Last week, several of the world’s largest banks and brokerage firms lost hundreds of millions of dollars when the Swiss franc surged suddenly and surprisingly against the euro. It is eerily fascinating to see how unexpected moves in a single financial instrument, traded in a little-understood corner of the global financial markets, can have significant ripple effects internationally and across market sectors and defy the efforts of regulators to protect investors.
Here’s the story in a nutshell. The Swiss National Bank suddenly and without advance warning ended its three-year policy of capping the Swiss franc at 1.20 per euro. This caused the franc to surge by as much as 41 percent versus the euro last Thursday, the biggest gain on record. In fact, the franc climbed by more than 15 percent against all of the more than 150 currencies tracked by Bloomberg.
The US Commodity Futures Trading Commission and the National Futures Association allow investors to put down as little as 2 percent of the value of their foreign-exchange bets. Brokers, therefore, took the hit for losses suffered by their clients who used leverage to bet against the franc. That generated negative equity balances owed to one large retail foreign exchange broker of approximately $225 million and resulted in a nearly 90 percent drop in the value of the publicly-traded shares of that broker. Another broker lost about 25 percent.
A senior executive at one hard-hit broker explained that currencies don’t move that much, so if there was no leverage, nobody would trade them. At the same time, that company warned investors (who consisted primarily of retail customers) that its risk controls were imperfect. In a regulatory filing, the company disclosed: “Some of our methods for managing risk are discretionary by nature and are based on internally developed controls and observed historical market behavior. These methods may not adequately prevent losses, particularly as they relate to extreme market movements.” Despite such warnings, most of that broker’s retail clients lost money in 2014, according to the company’s disclosures mandated by the CFTC. The percentage of losing accounts climbed from 67 percent in the first and second quarters to 68 percent in the third quarter and 70 percent in the fourth quarter of last year. To be clear, seven in ten customers lost money from their trading!
Despite the low percentage of successful retail forex investors, this broker and other large online brokers have prospered over the past decade from a rise in small-time currency speculation. Nevertheless, following last week’s heavy losses, this broker was forced to agree to an emergency, high-interest rate loan simply to stay afloat, at least for the time being.
Isn’t this the kind of speculative trading that regulators have tried to prevent? In October, 2010, the CFTC issued final forex rules requiring any firm acting as a counterparty to certain retail off-exchange forex transactions to register as a Retail Foreign Exchange Dealer (RFED). (Futures Commission Merchants offering forex transactions to its retail customers but acting primarily or substantially as a traditional FCM are exempt from registering as an RFED but must be approved as a “Forex Firm” and designated as a “Forex Dealer Member of NFA.”)
So, why are regulators still allowing banks and brokers to take on such high-risk trading activities, especially for retail customers? When retail clients end up owing money to a bank due to highly leveraged currency trades, the bank can easily end up stuck with the losses. There is the additional question as to whether certain institutions, some of which received federal bailouts, should be permitted to deal with retail clients in highly-speculative and risky trading of foreign currencies. One bank’s risk disclosure states: “Trading is not on a regulated market or exchange - your national bank is your trading counterparty and has conflicting interests. The retail forex transaction you are entering into is not conducted on an interbank market nor is it conducted on a futures exchange subject to regulation as a designated contract market by the Commodity Futures Trading Commission. The foreign currency trades you transact are trades with your national bank as the counterparty. When you sell, the national bank is the buyer. When you buy, the national bank is the seller. As a result, when you lose money trading, your national bank is making money on such trades, in addition to any fees, commissions, or spreads the national bank may charge.”
When the market turns suddenly, as occurred with the Swiss franc, retail clients lose, which may cause the banks and brokers to teeter on the verge of collapse, and their shareholders suffer. Alarms are again sounded about the potential for widespread systemic risks. The question remains, however: does the cure lie in still-greater regulation (for both investors and their brokers), or greater education?. Many commentators believe that it makes little sense to restrict what people can and cannot do with their investment decisions. As with any investment strategy, investors ultimately are responsible for what they do with their money, and that includes investigating those with whom they partner in the trading process. This latest market tremor is unlikely to trigger the regulatory introspection that lead to the massive financial regulatory reform as part of the Dodd-Frank Act, especially with a Republican majority in both houses of Congress. Still, the sudden move in the Swiss franc, and the impact of that move on US retail forex customers, their banks and brokers, and the shareholders of those banks and brokers, and beyond, provide clear indication that increased regulation has not necessarily made the world’s financial markets significantly less susceptible to widespread systemic failures.