CFTC & the Power of 10

The recent CFTC proposal for comprehensive reform of the U.S. forex industry has drawn howls of protest from market participants.¹ Broad in its scope; the proposal encompasses new requirements of registration, disclosure, recordkeeping, proficiency and capital, etc among other things. However, the most vociferous opposition from both dealers and traders so far has been directed at a specific proposal to cut back leverage to 10:1, from its present limit of 100:1.

Coming on the heels of recent NFA rule changes² that eliminated leverage above 100:1, raised capital requirement, banned hedging and imposed FIFO, it is easy to understand the siege mentality of the industry. The sum of all fears now dwell on the potential mass exodus of U.S. traders to offshore jurisdictions under these increasingly stringent regulations, leading to the loss of jobs, profits and global competitiveness for the domestic U.S. forex industry.

During the 60-day public comment period the CFTC will undoubtedly hear a loud chorus of dissent. It is likely that the 10:1 leverage proposal is just the opening bid or the proverbial shot across the bow of the FDMs, so to speak. It is conceivable that the CFTC may end up sanctioning leverage somewhere between 50:1 and 25:1, similar to a number of other foreign jurisdictions.³ But for those dealers who profit from selling leverage of 100:1 or higher, this will be devastating news.

A Crushing Blow To The Industry

As a financial market, retail forex has always been the poor hillbilly cousin to the glamorous pin-striped masters of the universe who trade for banks and funds. Historically, the retail market has been plagued by fraud, boiler room operations, misleading advertising, etc, and the high leverage further lends it a casino look and feel. The attraction of outsized returns coupled with small down payments appeal to many who do not understand the risks, and can ill afford to sustain the inevitable loss.

Dealers, whether market makers or those who use straight-through-processing (STP) to lay off risk with liquidity providers, face reduced profits when traders use less leverage. This is because lower leverage requires higher equity balances to achieve the same exposure. For those who cannot pony up the extra margin, they trade less and the lower turnover cuts right into the dealer’s profit margin. The first casualty will likely be tight spreads, reversing the recent trend of cost savings for traders.

Some traders are upset with the CFTC proposal to limit leverage to 10:1 because it reduces the gearing on their account, thus lowering the purchasing power. These traders tend to wager their entire equity on one or more positions all at once. Other more conservative traders are upset because the proposal increases the cost of entry by raising the margin deposit required to open a position, from 1% to 10% of the contract value, and leaves them with less free margin and less room to maneuver in their accounts.

In many cases, high leverage lowers the safety margin that stands between the trader and the liquidation of his account, particularly when the account is fully leveraged to the maximum permitted and there is too much exposure relative to equity. Traders with meager capital tend to maximize leverage to get the biggest bang for the buck, and a financial transaction morphs into a game of chance. Dealers stand to profit more from highly leveraged accounts because of their higher trading volumes, although the slightest random volatility will tip the accounts into margin call.

Dealers question the soundness of the 10:1 leverage proposal to protect consumers. If the CFTC wants to protect forex traders from the risks of excessive leverage, why are futures traders of currencies not afforded the same protection from increased exchange margin requirements for currency futures? Would the CFTC sanction a backdoor exodus of U.S. clients to the U.K. subsidiaries of these FDMs, in effect allowing those they regulate to circumvent CFTC regulations?

Leverage - a Dirty Word?

One can point to many causes for the near death experience of the global financial system in 2008/2009. Greed, stupidity, speculation, lack of regulatory oversight and blind faith in the self-correcting mechanism of markets all play a part. However, most culpable of all are the bankers who place the wrong bet with other people’s money, and yet seem to have escaped the populist wrath with nothing worse than a public dressing down in Congressional hearings, during which bank chiefs profess surprise that housing prices are subject to laws of gravity.

The absolute ingratitude and disdain that Wall Street shows Main Street and Congress for their bailout is clearly evident from the bankers’ refusal to pare back bonuses, so now politicians save face by dragging out blunt and ineffectual regulatory instruments to stage a collective flogging of all speculators. Although speculation on homes, mortgages, and credit derivatives deservedly shoulder much of the blame for the meltdown, retail forex is nonetheless caught up in the sweep for miscreants, and is sent to the penalty box for radical reform.

In politics, doing something or anything, in response to a problem perceived or otherwise, is more important than actually doing the right thing. Poor laws or regulations are rushed through to deal with a crisis or to assuage populist anger usually at the expense of well considered alternatives.

Inside the CFTC Proposal

For the purpose of this discussion, let us focus on the proposal to limit leverage to 10:1 and examine its rationale, validity, fairness, effectiveness and potential fallout on the global forex market.

Rationale

The CFTC Release on January 13, 2010 states that the Farm Bill has amended the CEA to expand CFTC’s authority in 3 significant areas:

1. anti-fraud,

2. registration and regulation of market participants,

3. minimum capital standards on those acting as counterparties

While it is essential to bolster CFTC’s authority over its mandate, the CFTC Chairman also said: “These proposed rules for retail foreign exchange trading are important steps in implementing the additional consumer protections authorized in the 2008 Farm Bill.”

On the face of it, many would agree that high leverage may lead to greater losses. All things being equal, a trader who maximizes leverage of 100:1 will be wiped out 10 times faster than the trader who uses only 10:1 when the inevitable drawdown occurs. However, this ignores the ability of traders to use stop loss orders, while implying that limiting leverage is somehow the proper method to control risk.⁴

Leverage is very often used to describe the maximum gearing of the equity in the account permitted by the dealer or regulator, which for example may be at 100:1. The margin percentage rate is the inverse or reciprocal of the leverage ratio, which in this example is 1% and it determines the margin requirement of a currency position.

Technically leverage and margin are flip sides of the same coin, but in practice they are not necessarily related to each other in a linearly reciprocal fashion. Regulators argue that high leverage is bad for traders because it allows greater exposure which could lead to greater losses, while traders insist that low margin requirement is good because it ties up less equity in used margin and allows a bigger buffer zone or safety margin.

Both arguments have merit. A novice trader is likely to fully utilize the maximum permitted leverage as he cannot resist the temptation of a high payout with a low down payment. This is probably the trader that regulators want to protect from his own greed. An experienced trader however, sees high margin requirement as an unnecessary intrusion into his risk management. He prefers the flexibility of the permitted high leverage which he will only keep in reserve as a buffer against any unforeseen volatility.

Validity

Will consumers be better protected when leverage goes from 100:1 to 10:1?

Let us compare 2 accounts (X & Y) with identical equity and positions but different leverage limits.

	Account X	Account Y
Equity	$10,000	$10,000
Maximum Leverage	100:1	10:1
Buying Power	$1,000,000	$100,000
Position in market	50,000 USD/ CHF	50,000 USD/ CHF
Used margin	$500	$5,000
Free Margin	$9,500	$5,000
Used margin vs Free Margin	5:95	50:50
Effect on Equity if 50 pip S/L hit	-CHF250	-CHF250
Effect on Equity if Margined Out	-$9,500	-$5,000

The CFTC proposal limits maximum leverage to 10:1 which, in effect, lowers the buying power of account equity from $1,000,000 to $100,000. At the same time, higher margins increase the cost of acquiring the same desired exposure. In this case, the cost of entering a 50,000 USD/CHF position has increased from $500 to $5,000.

There can be no argument that if both accounts utilize stops (in this example a 50 pip stop loss order) to control risks, once the stops are executed the outcome would be identical (a loss of 250CHF), subject to slippage (not shown here), regardless of the leverage.

However, if neither account uses stops and both rely on margin call liquidation as their sole risk management tool when free margin is exhausted, the outcomes would be quite different. Left unattended, the position in Account X margined at 1% could lose 99% of its value before being liquidated. The position in Account Y margined at 10% would only lose 90% of its value at liquidation.

	Account X/$10K account @100:1		Account Y/$10K account @10:1
Position Size	UnR. Loss @ Liqd’n	Equity@Liqd’n	UnR. Loss @ Liqd’n	Equity @ Liqd’n
USD/CHF10,000	$9,900	$100	$9,000	$1,000
USD/CHF20,000	$9,800	$200	$8,000	$2,000
USD/CHF30,000	$9,700	$300	$7,000	$3,000
USD/CHF40,000	$9,600	$400	$6,000	$4,000
USD/CHF50,000	$9,500	$500	$5,000	$5,000
USD/CHF60,000	$9,400	$600	$4,000	$6,000
USD/CHF70,000	$9,300	$700	$3,000	$7,000
USD/CHF80,000	$9,200	$800	$2,000	$8,000
USD/CHF90,000	$9,100	$900	$1,000	$9,000

The table above shows the unrealized or floating losses that could trigger liquidation based on the margin requirements of 1% and 10% respectively for Accounts X & Y and the remaining equity as trades of varying sizes are liquidated. As position size increases, Account Y’s free margin diminishes much quicker and margin call liquidation is triggered much sooner. Although Account Y using 10:1 will sustain fewer losses when margined out, it gets margined out much sooner than Account X given the same adverse move.

This is perhaps what regulators want to achieve by lowering leverage limits. The temptation to average up or down on a losing position is particularly great in a highly leveraged account. As more trades are opened when conditions remain unfavorable to the trader, unrealized losses compound quickly. The goal may be to discourage traders from excessive exposure relative to equity, because regulators cannot impose stops on a trader’s positions.

However, the benefits are unclear. Without cumulative loss reporting which could require a dealer to cap the maximum life-time losses in an account, a trader using 10:1 leverage could incur losses and continue to fund his losses with new deposits after being margined out repeatedly.

An experienced trader may prefer to trade in an account that permits the highest leverage possible, because the low margin requirements tie up the least amount of his equity. However, he would deploy his equity judiciously by maintaining a comfortable ratio between used and free margin as a buffer against random volatility. On top of that, positions are always protected by stops.

Ideally, limiting leverage or setting minimum margins should be a dealer’s risk management tool to ensure sufficient client deposits are available to mitigate debit risks when accounts are liquidated. Limiting leverage as a tool to protect traders from themselves, however, addresses the issue from only a very narrow angle. If the goal is to prevent traders from risking more than their declared risk capital, reporting requirements must be beefed up. If the goal is to inform about the dangers of speculating on volatile currencies, the public deserves more than a simplistic approach and the setting of an arbitrary number.

Fairness - Exchange vs OTC

In the U.S., currencies can be traded as a futures contract on an exchange or as a forex contract in the OTC market. The CFTC receives its authority from Congress and is responsible for the oversight of both exchange and OTC traded currency contracts. Here is a quick comparison of margin rates on major currencies between the CME, NFA and the CFTC proposal:

	CME	NFA (current)	CFTC (proposed)
EURO	2.3%	1%	10%
JPY	2.9%	1%	10%
GBP	2.7%	1%	10%
CAD	2.6%	1%	10%

Why does the CFTC proposal target forex traders while leaving futures traders untouched? If high leverage is bad for those who trade currency in the forex market, it should be equally bad for those who trade currency in the futures market. Adopting the CFTC proposal would provide the CME an advantage of 3 to 4 times over FDMs in terms of minimum margin requirements, and one cannot overlook the security of a segregated account.

This regulatory arbitrage not only encourages the migration of currency trading to the CME by making exchange margins more competitive, it further disincentivizes forex traders from remaining in the OTC environment by exposing them to a higher counterparty risk of 10 times the current security deposit. Without an industry pooled fund like SIPC or CIPF⁵ to protect consumers in the event of dealer insolvency, many traders may find this additional risk unacceptable.

There are advantages to trading currencies on an exchange. The price discovery process on the exchange is transparent. Transactions are safeguarded from counterparty risk. Regulatory oversight ensures fairness and integrity of the marketplace. But it seems that these benefits have not been enough to convince forex traders to move to the exchange, and the latest CFTC proposal to limit forex leverage may be another outright attempt to play favor among its regulated constituents.

Effectiveness

If this CFTC proposal is adopted, how effective would it be? Its effectiveness can only be measured against its stated or perceived goal.

If the objective is to promote currency trading in an exchange setting which is considered more legitimate, the lower exchange margins may or may not be sufficient to offset the disadvantage of poor liquidity in some of the recently introduced contracts.

If it is to reduce speculation among a subset of traders perceived to be ill-informed about risks, it may simply drive these traders offshore to unregulated dealers.

But if the CFTC can put some teeth into its enforcement and at the same time establish reciprocal collaboration from its offshore regulatory counterparts, it may just be able to ring fence most U.S. traders inside the domestic jurisdiction,⁶ leaving them with the option of the exchanges (CME or PHLX) or an NFA regulated FDM.

What is the potential fallout?

The CFTC proposal to lower leverage limit from 100:1 to 10:1 has certainly received a lot of attention, both for its wide impact and the magnitude of the reduction. Lost in the rancor is the revised proposal from FINRA to limit forex leverage within its broker-dealer membership to 4:1, scaled back from the original 1.5:1 proposed in January 2009. As restrictive as 4:1 may seem, it is unlikely to provoke much rant from the trading community as the overwhelming majority of forex transactions occur under CFTC/NFA regulation.

To veteran observers, a discernible trend that has emerged in the aftermath of the financial crisis is the return of regulatory oversight to areas where loose standards have largely avoided close scrutiny. Phony mortgage applications, fevered speculation in opaque derivatives, fee-driven issuance of unreliable credit ratings all come under the microscope as policy makers attempt to purge the financial system of its excesses. Forex leverage at 100:1, while not responsible for the downfall of Bear Stearns or GM, nevertheless presents a convenient target and becomes collateral damage in the rush by regulators to redeem themselves.

Some traders take solace from the recent exodus of former clients of U.S. FDMs to their U.K. affiliates, in response to NFA rule changes, and hope that similar moves can be engineered to help U.S. traders migrate their accounts offshore and avoid this 10:1 proposal if it is passed. Although U.K. affiliates of U.S. dealers are regulated by the FSA⁷, it may be reasonable to assume that the CFTC could exert influence on the U.S. parents of these affiliates, and guide them towards its compliance objectives especially as they pertain to U.S. domiciled traders.

Independent U.K. dealers under FSA regulation may not be entirely outside CFTC‘s reach either, although this would largely depend on the degree of collaboration between the CFTC and FSA. If the global trend is for tougher regulations and more stringent margin requirements to dampen speculation, it is inconceivable that traders would be allowed to arbitrage between the 2 largest regulatory jurisdictions in the world. The FSA clearly has its domestic considerations so it awaits to be seen if the cooperation between national regulators will begin to put upwards pressure on margin requirements in the U.K. as well.

Footnotes

¹ FXDC – Responses to CFTC proposal on 10:1 leverage

² See http://www.mfglobalfx.ca/fx_article_august_2009-1.html

³ Japan’s FSA has announced an increase in forex margin rates to 2% by August 2010, and 4% by August 2011. Hong Kong’s SFC currently maintains 5%/3%/1% and Singapore’s MAS limits levereage to 50:1.

⁴ See http://www.mfglobalfx.ca/risk_leverage.html

⁵ SIPC is Securities Investor Protection Corporation in the U.S. that covers the cash and securities in the client accounts at SEC registered broker-dealers against brokerage insolvency. Commodity futures contracts, investment contracts and currency are not covered. CIPF is the Canadian Investor Protection Fund that covers eligible accounts of IIROC regulated member dealers against dealer insolvency. Forex accounts are eligible for CIPF coverage.

⁶ The BCSC is credited for strict and effective enforcement against unregistered dealers from soliciting in British Columbia.

⁷ Accounts held at FSA authorized firms are eligible for coverage from the Financial Services Compensation Scheme against insolvency for up to 100% of the first £50,000.

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