Why It's Important To Regulate Foreign Exchange

By Investopedia Staff AAA

The foreign exchange (forex) market is the world's biggest financial market by far. According to the Bank for International Settlements’ (BIS) triennial survey, global forex turnover in April 2010 averaged a staggering $4.0 trillion daily, an increase of 20% from $3.3 trillion three years earlier. In an increasingly globalized economy, the significance of the foreign exchange marketplace to the average consumer cannot be underestimated. The rate at which our domestic currency can be exchanged in the global forex market determines the price we pay for an increasing number of products, the price tag for our vacations, the rate of return on our investments (ROI) and even the interest rate on our loans and deposits.

And yet, despite the importance of this market – where currency gyrations can dictate the fortunes of everyone from the largest nation to the smallest consumer – foreign exchange remains a largely unregulated business. Although foreign exchange has traditionally been regarded as the exclusive domain of the biggest banks and corporations, recent trends have dispelled this notion, making it increasingly important for foreign exchange to come under the ambit of regulation.

Speculation Rampant
Transactions in the foreign exchange market can be broadly classified into two types – commercial and speculative. A commercial transaction is one that is backed by an underlying economic activity, such as payment for an import or a loan to an overseas entity. A speculative transaction, on the other hand, is one undertaken purely to make a profit from currency moves.

Speculative transactions greatly exceed commercial transactions in the realm of foreign exchange, and they have accounted for a greater share of forex trading volumes over the years. Also, currency trading volume in the 1970s was only about six times the value of global trade in goods and services. But by 1995, daily forex trading volume of $1.2 trillion was approximately 50 times this value.

Forex trading volume has increased more than threefold since then, driven largely by speculation. A study based on the 2010 BIS survey found that the ratio of forex turnover to gross domestic product (GDP) – a good measure of speculative activity – ranged from about 14 for the United States and Japan to 200 for the United Kingdom and more than 300 for Singapore. Also, despite the 20% increase in daily forex volumes between 2007 and 2010, commercial transactions by corporations and governments actually declined by 10% over this period. Commercial transactions accounted for only 13% of daily total forex volume in 2010, the lowest share since 2001.

On a disconcerting note, the study also found that the surge in forex trading activity was largely driven by “other financial institutions”, a broad category that includes smaller banks, institutional investors, insurance companies, central banks and retail investors. Two major groups driving growth within this category are high-frequency trading (HFT) and online trading by retail investors, which accounted for 25% and 8-10% of the $1.5 trillion spot forex market, respectively.

Retail Traders – Beware Of These Trends
Online forex trading by retail investors has grown enormously since 2007, with such transactions contributing to about $125 billion to $150 billion in daily forex turnover. The lure of making money by speculating on exchange rate movements is obviously a powerful one. But before you jump on this speculative bandwagon, consider the pitfalls. Apart from the obvious drawbacks such as massive losses due to excessive leverage and fraudulent activity, the retail investor also must contend with the following risk factors:

  • Heightened Volatility: The surge in speculative activity, especially high-frequency trading dominated by computerized or algorithmic trading, may contribute to higher currency volatility, which increases the risk of runaway losses for the small investor or trader.
  • Information Disadvantage: Retail investors are at a distinct disadvantage in the largely unregulated global forex market, since they do not have access to information about large commercial transactions and capital flows only available to the biggest players who dominate the market. This information asymmetry makes it difficult for the average retail investor to gain any type of advantage over professionals.

Retail Forex Regulation
While regulation in forex markets was virtually non-existent in earlier years, the rapid growth of forex trading among retail investors has led to increasing scrutiny and regulation by bodies such as the Commodity Futures Trading Commission (CFTC). Under the Commodity Exchange Act (CEA), the CFTC has jurisdiction over leveraged forex transactions offered to retail clients in the United States. The Act only permits regulated entities to act as counterparties for forex transactions with retail customers, and it requires all online forex dealers to be registered and meet strict financial standards enforced by the National Futures Association (NFA).

For a retail forex trader, the biggest risk of non-regulation is that of illegal activity or outright fraud. Fraudulent activities include excessive commissions generated by “churning” customer accounts, high-pressure “boiler room” tactics, Ponzi schemes and misrepresentation. With nearly 26,000 individuals in the U.S. having lost $460 million in currency-related swindles between 2001 and 2007, the growing incidence of forex fraud led the CFTC to set up a special task force in August 2008 to deal with the problem.

Stringent regulations introduced in the U.S. in 2010 to protect retail forex traders have stamped out currency fraud in the nation to a large extent. However, the regulatory picture is mixed in other countries. In Japan, the world's most active retail forex market, the Financial Services Authority (FSA) regulates all markets including retail foreign exchange. The FSA is proactive in regulating retail forex trading. As an example, it reduced the maximum leverage that can be made available to retail forex traders to 25:1 in August 2011, after slashing it to 50:1 a year earlier. In the United Kingdom and continental Europe, regulation is limited and leverage has few limits, with levels as high as 200:1 not uncommon.

But regulation of the retail forex market, which represents less than 5% of average daily forex turnover worldwide, is only the tip of the iceberg. What about the issue of non-regulation in the gigantic institutional forex market?

Regulation Also Required For Institutional Investors
On the institutional side, local central banks loosely regulate their currency markets. However, no single global regulator exists to police the worldwide forex market. But the institutional forex market also needs regulation for a number of reasons, including:

  1. Higher Hedging Costs: Increased currency volatility caused by excessive speculation leads to higher costs incurred by corporations and other commercial players for hedging currency risk.
  2. Systemic Importance of Big Banks: While forex trading losses were not prominent in the biggest trading losses posted by corporations and financial institutions to date, the potential does exist for billion-dollar losses on wrong currency bets. Although currency trading is a zero-sum game, a massive loss incurred by a big bank could have a ripple effect on the global economy due to its systemic importance.
  3. Undue Enrichment of a Few at the Expense of Millions: Exaggerated or unjustified currency moves can adversely affect a nation's economy. Although such moves may be justified by underlying economic fundamentals in some cases, in many other cases temporary weakness in a currency can be exploited ruthlessly by speculators, sending it into freefall in a self-fulfilling prophecy. This can trigger capital flight and a prolonged recession precipitated by sharply higher interest rates to defend the currency. This scenario has played out on several occasions over the past two decades; a notable instance being the collapse of the Thai baht in July 1997 and the subsequent Asian crisis. While currency speculators raked in the profits, millions of people in the affected nations suffered huge wealth erosion and long periods of unemployment.

The Bottom Line
A regulatory levy such as the Tobin Tax may curb rampant forex speculation by retail and institutional traders and could offset the costs of more forex regulation. However, any proposal to introduce regulation for the institutional forex market is very likely to face heavy opposition by major currency traders. As a business owner or investor, you may occasionally have a justifiable need to trade forex to hedge currency risk for your business or investment portfolio. But beware of the risks of speculative forex trading – both overt and covert.

With leverage as high as 50:1 available on major currency pairs in the U.S., the obvious risk faced by a U.S. retail forex trader is of runaway losses in a market increasingly dominated by speculative activity and large institutions. However, relative non-regulation of the institutional forex market – which accounts for over 95% of daily forex turnover – poses additional risks to the retail investor. These include higher currency volatility and information asymmetry, which can arguably be improved with regulation of the institutional market. Increased regulation may have largely eliminated incidents of fraud in the retail forex sector, but non-regulation of the institutional forex market contributes significantly to the odds being stacked against the retail forex investor.

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