Regulators eye leverage cap in FX
The convulsions after the SNB’s decision to cease pegging the Swiss franc to the euro are still being felt, with regulators in Europe and Australia debating the merits of tougher controls on leverage in FX markets for retail investors.
Australia is weighing up the benefits of a cap on leverage in FX, with Greg Medcraft, chairman of the Australian Securities and Investments Commission (ASIC), reportedly concerned that Australia is being “picked off” by FX brokerages because of its tolerance of high levels of leverage.
The data suggest that there has been less than an overall 3% decline in FX trading volumes in the US
Australia is not alone. The European Securities and Markets Authority is also looking at the issue and there is a recognition that in Europe the Markets in Financial Instruments Directive (Mifid) – the ruling concerned with the protection of retail investors – has a blind spot when it comes to FX.
Mifid was written with securities and derivatives markets in mind, and FX does not explicitly fall under its remit. It has therefore failed to prevent excessive leverage in FX transactions from building up, as high as 3,000 times, brokers tell Euromoney. In Australia, ASIC reports similar levels of leverage in FX transactions.
Currently, ASIC limits the provision of licences to institutions that have demonstrable business ties with Australia, in an attempt to prevent speculation on the Australian dollar by those outside the country with no material onshore business. It has also limited the licensing for firms offering excessively high amounts of leverage, without introducing an explicit leverage cap.
While this has been an important step, it has not alone been sufficient to stem speculation on the Australian dollar with highly leveraged positions, especially by retail traders inside and outside of the country.
The concern among regulators is that any attempt to cap leverage taken at the national or regional level will only drive trading away to jurisdictions where no such limits exist and where traders can therefore generate greater returns.
The US is among countries that have introduced a leverage cap, with the US Commodity Futures Trading Commission limiting leverage to 50 times the principal invested in 2010. Japan also introduced a leverage cap in the same year. Although it is difficult to draw definite conclusions, it does not seem that New York or Tokyo have suffered a dramatic decline in liquidity as a result.
FX should be boring
Fred Ponzo, GreySpark Partners
“The data collected from October 2010 to October 2013 suggest that there has been less than an overall 3% decline in FX trading volumes in the US,” says Alexandra Dobra, senior associate on the regulatory consulting team at Kinetic Partners, a financial advisory firm.
The cap did not skew behaviour in terms of instruments traded, she adds, with the proportion of options, swaps, forwards and spot contracts, as well as counterparty types, remaining broadly consistent before and after the cap.
Richard Crannis, managing director of regulatory consulting at Kinetic Partners, adds: “For the biggest financial centres to remain attractive, they need to guarantee a safeguarded financial environment, and investors are looking at factors such as maturity, political stability, quality and electronic capabilities.”
Industry concerns about variations in global rules and regulatory arbitrage are particularly acute when it comes to leverage. If one jurisdiction applies a strict leverage cap, it is very easy for a trader to relocate to a jurisdiction where less draconian rules are in place to avoid the cap.
A global deal on leverage would be a big step towards reducing overall systemic risk, but this does not look likely any time soon.
The leverage issue was exposed by the crisis after the Swiss National Bank's (SNB) decision to remove the Swiss franc peg to the euro. Regulators are only now waking up to the scale of the problem of excessive leverage in retail FX, according to Fred Ponzo, managing partner at GreySpark Partners.
“Although, by law, losses are capped to the amount of margin a retail client puts in, the reality was different during the CHF debacle,” he says. “Trading was frozen, liquidity was not available to investors wanting to cut their positions and brokers tried to push losses in excess to the margin to their clients.”
However, Ponzo is confident the events of January have pushed this issue up the regulatory agenda.
“If it is in the press, it is in the public’s mind,” he says. “If it is in the public’s mind, it is in the legislators’, and therefore in the regulators’.”
While retail investors already had protection via strong customer protection provisions limiting losses, European legislators are now thinking about whether there should be explicit, US-style caps on leverage on the wholesale side, says Ponzo.
Caps are unlikely to be popular, especially at first, considering the returns that are made on highly leveraged FX trades. Many brokers take the view their clients want the ability to lever up their trades and are keen to allow them to do that.
In an exclusive interview with Euromoney, broker FXCM, which was among the worst hit by the SNB’s decision in January, dismissed the leverage debate as “irrelevant”. Many traders would still have been wiped out, even without leverage, due to the severity of the market moves in January, FXCM said.
However, Ponzo says: “Capping leverage would be like enforcing the use of seat belts. There might be some resistance at first, but ultimately it is for investors’ own good. And it is only likely to be an issue for the most speculative retail investors, which represent a small proportion of traders.”
Crannis says: “I believe it will lower the incentives for speculation on the side of firms and therefore customers will implicitly be better protected.”
Some brokers might welcome the move for creating a level playing field. Some understood the risk their clients’ leverage posed to their businesses and took steps to reduce it without being instructed to do so by a regulator, and while their decisions might have been vindicated by the markets in January, in times when there is no crisis, limits on leverage might be seen as a competitive disadvantage.
Steen Blaafalk, Saxo Bank
Steen Blaafalk, group chief financial and risk officer at Saxo Bank, says: “We did warn as early as September last year that the Swiss franc could face a storm and, as a result, we significantly reduced our clients’ access to leverage. We did this both to protect clients and also to protect ourselves.”
Saxo believes the market is returning to extreme volatility, the likes of which have not been seen for years in FX.
“We want our clients to be fully prepared for increased volatility and short-term shocks, such as the recent SNB decision, and we expect to change margin requirements more dynamically in the future,” says Blaafalk.
He urges other brokers to look at their business models and to act, even without regulatory compulsion: “This industry needs to change before it has to and we want to act as a responsible industry player and certainly do not want to compete on risk.
“Therefore, we decided to tighten access to leverage even more the week after the SNB decision because we want our clients to be fully prepared for increased volatility and short-term shocks and manage their risk appropriately.”
Interestingly, Blaafalk insists Saxo Bank saw an increased number of new clients transferring their accounts from other brokers to Saxo, despite it imposing stricter leverage rules than some of its competitors. This might suggest traders are not simply relying on regulatory protection to bail them out in the case of extreme losses on FX trades, but want to actively manage their own risk to minimize their own losses.
“FX should be boring,” says Ponzo.
Investors will surely disagree when it comes to returns, from which they will always hope to derive some excitement – but when the market moves against them, and high levels of leverage wipe them out, they will probably agree that is one form of excitement they can live without.