Roughly a month ago the Swiss National Bank rocked the world with a surprise announcement. During the middle of the night on January 15, 2015, Swiss banking authorities announced they would lift a three year exchange rate target of 1.20 Francs per Euro; a decision almost no one saw coming. The result? A meteoric rise in the value of the Franc against both the Euro and the US Dollar in a matter of minutes. At one point the Franc had rallied as much as 39%; a staggering move for any market but a real record setter for global foreign currency traders.
US Industry Damage
One of the most widely publicized victims of the surprise run up in the Swiss Franc was FXCM, a Futures Commission Merchant (“FCM”) registered with the US Commodity Futures Trading Commission (“CFTC”). The event was so devastating that FXCM clients accumulated debit balances (money owed to FXCM as an Over-the-counter “OTC” forex dealer) of nearly a quarter billion dollars in a matter of minutes. In order to maintain its day to day operations FXCM was forced to secure financing of $300 million from Leucadia National Corp. (“Leucadia”), the owner of Jeffries Group, who also played a role in saving Knight Capital Group (“KCG”) in 2012. The result for FXCM? Its stock value collapsed roughly 90% and as of the date of this article it has not truly recovered.
While FXCM was one of the most discussed casualties of the Swiss move, other CFTC registrants, including FCM’s, Introducing Brokers (“IB”), Commodity Trading Advisors (“CTA”), and Commodity Pool Operators (“CPO”) were impacted as well. According to a variety of sources, Interactive Brokers, an FCM, suffered a loss of approximately $120 million that day. In contrast, it was also widely reported that Gain Capital, another FCM, actually turned a profit on the Franc’s rise. CTA Intelligence and Lyxor, both of whom follow professional CTA and CPO activity closely, expressed that they believed the managed funds universe as a whole likely benefited from the volatility in the Franc. With winners and losers on both sides of the trade, what can be learned looking back on this event? Does the US commodity futures and forex industry need to respond? If so how?
Industry Mechanics
When evaluating the question “How should we respond?” it’s important to fully understand three basic concepts about the forex marketplace as it relates to the Swiss move:
1) From what was reported upon most publically it appears losses were primarily felt throughout the retail OTC forex community. FCMs offering OTC financial transactions trade principally with their customers. This means when a position is initiated with them the FCM always holds the opposite side of that customer’s trade.
2) FCMs dealing in OTC forex can choose to hedge their exposure relative to the trades they offer to their clients. If the decision is made to hedge customer exposure, FCMs must effectively hold the same position their clients hold with an outside third party (usually banks). For example, if an FCM’s customer is long 1 lot of EUR/USD, then the FCM is by default short 1 lot EUR/USD since they are the counterparty to the customer transaction. Thus, in order to effectively hedge its exposure to its customer, the FCM must transact with another firm to obtain a long 1 lot EUR/USD position.
3) In OTC forex, FCMs must assume that their clients will perform on the positions they have entered into with the firm. This is a critical component with respect to a firm’s decision to hedge its customer position risk. In the event an FCM holds a “fully hedged” position between its client(s) and an outside firm, but its customers cannot perform on their side of the trade, the FCM is then likely to suffer losses at least equal to, if not greater than, those sustained by its clients on the trade.
Current Regulatory Response
It probably came as no surprise to many reading this article that shortly after the Swiss event Congress started to get vocal. They once again made Dodd Frank the topic of the day saying the legislation had not done enough. FXCM got the type of press from the talking heads that no one wants. To make matters worse Leucadia stepping in to help them only brought back more painful memories from Knight’s problems a few short years ago. Pressure on the CFTC to “do something” ratcheted up quickly to say the least.
Shortly after the event the response people were calling for finally showed up. National Futures Association (“NFA”), the self-regulatory organization that oversees retail OTC forex trading in the US, announced an increase in the amount of customer “security deposit” (read – margin) that they would require FCMs to collect on OTC forex trades in the Swiss Franc. A few short days later they also re-evaluated the amount of margin required to trade in a variety of other currencies. The end result was that NFA called for margin obligations in retail OTC FX to increase. Was this the right decision? Had these margin requirements been in place prior to the Swiss move, would FCMs have been better protected? Are FCMs dealing in retail OTC forex better off today than they were last month?
What Actually Happened
On the day the Swiss Franc jumped the market gapped and no liquidity was available to unwind trades. Certainly an increase in the amount of margin required to trade forex with FCMs would have reduced losses. The unfortunate reality though is that an increase in margin can never eliminate the risk of a gapping market. As long as we allow leverage to be used in trading we will always have winners like Gain Capital but we will also always have losers like FXCM and Interactive Brokers. Frankly, on that day, the CFTC and NFA could have required many times the current security/margin deposit and yet its likely accounts still would have suffered devastating losses. Gapping is a basic market risk all participants in the trading industry must accept and have understood for generations.
During the gap, with liquidity for trades in the Franc gone, customers could no longer perform on their obligations to their FCMs. As accounts took near instantaneous losses customer positions were auto liquidated by FCM trading systems. When this happened customers went debit and ended up owing money to their respective trading firms. With customer account equity wiped out, FCMs then had to post their own capital to cover the trades they had placed to hedge customer risk with outside parties. Game. Set. Match. The primary assumption of principal OTC forex dealing was violated and broken on January 15, 2015.
A Better Alternative
The CFTC, NFA, and frankly the forex industry as a whole should consider a shift in thinking. Certainly passing through customer risk to outside third parties works in periods of low volatility. It does not work well though when we have days like January 15th. While one could argue the Swiss move was unprecedented, it happened and very likely will happen again with another currency in the future. This should start the discussion about whether or not pass through hedging of retail client positions to third parties is as safe as regulators assume it is. In the event FCMs had chosen not to hedge clients in the Swiss, it’s likely the real losses they experienced that day would have been lessoned.
On this point retail OTC forex FCMs should not be vilified by regulators or industry participants for “taking the other side” of a client trade. The business by its very nature requires FCMs to trade principally with clients even if they hedge instantaneously with an outside third party. So long as clients are provided a fair market that has not been manipulated this practice shouldn’t be seen as a “problem”. Sometimes the right risk decision is to not hedge a customer trade, other times the right risk decision is to hedge a customer trade; FCM risk departments should manage this choice. Forex dealing firms should be able to fully benefit and suffer from the consequences of their decisions even if that means going out of business.
Another key consideration that should be debated is that many retail forex firms either currently or have previously marketed that retail customers will not be responsible for debits beyond the cash available in their accounts. In the past this has largely been tolerated by regulators as it should be so long as FCMs honor this. Indeed, for most of the past, that has been the case as FCMs have demonstrated that their trading systems reduce client liquidity in real time lock step with published market pricing. These systems have also demonstrated they will automatically stop clients out of the market if cash on hand gets too low. This thinking should be re-evaluated if FCMs are going to lay off client risk with outside third parties.
Conclusion
What then could have and still should be done to help eliminate this problem in the retail forex market place? Is there a solution that NFA could easily implement? The answer to this in my opinion is yes there is. It is well within NFA’s ability to require member firms to clearly articulate their policy to clients on debit balances. When trading with leverage, whether stated or implied, those taking risks should be responsible for all losses even if those losses are more than their original deposit. It needs to be clear who is liable when a customer cannot perform on a trade. This is especially true if, as an industry, we are going to push FCMs to hedge customer risk. What about FCMs collapsing and customers losing funds you might ask? To this point NFA should require FCMs to publish something akin to a risk/capital ratio. The ratio’s intent would be to show total client notional position exposure converted to USD against total client funds and capital collateral pledged to the FCM in USD. Free markets and transparency will sort out who is taking too much risk if this information is readily available.
In an era of low volatility, whereby traders literally wait on baited breath for global central bank announcements, the brokerage industry has grown complacent. Credit is extended to clients through leverage that can never be paid back. Neither technology nor regulation can fully insulate us from the inherent risks of trading. Markets have always and will always gap on significant and unexpected news events. When they do, firms who have offered too much leverage to customers won’t be paid back and will suffer. On days like January 15, 2015, there is no amount of regulation that will be able to save those on the wrong side of a trade. While a Laissez Faire approach to regulation may not work in all instances, in the case of the Swiss Franc move, less is certainly more. History has shown us that with time, after the dust finally settles, we’ll always have firms like Leucadia to come in and pick up the pieces.
Biography
James Bibbings is the Founder of North America's Best Regulatory Advisory Firm, Turnkey Trading Partners, as named by Hedge Week in 2013 and then again by CTA Intelligence the following year. Turnkey supports CFTC and NFA regulated firms with all of their commodity, forex, and swap specific regulatory and business needs. James is a former NFA Supervisor responsible for conducting regulatory audits at FCM, IB, CPO, and CTA registrant/member firms. James' insights and work has been featured in/at the National Introducing Brokers Association, Bloomberg, Reuters, Financial Times, WSJ Market Watch, MSN, Yahoo, FX Street, Forex Factory and others. He is a frequent speaker at both foreign and domestic conferences on a variety of CFTC/NFA related topics.
