A complete guide to forex regulation and protection

Think about what it would be like if there were no law and order in the world. The absence of rules, guidelines, restrictions, and control, as well as the freedom of individuals to do as they wish. If the scenario described above were to occur, what would be the inevitable outcome? Nothing but chaos and mayhem! The same can be said for the forex market, an industry worth a market capitalization of over $5 trillion. In light of the growing speculative activity in the retail forex market; major and minor players in the foreign exchange market are subject to regulations and supervision so as to ensure a high standard of legal and ethical procedures.

Throughout the world, the foreign exchange market is constantly active through the over-the-counter market; a borderless market that provides seamless access to trading. For example, regardless of geographical boundaries, an American trader can trade the pounds against the Japanese yen (GBP/JPY) or any other currency exchange pair through a U.S-based forex broker.

Forex regulations are a set of rules and guidelines specifically designed for retail forex brokers and trading institutions in order to regulate retail forex trading in a global and decentralized financial market that operates with no central exchange or clearing house. Due to its global and decentralized structure, the forex market has been more vulnerable to foreign exchange fraud and has had less regulation than other financial markets. As a result, some intermediaries like banks and brokers are able to engaged in fraudulent schemes, exorbitant fees, discreet charges, and excessive risk exposure through high leverage and other unethical practices.

Furthermore, the introduction of mobile trading applications via the internet provided an easy and smooth trading experience for retail traders. However, it came along with the risk of unregulated trading platforms that may close abruptly and abscond with investors' funds. To mitigate this risk, forex regulations and systems of checks have been put in place to guarantee that the forex market is a safe place to be. Regulations like this ensure that certain practices are avoided. Aside from protecting individual investors, they also ensure fair operations that serve the interests of clients. For compliance with these legal and financial standards to be ascertained, industry watchdogs and overseers are set up to monitor the activities of industry players. In some countries, foreign exchange brokers are regulated by governmental and independent authorities, such as the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) in the US, the Australian Securities & Investments Commission (ASIC) in Australia, and the FCA; Financial Conduct Authority in the UK. These bodies serve as watchdogs of their respective markets and issue financial licenses to institutions that comply with local regulations.

What are the objectives of forex regulations

In the forex market, regulatory agencies are responsible for ensuring that fair and ethical trading practices are adhered to by investment banks, forex brokers, and signal sellers. Regarding forex brokerage firms, they are required to be registered and licensed in the countries where their operations are based to ensure that they are subject to recurrent audits, reviews, and evaluation checks and that they meet industry standards. Capital requirements for brokerage firms often require that they hold sufficient funds to execute and complete foreign exchange contracts concluded by their clients as well as guarantee the return of clients' funds in the event of bankruptcy.

Although forex regulators operate within their own jurisdictions, regulation varies significantly from country to country. Contrary to that notion, in the European Union, a license issued by one member state is valid throughout the whole continent under the MIFID regulation. In addition, many forex trading institutions prefer to register in jurisdictions that have minimal regulation, such as the tax havens and corporate havens found in offshore banking activities. This has resulted in regulatory arbitrage where institutions select an EU country that imposes similar policies such as CySEC in Cyprus.

General forex regulatory requirement for brokerage firms

Prior to signing up for a trading account, be sure to compare and verify the ownership, status, website and location of several forex trading firms. There are many forex brokerages claiming low trading costs and high leverage (some as high as 1000:1), allowing more risk exposure even with minimal equity balance. Below are some general rules that retail forex brokers must abide by.

Ethics in client relations: This is to protect clients from unrealistic or misleading claims. Brokers are also prevented from advising clients on risky trade decisions or providing trade signals that are not in the best interest of their clients.

Segregation of client funds: This was put in place to ensure that brokers do not use clients' funds for operational or other purposes. In addition, it is required that all client deposits be maintained separately from the broker’s bank accounts.

Disclosure of information: The broker is responsible for making sure that all clients of theirs are fully informed about the current status of their account, as well as the risks associated with forex trading.

Leverage limits: Having a set of leverage limits ensures that clients are able to manage risks in an acceptable manner. In this regard, brokers are not allowed to offer traders excessive leverage (say, 1:1000).

Minimum capital requirements: Clients are protected by these restrictions in their ability to withdraw their funds at any time from their broker, regardless of whether or not the brokerage firm declares bankruptcy.

Audit: When an audit is conducted on a periodic basis, the broker is assured that the financial risk is contained and no funds have been misappropriated. It is therefore mandatory that brokers submit periodic financials and capital adequacy statements to the relevant regulatory body.

U.S. Regulatory Framework for Forex Brokerage Accounts

As the nation's premier trade association, the National Futures Association (NFA) is a leading independent provider of innovative regulatory programs that safeguard the safety and security of the derivative markets and ideally, the forex market. In general, the NFA activities includes the following:

• Granting licenses after a thorough background check to forex brokers who are eligible to conduct forex trading.
• Enforcing compliance with the necessary capital requirements
• Identifying and combating fraud where possible
• Ensuring proper recordkeeping and reporting regarding all transactions and business operations.

Relevant sections of the U.S Regulations

According to US regulations, "clients" are defined as "individuals with assets below $10 million as well as most small businesses." Asserting that these regulations are intended to protect the interests of small investors, high-net-worth individuals may not be eligible for standard regulated forex brokerage accounts. The provisions are outlined below.

1. The maximum leverage that can be applied to a forex transaction on any of the major currencies is 50:1 (or a minimal deposit requirement of only 2% of the notional value of the transaction) so that unsophisticated investors do not assume excessive risks. The major currencies are the U.S. dollar, British pound, Euro, Swiss franc, Canadian dollar, Japanese yen, euro, Australian dollar, and New Zealand dollar.
2. For minor currencies, the maximum leverage that can be applied is 20:1 (or 5% of the notional transaction value).
3. Whenever short forex options are sold, the notional transaction value amount along with the option premium received should be kept as a security deposit in the brokerage account.
4. There is a requirement for the entire option premium to be held as security as part of a long forex option.
5. FIFO, or the first-in-first-out rule, prohibits the simultaneous holding of positions on the same forex asset, i.e., any existing buy/sell positions on a particular currency pair will be squared off and replaced by an opposite position. Thus eliminating the possibility of hedging in the forex market.
6. Any funds owed by the forex broker to clients should be held in qualified financial institutions in the United States or countries with money centers.

Here is a list of top forex brokerage regulators

Australia: Australian Securities and Investment Commission (ASIC).

Cyprus: Cyprus Securities and Exchange Commission (CySEC)

Japan: Financial Services Agency (FSA)

Russia: Federal Financial Markets Service (FFMS)

South Africa: Financial Sector Conduct Authority (FSCA)

Switzerland: Swiss Federal Banking Commission (SFBC).

United Kingdom: Financial Conduct Authority (FCA).

United States: Commodities and Futures Trading Commission (CFTC).

Summary

Regulatory requirements regarding the use of leverage, deposit requirements, reporting, and investor protections differ from country to country. This is due to the fact that there is no central regulatory authority and the regulations are administered locally. These local regulatory bodies operate within the confines of the laws that govern their respective jurisdictions.

Regulatory approval status and the licensing authority are the most important factors to consider when choosing a forex broker.

There are a large number of brokerage firms that are hosted and operated outside of the United States. Some of these firms are not approved by their home country's regulatory authority. Even those that are authorized may not have regulations that apply to U.S. residents or other jurisdictions. However, all regulatory bodies in the EU can operate in all countries around the world.