Regulatory arbitrage

As an industry, retail foreign exchange is barely a decade old. And it's only within the past several years that the market has really exploded. By some estimates, more than $100 billion a day is now traded by retail investors around the globe. One of the biggest drivers of this growth is the fact retail investors feel more comfortable trading FX because it is regulated in major markets such as the UK, Japan, Hong Kong, Australia and the US. Moving forward, industry participants must work with the regulatory bodies to continue developing new rules and standards that protect traders but don't stifle innovation and progress.

Gain Capital has been regulated by the National Futures Association (NFA) in the US since 2001. In 2009, we completed the registration process with the Financial Services Authority in the UK and the Securities and Futures Commission in Hong Kong, and acquired a regulated firm in Japan. Based on this experience, we've become acutely aware of differences in rules and regulations governing retail FX around the globe.

In the US, particularly, regulatory oversight is evolving rapidly. Among the key drivers is the fact retail FX has taken off dramatically in the US over the past few years and several of the dominant players in the global forex market are based there. The drive to improve customer protection has resulted in a host of new rules and regulations, which do not all necessarily achieve the intended goal of further protecting the retail investor.

Consider the adjusted net capital requirement for US registered firms, which increased from $250,000 to $1 million in 2006, $5 million in December 2007 and then $20 million in May this year. This is a noticeable departure from the risk-based capital requirement used not only in the UK, Japan and Hong Kong, but also to assess futures dealers in the US (also regulated by the NFA).

Risk-based capital requirements are set at levels that are commensurate with the firm's business and trading activity. The higher requirements have affected a big percentage of firms registered to do business in the US. As of May, we counted 14 registered forex dealer members in the US - firms whose principle business is retail FX. Less than a year ago there were close to 30. Some exited the US market altogether, some moved offshore and some consolidated with larger players. Ultimately, less competition hampers innovation and is disadvantageous to the customer from a pricing and service standpoint.

A secondary but no less illustrative example is the so-called 'no hedging' rule for US firms. With this new rule, NFA regulated firms can no longer allow their customers to establish simultaneous long and short (or 'offsetting') positions in a single currency pair, and positions are required to be offset on a first-in, first-out (Fifo) basis. The merits of the rule notwithstanding, it seems some US regulated firms will lose customers as a result. Several brokers have already communicated to their customers that their platforms do not support the Fifo trading method, and that, to comply with this rule, they are developing workarounds that change the user's trading experience and reduce the risk management capabilities of their platforms by no longer allowing users to leave stop or limit orders to manage their position risk. Retail investors who wish to keep these capabilities must either switch brokers or move their accounts to offshore firms where there is no such restriction on this trading strategy.

Another issue with the global regulatory environment is the fact that rules and regulations differ distinctly from market to market when it comes to the safety of funds and leverage. In many jurisdictions, including the UK, Australia, Japan, Singapore and Hong Kong, investor fund protection exists in the event of a dealer's bankruptcy but the same protection does not exist in the US for retail FX investors. This puts US-regulated firms at a disadvantage compared with their international peers, especially in terms of attracting larger accounts.

The leverage available to traders also varies around the globe, from 25:1 in Hong Kong to up to 200:1 or even 400:1 in other markets. While it seems a consensus is now building in multiple jurisdictions to lower leverage ratios across the board, it's all but certain there will be a wide gap between the different markets for quite a while. As a result, retail business could easily flow away from the markets with the most restrictive leverage restrictions.

In our global economy, consumers have choices and, in practicality, trading online is just as easy with a firm in the UK as it is with one in the US. Firms with multiple registrations now find themselves reluctant participants in a game of regulatory arbitrage. As more and more retail investors seek out providers that can deliver the best all-round offering, retail FX firms must make sure they navigate and understand the rules and regulations in each jurisdiction to effectively service their customers.