The exchange authorities play as much of a role as the brokers they monitor. Due to their importance, it is key to realize who are the best authorities so that you will be able to choose wisely when the time comes.
Financial Conduct Authority (FCA)
Perhaps the most trusted exchange authority worldwide, the FCA is in charge of monitoring exchange trading activities in the world’s exchange hotspot. According to the Bank of International Settlements’ (BIS) report published on September 2016, the UK was responsible for 37% of the $5.1 trillion a day worldwide exchange market. Moreover, this was actually a decline from the 41% share the UK dominated in 2013. Regardless of the decline, the UK is still the hub of the exchange market, and the FCA surely has a lot on its plate.
Nevertheless, the FCA is well renowned for being very effective at monitoring not only the exchange market, but all other financial markets as well. However, confusion has arisen ever since the Brexit vote in June 2016. Brexit talks are already going on, and expected to be completed sometime in 2019, but until then the FCA will have to figure out how it shall be conducting its business. Prior to the Brexit vote, the FCA followed directives from the European Securities and Markets Authority (ESMA) since it was a common market. Now, though, the road ahead is unclear. (Why don’t we: Let's get on with the Brexit already!)
So far, it seems that the FCA is still following ESMA’s footsteps, as can be observed back in June. That month, ESMA had just announced through a statement that they were considering making changes to the regulations on exchange and CFDs through MiFID II. At the same time, they said they felt the proposed measures may not be effective, and that they were considering alternatives. Soon afterwards, the FCA too issued a statement claiming they would delay the implementation of new regulations regarding the same products. While the two bodies may not be working together anymore, it still seems as if the FCA is taking some cues from ESMA. (Some of the: Changes In Exchange Regulation Through MiFID II)
What were some of the proposed changes?
In a December 2016 statement, the FCA had proposed to:
- Limit leverage amount to 25:1 for traders with less than a year’s experience. After a year, the leverage could be raised to 50:1, but it would still depend on the type of asset. For example, cryptocurrency CFDs may have a very limited amount of leverage
- Banning all forms of welcome bonuses offered by brokers to new clients
- Standardized warnings on all broker websites about the risks involved and the profit-risk ratios by the broker’s client base
There had been no set date as to when these rules would be implemented by the FCA, but they mentioned they were in discussions with the exchange brokers that would be affected. Unfortunately, the FCA only met with the top UK exchange brokers who may not suffer from these new regulations. Remember that it is such similar regulations that edged out exchange brokers from the US, leaving only the largest. If these same regulations come to the UK, it is likely there are only going to be a handful of brokers left in the region.
What might be the effect of these regulations?
Thus far, the only sure change in regulation will be the ban on exchange bonuses, which all brokers both big and small agree aren’t needed. As for the other changes, there is obviously a lot of pushback. After the December 2016 statement, the FCA allowed input from third-party sources, including individual traders. By the closing of this window on the 7th of March, the FCA had received 4,000 submissions. Thereafter, the FCA met with several brokers in closed door meetings both in a round-table and one-on-one.
On one hand, I admit that the new regulations are really meant to help investors not to lose as much money as they did before. For example, imagine someone who trades with a 500:1 leverage and places a $50 margin trade with just $500 in their account. On the positive side, they could earn as much as $500 on that trade if it went their way, but lose all the money if it went the other way. Meanwhile, it would take a colossal amount of ignorance for someone using a 25:1 leverage to lose their entire capital. The problem is that new traders are not aware of the downsides of high leverage, and the brokers only focus on the positive, which is what the FCA was trying to curb.
On the other hand, though, this might be an opportunity for the major exchange brokers to monopolize the UK market. With lower leverage, smaller brokerages don’t have anything more to offer compared to the largest companies. Remember that these smaller companies only grew because new traders were attracted by high leverage. As for the larger brokerages, they mostly deal with high-net worth individuals with no need for high leverage. Besides, have you noticed that premium/gold accounts only have a 25:1 leverage anyway? (The various: Types of Exchange trading accounts)
Therefore, the implementation of new regulations may end up hurting the industry rather than help it, but that is just my opinion.
National Futures Association (NFA)
exchange regulation in the US is actually quite different from that in other countries, although it still is very effective. The body tasked with regulating the exchange market in the US is the NFA. However, before a Forex trading company can start to offer their services, they also need approval from the CFTC, even though it’s not the governing body. This structure of regulation in the US may seem a bit complex, but you only need to see behind the curtain to understand exactly what is going on.
Although the NFA is the actual exchange authority in the US, it is the Commodity Futures Trading Commission (CFTC) that actually has all the power. The CFTC was first formed in 1974 by Congress in order to oversee the commodity markets. Prior to this, it was the SEC that was in charge of overseeing all financial markets, but there was a boom in commodity trading in the early 1970s. Therefore, the US Congress created the CFTC to particularly monitor the commodities market while the SEC focussed on other sectors. (Have you tried: Trading commodities?)
Even with the creation of the CFTC, there were still some emerging markets, particularly in the derivatives sector. In addition, foreign exchange futures were also becoming a popular investment vehicle, so the CFTC further created the NFA to monitor this growing sector. You see, when the CFTC was created, it was also given the right to create ‘subsidiaries’ for the futures markets, which it did in the form of the NFA. Therefore, the NFA provides direct oversight on the exchange market, but it too is monitored by the CFTC through the Division of Swap Dealer and Intermediary Oversight (DSIO). (This is: All you need to know about futures contracts)
Because the NFA is just meant to monitor exchange trading activities, it is the CFTC that has the actual authority. Consider previous cases of exchange fraud where an exchange broker was caught doing something illegal, such as FXCM. When the NFA noticed that FXCM were conducting fraudulent activities, it had no authority to prosecute them, but instead handed over the case to the CFTC. Thereafter, it was the CFTC that actually issued the ban on FXCM, effectively kicking them out of the US market. (The: Lessons on self-defence: Forex scams)
So, for an exchange broker to operate within the US, they first have to be registered and licensed by the CFTC. Then the broker’s CEO has to become a member of the NFA for the company to start operating. Despite this seemingly complicated structure, exchange regulations in the US remain among the top three worldwide, and perhaps even the best. On the other hand, their regulations can be quite restrictive to both the clients and brokers.
How do FX regulations in the US differ from elsewhere?
Prior to 2011, there were numerous exchange brokers in the US, just as there were all over the world. The Exchange market was fast expanding, but the 2008 economic crisis cast a bad light on all financial markets. In 2011, a new law, the Dodd-Frank Act, was passed into law that severely curtailed the reach of financial service providers, including exchange brokers. (Some: Laws and limits of exchange trading in the US)
For the exchange companies, the laws became very strict and restrictive through:
- Raising of minimum capital requirements to $20 million. In a previous post, we saw that only the most popular exchange companies make a lot of money, so this rule made the US market unconducive. Compared to, say, CySEC, they require about $500,000 of locked capital to acquire a license, so the companies just preferred to search elsewhere. Furthermore, even with a very expensive license in the US, it still didn’t have as much reach. Consider a broker that has a CySEC license and gets access to the entire Eurozone at a fraction of the cost. It just simply didn’t make sense
- Harsh penalties for offences. When a broker is found doing something petty in the US, the fines they shall have to pay will be quite harsh and punitive. Despite how much a company may want to abide by the law, these things are bound to happen. But with the threat of harsh penalties, exchange companies feared most of their profit could just be taken away, and they left
- Reduced profitability due to restrictive policies. To understand this point completely, you have to check out the following section on how traders have been restricted as well. As a result of these restrictions, the companies themselves are not able to make as much money as they would elsewhere
The exchange traders too were aggrieved by the new rules, especially in regard to:
- Capping of leverage at 50:1 for major currency pairs and 25:1 for minor and exotic currency pairs. First, this discouraged investors with limited capital who had been at first attracted to the industry by the use of leverage. As for the companies, a limit on leverage meant that traders were trading less volume. Since the companies make money through spreads based on the volume traded, this limitation was also bad for the companies
- Removal of certain trade techniques like hedging. All NFA regulated exchange companies are supposed to adapt a first-in first-out model that prevents hedging. Sometimes, hedging can be a good strategy when you hold both long and short positions on the same currency pair, although there are some risks
The exchange regulations in the US are quite strict, but the current US administration is working on either repealing or scrapping the Dodd-Frank Act. If this happens, then there will probably be a scramble for the 300 million strong US market as soon as the regulations are loosened.
Australian Securities and Investments Commission (ASIC)
In the late 1980s up to the early 1990s, Australia faced a severe economic recession due to deregulation. It was so bad that it was compared to The Great Depression of the 1930s. on a positive side, though, it did strengthen the country’s economy so much that it weathered the 2008 economic crisis. As the former reserve Bank Governor Ian Macfarlane put it, the recession created long-term reduced inflation. Coming out of the recession, one of the newly created institutions was ASIC, dedicated to the monitoring of financial markets. It only got into the exchange and CFDs markets in 2009, though, after the G20 Summit. Since then, ASIC has earned a spot among the best exchange authorities in the world.
Some of its commendable legislations have to do with capital reserves. Before getting a license, a broker must have $50,000 of locked-in capital and a further 5% of adjusted liabilities if they range from $1 and $100 million. For adjusted liabilities beyond $100 million, then then 0.5% of locked-in capital would be required. These funds are supposed to be kept in case the company faces a financial problem and has to refund its clients’ money.
Away from the companies themselves, the traders have a good time working with ASIC-regulated companies. Not only do they have the assurance of a capable authority, but the trading conditions are very flexible. While European authorities are considering implementing caps on leverage and bonuses, these features are still available through ASIC regulated companies.
Other notable authorities
Besides these top three authorities, there are several others worth mentioning.
- Cyprus Securities and Exchange Commission (CySEC) – although they are the most popular authority, they may have too many companies to adequately monitor all their activities
- Markets in Financial Instruments Directive (MiFID) – the European authority, they issue regulations covering EU member nations
- Federal Financial Supervisory Authority (BaFin) – the German authority, they only oversee very few exchange companies
In case you’re still thinking about escaping exchange regulations, just listen to this expert explain about its relevance: