We are often comforted by the aphorism that, “A rising tide lifts all boats”, but when concerns of fraud are about, the reverse is true: “A receding tide reveals all rocks.” We can always be critical of the first quote if we do not have a boat in the first place, but the second bit of wisdom cautions us to be wary when the tide changes for whatever reason. The Swiss Franc Debacle certainly qualifies as a tide changer in the first degree, but is it also warning us to take a closer look at our forex broker of choice? It may actually be a bad thing if your forex broker came out squeaky clean on his Swiss Franc positions.
When Swiss banking officials dropped the guillotine blade on the forex industry by abruptly lifting their peg to the Euro, the losses incurred over a 24-hour period by the brokerage industry were astonishing to behold. Catchphrases were coined by the minute, as the tale of hundreds of millions in foreign exchange losses hit the headlines. Black Swan Event and Francogeddon were often repeated, but trying to catch a falling knife seemed the most apropos. The forex brokerage community appears to have taken the brunt of the damage, but the jury is still out on other financial market participants.
Through this entire frightening event, there has been little talk about the winners in this fiasco. The ratio that has been bandied about in the press has been that trader sentiments were “50/50” before the announcement commenced a tsunami tide of carnage. If you were luckily on the long side of a Swiss Franc bet, then you made out big time. Your broker may be questioning the degree of your winnings, however, since liquidity providers are engaging in that age-old bad business practice of re-quoting the actual exchange rates used for settlement. Your withdrawal request may be in limbo for a while until this back office reconciliation nightmare is sorted out.
How did the winning and losing scenario play out?
The nature of this Black Swan Event was that it concentrated the loss experiences at the broker level. For the moment, we can put the winners aside. They are a dispersed lot, but their winnings belong to them. Brokers, on the other hand, had to deal with the losing side of the equation, and they were caught between their clients and their liquidity providers, a rock and a hard place, as it were. Client balances would be eliminated, and the total loss would depend on the level of leveraging and associated margin requirements, which were unusually low in many cases, as little as 3% as reported.
Brokers can operate in two distinct modalities – either as an ECN straight through processor where liquidity providers match each trade, or as a market maker where the back office is a dealing desk, aggregating trades and taking positions sometimes opposite to their clients. The ECN/STP mode would have fixed losses immediately when stop-losses were triggered at a much higher rate or after positions were closed when account balances were eliminated, with the broker stuck for the balance.
The second operating mode, however, is where it becomes a little cloudy. The broker in this case could have created his own catastrophic positions, as its dealing desk went through its daily litany of trading with the market on behalf of its customer positions. The lack of client funds when the margin call was made would have been the same, but there is one more possibility, one that would only happen if the broker were engaging in what could be best described as poor operating business practices, bordering on fraud.
How could the lack of CHF losses reveal fraudulent business practices?
The shady side of the broker community prefers to act more like a casino or spread-betting shop, rather than as one that passes your trades straight through to a liquidity provider. The degree of shade, so to speak, results because the broker elects never to go out to the market. There is no need for a liquidity provider. The back office fixes the Bid/Ask spread and maybe even the actual settlement rates, such that the odds favor the House over time. Since published loss rates in the forex world average roughly 65%, the “bucker shop”, as it is sometimes called, can play the waiting game, knowing that it will eventually collect your entire account balance, their definition of winning.
In the above “bucket shop” scenario, there would never be any losses over and above the client account balance, because the broker would not have to settle with a liquidity provider. The situation would actually mimic the back office of a binary option broker, where no losses were recognized due to the severity of the Swiss Franc shift. Bucket shops were quite prevalent in the early days of stock trading, but regulatory bodies did their level best to eliminate brokers of this persuasion. Yes, a bucket shop could lose when a client bets correctly, but loss ratios are so high, they know they can recover.
Do forex bucket shops still exist today? Yes, but they may be hidden behind respectable storefronts, rare, and located predictably in lenient regulatory jurisdictions where oversight is sparse. Did your broker go unscathed during the Swiss Franc Debacle, an extremely un-normal outcome considering the circumstances? You might want to perform a little more due diligence and shift your allegiances to one in a more regulated environment. If your broker’s clients are always losing their nest eggs, then their complaints should be easily visible across the Internet. Why take a chance, if the odds are deliberately manipulated and so stacked against you?
Did your broker have unusually low margin requirements for leveraged trades? Since forex loss rates are high, forex brokers must continually seek out new clients. Many resort to bonus schemes or low margin requirements to lure you to their offerings. Poor business practices do not necessarily connote fraud, but solvency issues may be the actual result of competing too hard for new customers. Their clock may be ticking.
Remember that due diligence should be an ongoing effort. As the Swiss Franc tide rolled out, it may have revealed quite a few forex “rocks” in the process. Be skeptical, and protect your downside at all times!