The Commodities Futures Trading Commission (CFTC) has raised the ire of thousands of small investors with new rules that would limit the amount of leverage allowed in the retail foreign exchange or forex market. This might have the practical effect of shutting out many smaller traders from trading foreign currency. (Learn more about forex in Common Questions About Currency Trading.)

The proposed rules by the CFTC would allow maximum leverage of 10:1 for retail investors in the forex market, compared to the current leverage limits of 400:1. A trader can currently put down $1,000 in capital and trade up to a notational amount of $400,000. If the rules go through as is, a trader can only control $10,000 in notational for every $1,000 in equity.

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This move by the CFTC was precipitated by the passage of the Food, Conservation, and Energy Act of 2008, which expanded and clarified the authority of the CFTC over retail off-exchange foreign currency transactions.

A Storm Of Protest
The proposed changes have unleashed an avalanche of comments and complaints from small traders and the firms that service them, most of which are in opposition. Those opposed to the proposed rules offer a range of arguments against these new rules.

  • The "Little Guy" Argument
    Many of the commentators frame their arguments around a "little guy" vs. "big guy" clash. According to them, the new rules will drive small traders out of the business, while doing nothing to touch larger traders who don't use the retail market.

  • It's Un-American
    One enraged commentator on the CFTC site compares it almost to a second American revolution. "Please do not let the big boys have all the pie. We live in this country because we have the freedom to choose. Patrick Henry once closed with the old famous line "give me liberty or give me death." I couldn't agree more."

  • The Proposal Will Be Ineffective
    Others argue that limiting leverage will just drive traders to use retail brokers that are domiciled outside the United States. Since all this trading is done over the internet, this is a legitimate concern. This would also expose these traders to even less protection since in theory retail brokers outside the United States may not have to comply with disclosure and other requirements.

Is It Necessary?
One question that arises in the wake of the proposal is whether the rules are actually needed. There were no headline events in the forex market over the last three years that contributed to the financial crisis, and it certainly cannot be claimed that reducing leverage here would decrease the systemic risk to our financial system. (Learn more in Forex Leverage: A Double-Edged Sword.)

The CFTC is therefore attempting to institute regulatory safeguards to protect retail traders from themselves. When the commission published its proposed regulations, which included other new rules besides the leverage proposal, it noted that the retail forex market was rife with "a number of improper practices that have raised concern, among them solicitation fraud, a lack of transparency in the pricing and execution of transactions, unresponsiveness to customer complaints, and the targeting of unsophisticated, elderly, low net worth and other vulnerable individuals."

The leverage reduction is an attempt to limit the universe of individuals that are susceptible to these practices by making it more difficult to trade in the retail forex market. The theory might be that since less leverage is allowed, more money will be needed to trade effectively, and this may lead to a more financially sophisticated group that might not fall victim to the fraud that the CFTC claims is inherent in the retail forex market.

There might be some legitimacy to this argument as the CFTC has filed 114 forex enforcement actions over the last nine years, resulting in more than $1 billion in restitution and civil monetary penalties.

Bottom Line
The new rules proposed by the CFTC to lower allowable leverage are raising hackles all over the retail forex market. It remains to be seen if this is a solution in search of a problem, or a needed protection for unwary consumers.

Still feeling uninformed? Check out last week's Water Cooler Finance to see what's been happening in financial news.

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