January 22, 2015 at 5:00 am ET
Last week the Swiss National Bank unexpectedly dropped the currency peg they’ve maintained since 2011, a move that bankrupted several retail foreign exchange (FX) brokerages abroad, nearly bankrupted one here in the U.S. and cost investors millions, though more likely billions of dollars, across the globe. Most professional investors understand the significant risks involved with investing in the largely unregulated global currency market. The regulatory outlook at the institutional level on a global scale is mixed given the complexities and numerous parties involved. The lack of coordinated regulation contributes to the longstanding reputation of FX as the Wild West among investors, something the recent alleged rate rigging scandals has only reinforced. If regulators want to truly protect investors though, they need to broadly re-examine the rules and practices as they relate to retail FX trading.
Currency trading was once the isolated to institutional and corporate managers, but has been one of the fastest growing segments of the asset management industry in the last ten years as investors are lured by the promise of high returns with small cash outlays. Dodd-Frank reduced the amount of leverage retail investors can take to 50:1, but it did nothing to address the suitability of these transactions for average investors. Many retail investors simply don’t truly understand the volatile nature and risks associated with trading currencies. Though they would have learned the hard way when they could not exit losing positions at their desired price last week.
Disclosing risks, however, is not the same as understanding risks. The FCA the UK’s main regulator, requires investors to take an “appropriateness test.” This is an exam-like questionnaire tailored to the asset or investment. Here in the U.S. an accredited investor is deemed to be financially sophisticated based solely on their net worth. It does not measure actual financial sophistication. FXCM, the retail brokerage firm here in the U.S. that had to be rescued by Jefferies due to the $300M capital shortfall created by losses in the wake of the SNB move, previously reported that 68% of its investor accounts are not profitable. One doesn’t need to be an accredited investor to trade FX, but it is clear the majority of retail FX investors do not understand the risks they are undertaking. FX traders on this platform can also fund their investment account with cash or a credit card. Even Las Vegas casinos prohibit the use of credit cards to fund gambling activity.
Losses related to the Swiss franc will likely continue to mount over the coming weeks and months, and stories of individuals wiped out from the move will fade. In order for the government and regulators to best serve the public they are tasked to protect, they need to move beyond investigations based on what will generate the best headlines. The NFA, National Futures Association, announced late yesterday it would be reviewing the leverage limits on foreign currency trades, but this addresses only a portion of the problem. Prohibiting investors from funding investment accounts with credit cards, reviewing the standards of investments only available to accredited investors and creating better standards to determine the appropriateness of an investment for individual are all changes that would more effectively protect investors and their retirement savings than simply lowering leverage limits.
Kristen Fanarakis is the Assistant Director at the Center for Financial Policy at the University of Maryland’s Robert H. Smith School of Business