Fraud Update: Have operating risk factors increased in the forex industry?

The forex industry, more specifically retail forex brokers and their clients, has had to sustain several severe body blows over the past few years. Whether it was from new regulations, poor risk management practices within the banking sector, or from central bankers bent on wreaking havoc on all things related to speculation, the financial impacts have been substantial for brokers, their business partners and investors, and, in many cases, their retail trading customers.

The term “Black Swan Event” has been over used, as well, to describe how each set of circumstances was unique and difficult to predict. Yes, storm clouds have been forming, driven most likely by the lingering effects of the Great Recession and the European Debt Crisis, but the suddenness of a host of abrupt changes in the economic landscape did take everyone by surprise. Adapting to changing market conditions is “Rule #1” in our industry, but every new blow was followed by another, and then another. The simple question then becomes, “When will this boxing round ever end?”

Unfortunately, the current consensus of so-called economic experts is that central bankers the world over have twisted the global economy into a very tightly coiled spring. At some point, this coiled up energy has got to be released. The shockwave will cause investors to run for the capital exits, creating a massive mountain of sellers, but no buyers to speak of, the definition of the dreaded “liquidity crunch.” Emerging markets or anywhere that has benefited from carry trade investment will be the most severely impacted under this scenario of doom and gloom. Analysts cannot predict when, but they have developed a multitude of charts that support their case for destruction.

What about current risk factors in the forex world?

Yes, the future may be uncertain, but that is its nature. For now, let’s concern ourselves with how the forex industry has coped with recent changes and if its inherent risk profile has been improved for the better in the long run. The update that follows covers four basic topics: 1) Regulation, 2) Cyprus Financial Crisis, 3) Central Bank Actions, and 4) Recent Event Aftermaths.

Regulation

The cause of the Great Recession has generally been attributed to the unbridled hubris of the global banking industry, especially in the area of creating OTC securities and the reckless trading and selling of those instruments to unsuspecting investors that had no idea of the high risk involved. In order to prevent a recurrence of bad habits, legislators around the globe have enacted new laws to “bridle” bankers, so to speak. The Dodd-Frank Act was adopted in the United States in 2010 and was designed to put curbs on the financial services industry, including Wall Street bankers and their business partners.

To this day, bankers have blocked the implementation of key reform regulations, but the CFTC has been able to institute many changes in the forex arena. These changes have led to a broad-based consolidation in the forex broker community, due to reductions in leverage, new reporting requirements, stricter licensing standards, and tighter rules regarding capital adequacy. As a result, many foreign-based brokers have exited the U.S. market and do not accept U.S. clients to this day. Others that were under capitalized have sold their programs to larger firms. Regulators have even blocked the use of credit cards for deposit purposes, and the beat goes on.

As a general rule, the global regulatory community tends to follow the lead of the United States. For that reason, if something works in the U.S., then you can expect other regulatory bodies to follow suit or modify the proposed legislation for implementation in their local jurisdiction. In other words, the impact of new regulations on our industry is far from over. More change is to be expected.

Cyprus Financial Crisis

If ever there were a third-party risk that had not been fully appreciated in advance by the forex industry, then the financial crisis in Cyprus in 2013 would have to qualify as a true “black swan” event. The two largest banks in Cyprus, which had become a financial center for European commerce, had invested heavily in Greek bonds, well beyond the prudent limits supported by their respective levels of capital. Attempts to raise more capital after Greek bonds were devalued failed. Consequently, regulators closed the smaller of the two banks and reorganized the primary, but only after the seizure of banking deposits. Local forex brokers that were severely impacted had to raise more capital, be sold, or close their doors.

CySEC, the local banking regulator, stiffened under the onslaught of criticism and quickly released new and tighter regulations to improve compliance oversight. For those firms that had liked the softer local approach, tighter operating, licensing, and capital adequacy standards were warning shots to leave the island or stay and comply. There are presently 182 CIFs (Cyprus Investment Firm) that fall under the new rules, and one sign that the new regimen is working is that only 24 forex firms incurred losses from the Swiss Franc Debacle, totaling € 42,5 million, but with little or no impact regarding the new tests for capital adequacy. As for the Bank of Cyprus, the surviving national bank, the latest news is that deposits are growing again. For 2014, it did suffer losses of  € 309 million after closing operations in Russia and the Ukraine, but it also netted profits from operations of € 42 million. The bank had also “successfully raised 1 billion euros in capital from private investors” by mid-2014, another positive sign.

Central Bank Actions

If you believe what many central bankers have noted in concerned speeches around the globe, then you would have to accept that the largest risk exposure posed to the global economy is central bank monetary policies. Near zero interest rate policies (ZIRP) have not provided the boosts that everyone wanted, nor the inflation that everyone feared. What it did do is fuel the bond casino-trading that most every global bank is engaged in, to the detriment of their local economies that are starved for small-business loans, and create a return chasing investor community, the likes of which have never been seen before.

The global risk profile has continued to increase with each re-direction of capital flows after successive central banks have reduced their benchmark lending rates or implemented new quantitative easing programs to spur exports. The export game at best is a zero-sum game, as are the trading exploits and profits that banks hunger for these days. If the global economy were robust and growing at a high rate, these tactics might provide a temporary fix, but temporary from a central banker’s eye stretches back to 2007. The undesired result could be a monumental rush for the exits, when and if a minor hint that bad news could be forthcoming. Negative capital flows are already impacting emerging market economies. Billions upon billions in carry-trade volume could unwind in an instant. To be forewarned is to be forearmed.

The first sign of this coiled spring effect occurred when the Swiss National Bank removed its out-dated Swiss France link to the Euro. Billions were lost. Many well known brokers shut their doors. The abrupt fall in the Russian Ruble had already sent many brokers packing, but that fall had been over several months, not minutes, as with the SNB action. The aftermath is still being felt, and no one knows yet what the impact will be on the Switzerland economy. Financial markets abhor artificial constraints, like currency “pegs” or near-zero interest rate policies. Whenever mankind has attempted to force a market to bend, it usually snaps back harder in the opposite direction when the dam finally breaks. An avalanche is coming, so be prepared.

Recent Event Aftermaths

Ripples from the Swiss Franc Debacle have not subsided. The two brokers that received the most press were FXCM, a publicly traded company, and Alpari UK, a foreign-owned subsidiary. After sustaining $276 million in client negative balance losses, FXCM has been busy selling off foreign operations, most notably their operation in Japan, in order to raise new funds to pay back Leucadia, the firm that provided a $300 million lifeline for FXCM. Alpari UK, however, went into insolvency. ETX Capital stepped in to buy the client lists of the insolvent broker, but client balance transfers under the UK Financial Services Compensation Scheme (FSCS) have been delayed until late April.

The Russian Ruble that had tanked in late 2014, due to low oil prices, sky-high interest rates, and the problems in the Ukraine, appears to be making a comeback. The Ruble had lost over 50% of its value during the latter half of 2014, but it presently has recovered nearly 50% of that lost territory. Russians are selling foreign currency assets and repatriating the funds back home, thereby appreciating the Ruble in the process. As one article pointed out, however, due to wild swings in volatility, “Experts are reluctant to predict future values, but some analysts warned yesterday that the ruble rebound could soon fizzle out.”

On a more amusing front, there has been a great deal of fanfare raised by CWM FX in the London press after a March raid on it offices by police at the direction of the FCA. Officials have denied any wrongdoing, but their major business partners have withdrawn their support, and their website was shut down. The Chelsea Football Club has also deleted them from their list of sponsoring organizations. A release issued by CWM states that, “CWM believes it has been the victim of a malicious campaign waged against it by persons who harbour a grudge against the Company.” Stay tuned.

Concluding Remarks

Risk comes in many forms these days, which suggest that operating risk factors have increased in the forex industry. Industry growth, however, continues at record pace, if the recent data from GAIN Capital Holdings, a leader in global online trading, is any indication. Their CAGR for the past two years has been in excess of 30% per year. Just remember that high growth can also imply high risk, as we have seen over the past few years. Stay cautious, stay skeptical, and stay tuned!

Chris Lee

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