Meanwhile….. South of the Border
As the deadline of Aug 1st 2009 approaches for Forex Dealer Members (FDMs) to implement NFA Compliance Rule 2-43 regarding forex orders,1 competing solutions have been offered to comply with the rule change and mitigate some of the impact to customers, in particular NFA CR 2-43(b) regarding offsetting transactions.
CR 2-43(a), Price Adjustments, is drafted to protect customers from arbitrary and adverse price adjustments by dealers, with NFA citing that “an FDM violates just and equitable principles of trade if it adjusts prices only when doing so favors the FDM.” This rule will ban the practice of price adjustments, except when done in the customer’s favour, or where the dealer automatically offsets customer positions with another counterparty, without human intervention and without exception, and the counterparty adjusts or cancels the trade. Other strict conditions will also have to be fulfilled, including prompt written notification and equal treatment for all customers.
CR 2-43(a) has met with little resistance from the FDM community although it does put pressure on the entire industry to upgrade its technology and move towards straight-through-processing, since the new rule will make a market-maker’s business model more onerous. Even for non-dealing desk operations where erroneous prices attributable to liquidity providers permit account adjustment and trade cancellation in very limited circumstances, this must be communicated to the customer within 15 minutes of order execution, because a customer’s reliance on an executed order will influence subsequent trading decisions.
The introduction of CR 2-43(b), Offsetting Transactions, however, has been more controversial with customers because it prohibits hedging and also stop and limit orders under first-in, first-out (FIFO) logic with a number of FDMs. Many disagree with NFA’s position that there is no proven economic benefit to hedging, and are prepared to take their business elsewhere. With the twin goals of regulatory compliance and customer retention, FDMs have responded with a range of solutions, which includes reconfiguring order execution, account transfer to a dealer’s offshore affiliate2 and opening additional accounts for customers to carry offsetting positions.
The rationale behind CR 2-43(b) stems from NFA’s belief that hedging is an ill-advised strategy practiced by retail investors who incur unjustifiable financial costs to exploit profit opportunities where there are none. While the merit of hedging is debatable,3 it is clear that the adoption of this particular rule will bring forex accounts more in line with equities or futures accounts (except for hedgers), where no long and short position in the same underlying investment can be held contemporaneously, and the offsetting of individual transactions must comply with FIFO, with some exceptions.
Potential abuses enabled by hedging to hide losses and inflate profits are worrisome for managed account customers who tend to be more passive, less savvy and thus warrant special protection. Although most dealers only allow performance fees to be collected when account equity (including both realized and unrealized gains or losses) reaches a net new high, the hedging feature still allows a manager to keep losing positions while offsetting only the winners in the same currency pair. CR 2-43(b) will remove the ability of a money manager to disguise the true performance in his customer accounts.
NFA Compliance Rule 2-43(b) –
(b) Offsetting Transactions
Forex Dealer Members may not carry offsetting positions in a customer account but must offset them on a first-in, first-out basis. At the customer’s request, an FDM may offset same-size4 transactions even if there are older transactions of a different size but must offset the transaction against the oldest transaction of that size.
How the Removal of Hedging Impacts an NFA Regulated Forex Account
While not mentioned in the actual rule, intra-day hedging is allowed if the long and short positions in a customer account are offset before the application of roll fees.5 However, this limited relief does not support a strategy where a customer may, in the same account, execute short term trades in either direction around a core long or short position held over the medium or ling term to capture a trending move.
Many critics of the practice of hedging have suggested that carrying equal long and short positions of the same currency pair amounts to paying the dealer for the privilege of having no real exposure. This is particularly true of entering into offsetting transactions at the same price level. However, some argue that, given the appropriate trade setup, a strategy that involves hedging as described in the previous paragraph produces additional profits that cannot be made otherwise. Is that true?
Consider this example:
A currency pair begins to trend higher due to favorable fundamentals. Trader takes a long position of 10 lots at A. Price advances to B, a long term technical resistance perhaps marked by a previous multi-month or multi-year high. Some long positions in the market liquidate from profit taking and price retreats to C, and this pattern of range trading prevails between B & C, until B finally yields and price advances to D.
(1) If hedging is available
Trader recognizes the resistance at B, but he is also convinced of the power of the improving fundamentals. Without relinquishing his original long position, he hedges half by entering a short position of 5 lots at B, with a protective stop order just above B (>B) and a limit order at C. As long as the market trades between B & C, Trader can keep his original long position while booking profits on the short term trades. If price goes above B without touching C, Trader covers his hedge at a loss.
| Hedging | ||||
| Price | Action | Position | Realized P/L | Unrealized P/L |
| A | Initiate Long | +10 | 0 | 0 |
| B | Hedge 5 lots | +10, -5 | 0 | 10 X (B-A) |
| C | Cover Hedge | +10 | 5 X (B-C) | 10 X (C-A) |
| B | Hedge 5 lots | +10, -5 | 0 | 10 X (B-A) |
| C | Cover Hedge | +10 | 5 X (B-C) | 10 X (C-A) |
| B | Hedge 5 lots | +10, -5 | 0 | 10 X (B-A) |
| >B | Cover Hedge | +10 | 5 X (B->B) | 10 X (>B-A) |
| D | Liquidate | 0 | 10 X (D-A) | 0 |
(2) If hedging is not available
Trader recognizes the resistance at B, but he is also convinced of the power of the improving fundamentals. Unsure of the strength of the resistance at B, he books his profit on half of his original position by selling 5 lots at B, to re-enter by either a stop entry order just above B (>B) or an entry order at C (an OCO or one-cancels-other order). As long as the market trades between B & C, Trader can repeat selling 5 lots of his long position at B and re-enter at C, re-establishing his long position of 10 lots. If price goes above B without touching C, Trader buys 5 lots to re-establish original position of 10 lots.
| Non-Hedging | ||||
| Price | Action | Position | Realized P/L | Unrealized P/L |
| A | Initiate Long | +10 | 0 | 0 |
| B | Sell 5 lots | +5 | 5 X (B-A) | 5 X (B-A) |
| C | Buy 5 lots | +10 | 0 | 5 X (C-A) |
| B | Sell 5 lots | +5 | 5 X (B-C) | 5 X (B-A) |
| C | Buy 5 lots | +10 | 0 | 5 X (C-A) |
| B | Sell 5 lots | +5 | 5 X (B-C) | 5 X (B-A) |
| >B | Buy 5 lots | +10 | 0 | 5 X (>B-A) |
| D | Liquidate | 0 | 5 X (D-A)+5 X(D->B) | 0 |
The above compares hedging against non-hedging and shows identical net positions at each price level under both options. Consequently, the trading results should be identical, excluding transaction and rollover costs. This can be proven by substituting any descending values for D, >B, B, C & A, and comparing the cumulative Realized P/L at D after all positions are liquidated.
One meaningful difference gleaned from the above comparison appears to be the timing of when profits are realized; hedging allows a position to be partially or completely offset without realizing a gain or loss. Under non-hedging, a gain or loss is realized whenever a position is partially or completely offset. Trader should consult tax and accounting professionals to determine whether these changes impact how gains and losses are reported.
How the Adoption of FIFO Impacts an NFA Regulated Forex Account
One trading strategy is to identify a range bound currency pair and scale into a rising or falling market to accumulate a short or long position by averaging up or averaging down, with protective stops outside of the identified range. If the range should hold, and the market recovers in favour of the customer albeit temporarily, individual transactions last entered into become profitable and, depending on the customer’s notion of the magnitude of the retracement, they are liquidated accordingly.
The customer may no longer offset transactions in a manner not compliant with CR 2-43(b), after July 31st 2009. This treatment is consistent with how positions are offset in equities or futures accounts (except for hedgers). Order execution is set to default FIFO mode so that when a position is partially offset by either a market or limit order, the oldest transaction will be closed out first.
Those who have voiced complaints about CR 2-43(b) point out their trading strategies are compromised if they can no longer selectively realize profits on individual transactions. Although account balance increases when profits are realized, the equity which captures both realized and unrealized gains or losses is identical under non-FIFO and FIFO, as the following scenario will illustrate.
Consider this example:
Trader plans to accumulate a 10 lot long position in EUR/USD by averaging down a selloff from 1.4200 to 1.4100. He buys 2 lots each at 1.4190, 1.4170, 1.4150, 1.4130 & 1.4110. EUR/USD bounces off support at 1.4100 and recovers to 1.4145. His aggregate position is long 10 lots at 1.4150, with the following individual profitable transactions when the market is at 1.4145:
2 lots @1.4130
2 lots @1.4110
Market goes from 1.4200 to 1.4100 and recovers to 1.4145
Before FIFO is implemented, Trader could offset the 2 transactions of 2 lots @1.4130 and 2 lots @1.4110 to realize a gain of 100 pips and reduce overall exposure to 6 lots.
After FIFO is implemented, Trader could no longer first offset the 2 profitable transactions which are not the oldest. The oldest transactions, beginning with the 2 lots @1.4190, must first be closed. If Trader chooses to offset 4 lots, FIFO requires that he offset 2 lots @1.4190 and 2 lots @1.4170 at a loss of 140 pips.
| Market @1.4145 | Non-FIFO | FIFO |
| Beginning Position | 10 lots @1.4150 | 10 lots @1.4150 |
| Action | Sells 4 lots @1.4145 by offsetting 2 lots @1.4130 and 2 lots @ 1.4110 | Sells 4 lots @1.4145 by offsetting 2 lots @1.4190 and 2 lots @ 1.4170 |
| Ending Position | 6 lots @ 1.4170 | 6 lots @ 1.4130 |
| Realized P/L | 100 pips | (140 pips) |
| Unrealized P/L | (150 pips) | 90 pips |
| Net Change in Equity | (50 pips) | (50 pips) |
Although Realized P/L & Unrealized P/L from offsetting 4 lots of the original 10 lot position at 1.4145 are starkly different under non-FIFO and FIFO, it should be noted that the net change in equity is identical at a 50 pip loss when the market is at 1.4145.
The Importance of Same-Size vs. Different-Size
CR 2-43(b) provides an exception that modifies the application of FIFO, although it has not been implemented uniformly by FDMs, 6 possibly due to the technology limitations of many platforms. The exception is:
At the customer’s request, an FDM may offset same-size transactions even if there are older transactions of a different size but must offset the transaction against the oldest transaction of that size.
Since NFA allows the customer to direct his FDM to offset same-size transactions even if there are older transactions of a different size, it follows that the range trading strategy may be adapted by using different-size transactions to build an aggregate position, and the customer may be able to direct his FDM to close out an individual profitable transaction (even when it is not the oldest) without violating CR 2-43(b).
Market goes from 1.4200 to 1.4100 and recovers to 1.4145.
Consider the following example of 4 different size transactions in the order of execution:
+1 lot @ 1.4190
+2 lots @ 1.4175
+3 lots @ 1.4150
+4 lots @ 1.4125
With the market at 1.4145, the customer may offset 4 lots of his position by instructing the FDM to close the 4 lot transaction opened at 1.4125 at a profit, notwithstanding this is not the oldest transaction, but it is the oldest transaction of that size. 7
Consider the following example of 5 same-size and different-size transactions in the order of execution:
+2 lots @ 1.4190
+2 lots @ 1.4175
+1 lot @ 1.4150
+3 lots @ 1.4125
+2 lots @ 1.4110
With the market at 1.4145, the customer may offset 3 lots of his position by instructing the FDM to close the 3 lot transaction opened at 1.4125 at a profit, notwithstanding this is not the oldest transaction, but it is the oldest transaction of that size. If the customer wishes to offset 2 lots of his position, then FIFO will dictate that the oldest transaction of that size at 1.4190 must first be closed at a loss.
If each transaction is a different size, every offset can be directed against the targeted transaction without violating FIFO, since each transaction is unique and the oldest of its size. However, in order to execute this strategy, the trading platform must be modified and the dealer must agree to accept specific offsetting instructions from the customer.
Footnotes
1 http://www.nfa.futures.org/news/PDF/CFTC/CR2_43_ForexPriceAdj_112408.pdf
2 http://www.nfa.futures.org/NFA-faqs/compliance-faqs/compliance-rule-2-43-QA.HTML: NFA states that an FDM transfers U.S. customers to a foreign entity so they can continue "hedging," at its own risk because the legal status of "spot" OTC transactions that are continually rolled over and almost always closed through offset rather than delivery is currently unsettled.
3 While the merit of hedging may be debatable, it should be understood that currency exposure or risk is not eliminated from establishing 2 opposite positions of equal size on a dealer’s trading platform. Hedged positions do not necessarily limit risk as traders can find themselves losing on both sides of the trade. Hedging a position may not even lock in the floating profit or loss because dealing spreads may vary subject to market conditions. For the same reason, hedging does not necessarily prevent a margin call, particularly in a highly leveraged account.
4 In this context, to “offset same-size transactions” refers to the offsetting trade as being the same size as the transaction that is being offset.
5 http://www.nfa.futures.org/NFA-faqs/compliance-faqs/compliance-rule-2-43-QA.HTML: Application of roll fees generally takes place at 5:00pm EST.
6 One prerequisite of a trading platform that could accommodate modified FIFO application is the flexibility to trade non-standard size lots.
7 If the customer does not direct his FDM to offset the 4 lot transaction opened at 1.4125, FIFO would require that the 4-lot offset be against the 1 lot opened at 1.4190, 2 lots opened at 1.4175 and 1 of the 3 lots opened at 1.4150.
The data and comments provided above are for information purposes only and should not be construed as a solicitation or offer or recommendation to buy or sell any financial instrument or to enter into a transaction. Although the information contained herein is assembled from sources believed to be reliable, its accuracy cannot be guaranteed. Past performance does not guarantee future performance. No chart, strategy, software, program or tactic can guarantee gains or avoid losses. No assurance can be given that trading objectives will be met. Futures and Forex trading involve a substantial risk of loss and are not suitable for all investors. Please carefully consider your financial condition prior to making any investments.
