains in the market. Leverage, however, can also have a dark side. It can magnify potential losses, as well. Traditional investors in stocks and other exchange traded securities often mistake leverage as just another term for margin, the ability to borrow a percentage of the value of an asset in order to invest more in the market. This type of margin comes with a cost, namely interest. Margin calls result when the market moves dramatically against you.

Leverage, on the other hand, can multiply the size of your investment position by as much as 50 or to even 500 times its size. Stock investors that are not in the know often disparage investing in the foreex market because currency movements can be so small. Their cry is something like, “How can anyone make any money in this market, when changes are so slight?”

At this point in the discussion with the uninformed, you must resort to an example. Let’s say your account is $10,000. You decide to stake 20% in a forex position. With “50:1” leverage, your position becomes $100,000. If your pair appreciates by 1% and you close it, you have a gain of $1,000, which happens to translate to a 10% return on your original account balance, and you only had to invest $2,000 of it. And, what’s more, the use of leverage was free. The broker funded it in his back office by aggregating other trades, hedging his risk exposure, and covering his costs via his spread income.

What is often absent from a discussion like this one is what is the broker doing in the background. Aside from aggregating and hedging, too technical to review in this piece, the broker enjoys two benefits from leverage. It has become a major marketing tool to attract new traders to the fold, a continuing challenge in an industry with such high casualty/attrition rates, estimated to exceed 65% on traditional products and into the nineties for the more riskier items like binary options and CFDs. In the above example, the broker could clear roughly $20 on a 2-pip spread, as long as it mitigated its risk.

Consequently, new rules that force leverage limits down to “50:1” or even lower for inexperienced traders are viewed as a “double” attack on the broker’s ability to make money and stay viable. Our example was for “50:1”, the prevailing rate in the U.S. market for major pairings, as mandated by the CFTC a few years back. Imagine for the moment that you had used “500:1” leverage. Your return would have been 100%. You would have doubled your money. Not bad for a single day’s or hour’s work. Try to find that return potential in the stock market, but don’t forget the downside loss potential!

Even though “50:1” leverage is adequate to ensure a healthy return on investment over a short period of time, brokers are concerned that their fickle client base will switch in an instant to a foreign-based broker that continues to offer exorbitant leverage levels. The cry from the brokerage community will be that traders will leave the market and go to riskier brokers across the sea where consumer protections do not exist. Did this mass migration occur in the United States when new rules were enforced? Yes, to a small degree, but analysts argued that the ones that left were not professional or even veteran traders and that these disgruntled beginners would soon learn the error of their way.

We would be remiss if we did not add a disclaimer at this point. If it were easy to pounce on a 100-pip winning gain in the forex market, then everyone would be doing it, and we would all be rich and prosperous. Forex trading is high risk. The forex market is very unpredictable, and its erratic shifts can wipe out a position, as quickly as it can generate a profit. It takes discipline and a well-defined plan to win at this game. Your chances are greater when you can identify a trend, jump on board, and then ride the wave as long as you deem necessary. Losses are a part of the game, and are the reasons why, in the above example, only 20% of the balance was put at risk. Caution wins.

What are the experts saying about these proposed new leverage rules?

The U.S. market has finally begun to grow again, and a preponderance of the experts, or at least the ones that are cited as such in articles of this nature, has said that “50:1” is adequate to assure good trading results and protect customers that are not at all acquainted with the level of risk that they may encounter when leverage is through the roof. What do independent experts think about the new leverage rules? One person, whose opinion is often sought after, is Naomi Ewart-Simcock, Head of the Chinese desk at AFX Group in London.

According to one interviewer, “Ms Ewart-Simcock is well known for her ability to provide incisive insight into complex topics concerning the Forex industry, especially the Chinese market and Chinese traders… It comes as little surprise that Ms Ewart-Simcock’s view on the impact of the new FCA rules on the industry is rather original.” In general, she believes that high leverage levels will eventually lead to another liquidity crisis, as happened during the “Swiss Franc Debacle” during January of 2015. If extremely high levels of leverage were allowed to persist, then, “Ultimately the biggest victims will be the brokers themselves.”

As for the benefits of lowering leverage allowances, she added, “In my opinion, new rules will not only tidy up the mess which was built up by ‘casino banking’, but will also take us back to a time when the market had a rhythm and could be analyzed. New rules will certainly reduce STP brokers exposure. 50:1 leverage is still high enough to ‘speculate’ the market instead of ‘invest in’ the market. In summary, both STP brokers and the retail traders might end up hand in hand winning out under a healthier environment.”

As for titans in the industry like the IG Group and CMC Markets, both companies are on the record stating that these new rules will be good for the industry in the long run. Both expect some jostling to occur during the transition, which should benefit the larger firms. As IG recently noted, “Our view, as we’ve stated several times, is that the FCA’s new Forex and CFD brokerage rules will ultimately be good for IG and the other leading brokers. High leverage and deposit bonuses are the tools which small brokers have been using to chip away at the market share of the industry leaders.”

Yes, the larger firms will gobble up the smaller ones that are stressed, but there is a larger concern, as well: “Inconsistent application of leverage rules across Europe could lead to “regulatory arbitrage”, with UK clients seeking high leverage “effectively encouraged to choose non-compliant providers who sell into the UK from other parts of the EU, or entirely illegally from elsewhere.” Are forex traders willing to balance the risk of dealing with an overseas broker with the allure that high leverage offers? Time will tell.

What is the FCA doing behind closed doors?

While some readers may cry “click bait” when headlines scream that clandestine meetings are being held by the FCA, the regulator is only doing its job. The level of pushback from the brokerage community and traders warrants a thorough review before final regulations are cut in stone. Regulatory officials have already publicly solicited the opinions of all industry participants. The next stage of the process is to discuss possible solutions in private with groups of brokers, and then set aside time for the collection of feedback directly from individual firms.

It may seem to be quite a time consuming process, but the impacts will be ubiquitous. The industry will be re-shaped. There will be winners and losers. It is never easy to “shake the box” that a horizontal grouping of competitors has been complying with and dedicating capital to for long-term growth and returns. While the larger firms comply and bide their time, the smaller firms will be under increased financial pressure to survive. It is in periods such as these that we often hear the word “consolidation”, a euphemism for the big fish gobbling up the small fry. Large firms can always grow organically, but the faster route to double-digit growth is often paved by mergers and acquisitions.

What has been the reaction from the so-called smaller firms? Per one executive: “The Financial Conduct Authority’s consultation paper is a classic case of the watchdog going after low-hanging fruit. We couldn’t believe it when we saw it… Targeting the spread-betting firms that play by the rules while largely ignoring unauthorised ones will — surprise, surprise — encourage more unauthorised businesses.”

Concluding Remarks

FCA officials are doing their job when they hold secret meetings with industry participants to discuss proposed rule changes. Prohibiting bonuses and limiting leverage levels will have heavy impacts on our industry. Try as it might, the FCA is duty bound to keep unintended consequences to a minimum, but that task will be difficult. There will be winners and losers. Stay cautious!

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