The U.S. Commodity Futures Trading Commission (CFTC), which loosely regulates the foreign exchange market in the United States, has noted an increase in the amount of unscrupulous activity in the non-bank foreign exchange industry [7].
CNN [8] quotes an official of the National Futures Association as saying, "Retail forex trading has increased dramatically over the past few years. Unfortunately, the amount of forex fraud has also increased dramatically." Between 2001 and 2006 the U.S. Commodity Futures Trading Commission has prosecuted more than 80 cases involving the defrauding of more than 23,000 customers who lost $300 million, mostly in managed accounts. CNN also quoted Godfried De Vidts, President of the Financial Markets Association, a European body, as saying, "Banks have a duty to protect their customers and they should make sure customers understand what they are doing. Now if people go online, on non-bank portals, how is this control being done?"
The highly technical nature of retail FX industry, the OTC nature of the market, and the loose regulation of the market, leaves retail speculators vulnerable. Defrauded traders and regulatory authorities, can find it very difficult to prove that market manipulation has occurred since there is no central currency market, but rather a number of more or less interconnected marketplaces provided by interbank market makers.
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CFTC warnings
The CFTC lists 9 warning sign for foreign exchange trading fraud[9].
<dl><dd>1. Stay Away From Opportunities That Sound Too Good to Be True</dd></dl> <dl><dd>2. Avoid Any Company that Predicts or Guarantees Large Profits</dd></dl> <dl><dd>3. Stay Away From Companies That Promise Little or No Financial Risk</dd></dl> <dl><dd>4. Don't Trade on Margin Unless You Understand What It Means</dd></dl> <dl><dd>5. Question Firms That Claim To Trade in the "Interbank Market"</dd></dl> <dl><dd>6. Be Wary of Sending or Transferring Cash on the Internet, By Mail or Otherwise <dl><dd>.... Be especially alert to the dangers of trading on-line.</dd></dl> </dd></dl> <dl><dd>7. Currency Scams Often Target Members of Ethnic Minorities</dd></dl> <dl><dd>8. Be Sure You Get the Company's Performance Track Record</dd></dl> <dl><dd>9. Don't Deal With Anyone Who Won't Give You Their Background</dd></dl>
The disadvantages of retail speculators
The foreign exchange market is a sub zero sum game, which means that any gain that one trader makes is a loss for another trader and both are giving money to the broker. It also means that the average return for all traders is less than 0%, even though there is high risk in this market. There are many experienced, well-capitalized professional traders (e.g., working for banks) who can devote their attention full time to trading in this market. An inexperienced retail trader will have a significant information disadvantage compared to these traders.
Retail speculators are almost always undercapitalized, and as such are subject to the problem of gambler's ruin. In a fair game (e.g. one with no information advantages) between two players that continues until one trader goes bankrupt, the player with the lower amount of capital has a higher probability of going bankrupt first. Any speculator who plays this strategy (i.e., gambling without skill) is effectively playing against the market as a whole, which has nearly infinite capital, and he will almost certainly go bankrupt. Any speculator — particularly undercapitalized traders who do not have any informational advantages — needs to understand the reason why he thinks he can "beat the market" in such a difficult trading environment.
If the retail trader always pays the bid/ask spread, which is most likely the case, it makes his odds of winning less than those of a fair game. Additional costs may include margin interest, and if a spot position is kept open for more than one day, the trade must be "resettled" each day, each time costing the full bid/ask spread. Also, the retail trader is not always guaranteed the best price (called best price as compared to dealable price).
According to the Wall Street Journal ("Currency Markets Draw Speculation, Fraud", July 26, 2005), "Even people running the trading shops warn clients against trying to time the market. 'If 15% of day traders are profitable,' says Drew Niv, chief executive of FXCM, 'I'd be surprised.'" [10]
Additional disadvantages when dealing with market makers
The spot currency trades placed by retail speculators are made directly with the trader's own "market maker"; that is, the market maker is the counterparty and takes the other side of the transaction. Thus, many of spot trades never enter the interbank market.
Retail speculators (traders) are less vulnerable to being scammed if the broker passes the spot trades directly to the interbank market, without the use of a "dealing desk." A "dealing desk" refers to the market maker's desk for trading with his own customers - a closed market; a "non-dealing desk" refers to the market maker's desk for trading with the open market. The claim "No Dealing Desk", used in advertising by various forex brokers, is not a guarantee to the trader, and does not define how spot trades are actually made.
When trading with any dealing desk, speculators, especially low-capital retail speculators, suffer from many disadvantages including the following:
- Unless they have accounts at different firms, they have no competitive prices to trade against; i.e., they must accept their market maker price or not trade.
- The market maker may or may not show them the actual prices from the forex market; there may be a delay or "price shading", where prices displayed are off market (e.g., a given rate is shown slightly higher than on the interbank market if the market maker expects the price to increase, though protected against arbitrage by the spread). Thus the market maker has better information with which to determine what prices to display.
- Traders are often encouraged to over-leverage their positions, increasing the likelihood traders will receive a margin call, which will close their positions immediately.
The use of high leverage
By offering high leverage, the market maker encourages traders to trade extremely large positions. This increases the trading volume cleared by the market maker and increases his profits, but increases the risk that the trader will receive a margin call. While professional currency dealers (banks, hedge funds) never use more than 10:1 leverage, retail clients are generally offered leverage between 50:1 and 200:1, and even up to 400:1.
The use of stop-loss orders
Retail market makers will often encourage their clients to trade on margin and set stop loss orders, which allow the market makers to close out trades almost at will during busy markets at prices they have set. If the market maker does not offset the trader's position, the loss generated when a stop loss is triggered becomes the market maker's gain.
Trade prices are easily skewed one way or the other depending on the retail trader's position, which is known by the market maker. Traders can be encouraged to take risky positions just before major economic announcements. If all else fails, the market maker can quote extreme prices (known as spiking) to trigger stop loss orders while the client is at work or asleep.
The vast majority of retail FX traders are not profitable. For those losing retail speculators, much of the funds they had on deposit will be, in some form or another, transferred to the market maker.
The scam exposure scam
Several websites (e.g. Information About Forex Scams and Forex Scams: How to Spot Them a Mile Away) give information on forex scams in order to attract customers to forex brokers who turn out to be forex scammers. For example, the first website above contains advertising links to several forex operators including one who sells FX prediction software which claims "80% accuracy."
Trader recourse and anticipated changes within the forex market
Traders have recourse to dedicated blogs that document the risks, scams and unfair practices associated with dealing desks [11] [12] Interactive forums allow discussion, complaint and rebuttle by both traders, and the brokers/market makers. see: http://nondealingdesk.com/ Such blogs and forums hold the possibility of creating change within the retail forex industry. The retail forex industry also faces structural change as a result of larger entities creating a centrally cleared marketplace. Such centralization will of necessity demand greater scrutiny and enforcement. [13]
