Forex Brokers:
Love them hate them, but don't mess with them

Love them, hate them, but don’t mess with them.” I think this
just about summarises the relationship between us, the traders, and them, the forex brokers and is the subject of this newsletter.

The Internet is full of sites and forums slating brokers, making it difficult for newcomers to make independent decisions on choosing a broker. The newbie thinks that he must somehow find the one honest broker amongst a legion of cut-throats. I don’t think this is quite the case. While I am the last person to sing any broker’s virtue, I do think that most brokers will generally get a thumbs-up from people that don’t mess with them. That’s why I take broker bashing with a pinch of salt – often it is done by inexperienced traders looking for someone else to blame when actually it is their own trading methods that stink.

The latest and most heated example of this blame game is the current news trading fad. Suddenly the same broker who was loved before is now a crook. Scratch a little and what appears is a disappointed trader – one who harboured a fundamentally flawed trading system – destined to make him broke.

Let me explain…

There are two main risks in retail forex trading, trading risk and counter party risk.

By far the largest risk is trading risk, which is the risk embedded in your trading strategy, the risk that you will systematically turn over your money to your broker. You are the sole architect of your demise. No measure of regulatory protection can shield you from this risk.

The second largest risk is called counter party risk. This is the risk associated with the process of taking your money and paying it into someone else’s bank account. The object of regulations are primarily to minimize counter party risk for retail investors.

This is a risk you can minimize. Before you get all fired up over the fancy charts and indicators offered by a forex broker, you should investigate his regulatory position. You should make sure that the broker falls under a regulatory regime aimed at consumer protection against financial market sharks. Such regulated regimes exist in countries such as the US, Canada, the UK, the European Union and Australia. There may be other regulatory regimes that I am not aware of, but I believe you have to have very good reasons to pay your money into the bank account of a forex broker who is operating outside of these jurisdictions.

In addition to checking out jurisdiction, you also need to make sure that the company you are dealing with is properly regulated. You need to be very specific. For instance, there are certain loopholes in US regulations that allow for the bypassing of some of the disclosures forex brokers should properly make. These disclosures are necessary to monitor the risk of your broker defaulting. If your broker made use of these loopholes to set up its retail trading business, you may be under the wrong impression as to the regulatory protection you really have.

How can you determine if your broker is really regulated? Usually the website will display their regulatory status and give a member or licence number. That’s a good start but not enough. The next thing you have to do is download the trading agreement and make sure you know exactly which legal entity you are intending to sign an agreement with. Is this the entity registered at the regulator? You can check this on the regulator’s database. If there are discrepancies in the name, warning lights must go off

The oversight regulatory regimes in the abovementioned jurisdictions are not pushed that hard as a selling point by brokers these days. In fact if a company is pushing it as a selling point, you should be careful. Swiss-based forex brokers tout their regulations heavily. Be very cautious. The regulations they have are not consumer protection based and basically only entail that they cooperate with international attempts to prevent money laundering. Most Swiss-based forex brokers were set up by non-Swiss companies precisely because of the non-“intrusiveness” of Swiss regulations.

Forex brokers that are operating from tropical islands, tax-havens and similar locations, more notable for their blue skies, large yachts and beach-front homes than sound regulations, are certainly not the lower-counter party risk type, despite their claims of being well regulated. You really have to have good reasons for dealing with them instead of a properly regulated broker.

And now for the real counter party risk…

In fact, the real risk is in the decentralized structure of the forex market. If you deal in the regulated markets like stock and futures exchanges, the exchange guarantees the transactions done by members of the exchange. Opposed to this the forex market is an OTC (Over-the-counter) market.

In the retail forex market it is entirely possible to deal with an entity that has no financial stability or credibility. Even though you may be paying your money into a Bank of America or HSBC account, your money is part of the assets of this small entity that is operating according to a highly lucrative business plan. There are obvious risks associated with this business.

Your broker is your counter party, in other words, your broker takes the other side of your position. I am sure you already see the problem. If you make money, they lose money. Now if your broker is Citi Group, Deutche Bank or UBS, you won’t have one moment’s worry about this. But it isn’t. In most cases, the broker is a dotcom start-up technology company with a flair for Internet marketing.

Your broker can’t absorb the risk of you making 100 pips profit while his potential profit is capped by the spread to two or three pips. In the hands of a group of profitable traders, he will go broke, never mind broker, in no time. He needs to offset this risk with his own clearinghouse. This is a complex proposition. Usually the broker will have to shoulder some of the burden (loss - take some of the risk on board and keep it). Are you starting to understand now why some brokers take measures to make it difficult for news traders to make money and easy for everybody to lose money?

Measures like increased spreads, limitations on placing orders, declaring abnormal market conditions around data releases, no guarantees and so on. Allow me to explain to you in figures the risk to your broker’s profitability and thus counter party risk.

Let’s assume it isn’t the largest broker out there and it’s customers will probably open a few hundred live accounts of all sizes in a month. Most of these accounts will be real Mickey Mouse accounts of a few hundred dollars. From the brokers’ point of view let’s say there are $150,000 deposits this month in easy to get, very small accounts. Below you will see why I say the following: the broker knows exactly what percentage of that money will be in their profit account in a few weeks. Very small accounts have very high turnover. In other words, the broker’s statistics tell him that he has merely by the depositing of these funds already secured a $100,000 profit within the next few weeks. That’s a great feeling in anyone’s books. But now watch how this can turn rather quickly and why the broker needs to manage his risk carefully. He certainly doesn’t want that $100,000 for which he has worked hard and paid dearly (it costs much more to acquire than to retain a customer) to disappear.

A group of traders, unrelated to the newcomers, some with large accounts, zoom in on a data release. Depending on the release they are all going to simultaneously hit the same (buy / sell) button, highly leveraged. Let’s say the value of these intended trades are 25 million GBP (GBPUSD). That is about 50 million USD. They hope this data release will give them 40 – 60 pips on average. Let’s calculate the pip value in order to calculate the aggregate profit they hope to make in three minutes and the loss will be for the broker – their counter party. 50,000,000/10,000 = $5,000. So the broker’s risk is, say 50 pips at $5,000 per pip. That is a cool $250,000 down the drain. Almost two months’ easy money can be lost in the blink of an eye. Would you allow this kind of risk to threaten your money printing machine?

The broker simply can’t offset this risk of being one second late on a huge leveraged loss of tens or hundreds of thousands of dollars. He can’t transfer this risk to anybody at that stage. In my previous newsletter I showed how the liquidity everyone drools about in the FX market simply evaporates and that a lack of liquidity like in any market is the reason for wild price gaps and fluctuations. The broker also has a big incentive to mess around by, for example, widening the spreads massively and gunning for stops in order to throw news traders off.

But the counter party risk also goes a bit further. Your broker can basically manage his portfolio with your money as collateral. And he can also use quite high leverage and incur big losses. He can for instance try to turn the potential loss in the news trading scenario in his favour and get you to lose the money to him. If successful he’s got it made – in three minutes! If not … (there are always a few sops with tight stops to gun at ... )

Your real counter party risk is that a small retail broker can become over-extended with these activities and go belly-up. In properly regulated environments, there are disclosure measures that limit the retail customer’s risk in this regard. For instance, US retail forex brokers must report, on a weekly basis, on the daily value of their customers’ open positions and the net profit or loss on all customer accounts. There are also certain jurisdictions that give a government backed capital guarantee in the case of insolvency of regulated brokers.

And the moral of all this? Counter party risk is pretty low as long as you stay amongst the regulated entities and the brokers manage their risks well, as they tend to do, considering their reaction to, for example, the threat posed by news trading and how they deal with it to protect themselves and indirectly their clients.

Trading risk

“If an experienced person without money meets an inexperienced person with money (and does business), soon the experienced person will have the money and the inexperienced person the experience.” – Anonymous.

This saying illustrates my next point.

In order to understand trading risk and why it is so vital to your eventual success or failure you must understand the business of your forex broker. A retail forex broker makes tiny amounts of money on high volume business. Volume is generated by lots and lots of customers or by the same number of customers doing more or larger trades. So, if this were your business, what would you need to do? You have to get customers to deposit money in your bank account and then you have to get them trading. Customers must generate fees. You have to convince them to trade more and larger positions.

So, whatever your forex broker claims he can do for you, you know that it is subject to the broker’s ability to get you to generate more fees. You wouldn’t expect anything else from a good businessman, would you?

Retail forex broking was a wholly new business opportunity only a few years ago. It was basically a dotcom business. Everything revolved around software. Brokers genuinely believed in the revenue principle of lots and lots of small fees generated by lots of clients. It didn’t take long for the entrepreneurial retail brokers to realise that there is more money to be made by taking on some of the risk, especially if that risk is basically no risk.

It is common cause that intra day currency price fluctuations are a random walk. The worst trading approach anyone can have is to ignore this and identify illusionary moments of non-randomness and then place highly leveraged financial bets on these notions right in the middle of the randomness vortex. No, that is the third worst trading approach. The second worst is repeating this by placing a “stop further losses order” close to the original trade, still in the randomness vortex. As you can see, this is a second expectation of a large directional (thus relatively non-random) move amidst undisputed randomness.

The very worst trading approach is to repeat the third and second worst trading approaches regularly. But this is absolute heaven for the forex broker. Instead of going through all that trouble for 1 pip on the spread (after the IB is paid and the cost of offsetting with the clearinghouse has been factored in), why not convince the inexperienced trader to part with 20 or 30 pips instead, resulting in a two or three thousand percent increase in the broker’s revenue? Heaven indeed.

Brokers do their homework

You see, long before the broker started to worry about supplying you with a nice trading station and all sorts of gimmicks to induce you to make more and larger trades, he took great care to make sure he had a second-to-none “back office” system that can gather intelligent information about the client base.

The type of information brokers like to gather includes:

If you know anything about statistics you will know that with a rather modest scientific sample you can make very accurate extrapolations of what is going to happen to a specific type of account.

Clients are categorized according to which profile they fit, based on initial statistics. It is not hard to work out which clients are likely to lose. Neither is it hard to work out which clients may pose a risk to profitability. This simple data enables brokers to distinguish which clients’ risk they can keep in-house – obviously those that are likely to lose - while offsetting the risk of clients who are likely to trade profitably.

The determinants are rather simple: the higher the volumes the client trades (number of trades and size of trades), combined with the use of close stops, the more likely he is to be placed in the loser category. These traders are likely to lose a large chunk of their capital in a rather short period of time, mainly through stop-losses. Here is something that you may not know: stop-loss trades can be flagged and identified. They are not simply another buy or sell position, but in fact a hand-over of capital from your trading account to the broker. By placing a stop–loss order in the market you tell the broker at exactly what price he stands to benefit and at no risk to himself.

Your broker knows exactly which percentage of say 10 pip, 15 pip, 20 pip, 25 pip, 30 pip, “stop-losses” are actually “make-losses”, and based on that they know what they have to do to cover their risk. That is why they want you to trade with close stops.

Pip wise, pound foolish

One of the things brokers use as a lure is “narrow spreads”. Now I ask you to think about the following: What difference does it really make to your bottom line if you trade on a 2, 3, or 4 pip spread? It will only be of real significance if your view is very, very short term and probably highly leveraged. Just for once look at the price action very closely, tick per tick for a few minutes during a generally busy time, say New York morning. Can you see how it goes like disco lights, tick by tick, up 1, down 1, down 1, up 3, down 1, up 1? Now tell me how this can have any meaning for you?

In order to convince you to do more shorter-term trades (preferably highly leveraged), the marketing machinery of these brokers is targeted at the very, very short term and at creating the illusion of potential success within this very short trading period. Why do you think you have tick, 1 minute, 2 minute, 5 minute, 10 minute, 15 minute charts? What’s their use?

Their use is in creating the illusion that that is where your opportunity lies. But it is also to confuse you. There is information overload contained in the sheer number of price changes. Add to them an array of technical indicators, tailored to this very very short term, and the problems are compounded to the point where you simply cannot win. You are fooled by and fooling around with randomness.

The global spread

When losers’ stops are hit in the very short term, they like to think the problem is the broker “gunning” stops. While this can’t always be excluded, there’s usually a much stronger case that the stops were in the middle of a random walk - roughly a 50 / 50 probability of being hit.

Fooling around with close stops is disastrous for anyone but the most astute very short-term traders. Trying to pinpoint entries with to-the-pip signals is another foolish strategy. Complaining about a limit not hit or an entry not filled after it has been carefully calculated is just stupid, considering the global spread.

The global spread is the result of the fact that forex is decentralised and that anyone that is a market maker can make any price he wants to make at any time.

If you deal with a market maker and you deal on a price or offer to deal on a price, it forms part of the global spread if a deal is executed. With thousands of dealing rooms trading simultaneously in the pyramid-like structure of the forex market, the worst buy and sell price at any specific time forms the global spread. This can at any time be up to 10 pips – notwithstanding widely used services like EBS and Reuters Dealing.

The point about the global spread is that it is in your best interest not to try to be too specific on any price. Prices can change within seconds, 10 pips up, or 10 pips down. If this is devastating for you, there is something wrong with your trading approach.

Same story, new address

A new wave of emails doing the rounds encourages people to think that trading with a non-dealing desk broker (NDD broker) will make all the difference. This is from an email I received on the 29 November 2006 from the champions of marketing wizards:

Advantages of “our” NDD trading