January 21 2015 Save Print License article The dark underworld…

by: Mohammad Hafiz

January 21 2015

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The dark underworld of forex trading

Jonathan Shapiro

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Investors around the world haven’t lost their appetite to trade in the post-financial-crisis era. But instead of playing the sharemarket, they fancy themselves as global currency traders. That has been propelling the growth of retail foreign exchange broking into a $380 billion industry, doubling since 2007.Australia has become a hot-bed of the industry by virtue of its trading culture, and as a safe jurisdiction for locally based players to market themselves to traders around the world. Such is its popularity that daily turnover at some of Australia’s largest brokers can exceed the entire cash equities volume of the Australian Securities Exchange on a given day.

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A Westpac spokesman said the bank was ending its relationship with OzForex reluctantly, and the move was influenced by increasingly tough regulatory requirements. Photo: Reuters

Forex trading is not new, but the electronic platforms and extreme leverage – sometimes as high as 500 to one – can make the Euro/US dollar pair as riveting as punting on a penny stock. Yet despite its rising popularity, some insiders are adamant the world of forex broking has been, and remains, a shifty business. Technology may have lowered trading costs but it has allowed many unsavoury practices to take place on a larger scale.

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The industry’s dirtiest little secret is the extent of trading profits that brokers earn by directly taking on their muggiest punters. Photo: Bloomberg

The industry’s dirtiest little secret is the extent of trading profits that brokers earn by directly taking on their muggiest punters. While some platforms act like true brokers others are more akin to bookmakers. They’re understood to split their trades into what is known in the industry as “A-books” and “B-books”.

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The “A-book” describe the trades the broker receives that are passed on to the inter-bank market with the broker clipping a ticket. The alternative “B-book” consists of trades that the broker has not passed on to the market but taken on themselves. Why would brokers take on their clients? Because an estimated 95 per cent of retail traders are pre-programmed to fail, which means the brokers will ultimately win by taking them on rather than passing them off to the market. The existence of leverage amps up the movements in clients’ positions, making it more likely that a stop-loss (mandatory sell order) will be triggered, speeding up the inevitable loss. And with brokers trading against their clients, they may possess the ability to tilt the game in their favour. This includes inserting charges such as “cost of carry” that retail punters have ­ little chance of reconciling. It has also been suggested the brokers can and do widen their bid-to-offer spreads moment­arily to hit the stop-losses, forcing a loss on the client. The B-book does carry risks that a large savvy trader will bet big and win, which means the larger accounts are shifted to the A-book where the broker pays an inter-bank dealer a fee.”B-booking” is a taboo subject and brokers are loath to admit they engage in betting against their clients. But insiders are convinced it is an integral part of several of the brokers’ business models that required them to constantly market for new clients. Cottage industry of trading analytic firms

As evidence of B-booking’s prevalence, a cottage industry of trading analytics firms has sprouted up to help brokers identify which clients have even the faintest idea what they’re doing. They’re then shifted to the A-book. There are reasons why foreign exchange markets are particularly well suited to the retail brokerage model. And much of the logic played out in reverse last Thursday evening. The FX markets never sleep, which means the sudden “gapping” in pricing that can blow up brokers and their clients in other markets is rare. That’s why former Axi Trader executive and currency trading expert Quinn Perrot believes high leverage of up to 400 times in certain currency pairs is not as dangerous as it sounds. “The FX markets have high leverage because they trade 24 hours a day, which usually prevents the type of gaps seen between market close and market open on the stock market,” he said. But on Thursday the Swiss franc gapped like no currency in history. Perrott says this was because larger ­ dealers had a view where the franc should trade without the peg. They instantaneously moved their market pricing to that point, blowing through stop-losses of broker clients. For a trader with 400 times leverage, a 30 per cent move resulted in a 1200 per cent loss. Such enormous losses, which exceeded client balances by many multiples, meant the big problems lay with brokers. Some either had a blowout in bad debts or closed out their client’s trades at different levels to where they could hedge the exposures. The losses effectively blew up the largest and third-largest retail forex broker and inflicted multimillion-dollar losses for other players. Perrott says poor risk management “too often confined to lawyers and operations staff stuck away in a corner office” caused brokers to collapse. He stress-tested scenarios where the peg was lifted and rejects the assertion that the Swiss move was a shock “black swan” event. “What was missing is they probably never sat down with their risk managers and brain-stormed the potential knock-on effects.”The melt-down of some offshore brokers has also raised the controversial issue of client segregation. Australia imposes tough restrictions on derivative brokers, but unlike other countries allows brokers to use client funds as collateral. On this issue, local and international brokers are at loggerheads. The Australia CFD Forum, which consists of big global players like IG Markets and CMC – lobbied governments to introduce segregation of client funds. Other brokers such as Pepperstone say they support client segregation but take exception to foreign firms lobbying for rule changes on their home turf. The risks of frozen client funds was apparent to local clients when global broker MF Global collapsed in 2011. It ran into trouble taking highly leveraged “off-piste” bets on European interest rates. That and the Swiss events are reminders of a lesson even the largest players often forget: the dangers of trading are beyond what meets the eye. Have you been burnt by currency trading? Please share your experience with jonathan. shapiro@fairfaxmedia. com. au

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