Regulation in Forex Markets: Why and How?

Cina Coren

The Foreign Exchange (FX) market is the largest, most liquid market in the world – with around US $5.3 billion traded daily. Day trading is quite common among currency traders but most investors depend on setting up trading accounts and executing their trades via Forex brokers.

There are hundreds of Forex brokers and new ones are constantly opening their doors to the public. This makes it difficult for traders to choose the best brokerage and leaves them at the mercy of the broker when it comes to honesty and transparency. Despite its huge size, regulation in the Forex market is scarce and there is no single global body to police it 24/7.

There are no accurate statistics, but the number of Forex and binary options brokers that work under a regulatory authority is minimal (5 percent is usually cited) and that leaves many firms able to take advantage of their clients and to engage in abusive behavior without any consequences.

Non-Regulation Risk

For retail FX traders, the biggest downside to the lack of Forex regulation for most brokers is that of illegal activity or outright fraud as well as runaway losses in a market increasingly dominated by speculative activity and large institutions.

Following a spate of currency-related swindles during the period between 2001 and 2008, the CFTC created a special task force to deal with the problem and stiff Forex regulations were introduced several years later to protect retail FX traders. Under the Commodity Exchange Act (CEA), the CFTC assumed jurisdiction over leveraged Forex transactions offered to retail clients in the United States. The Act permits only regulated entities to act as counterparties for Forex transactions with retail customers in the States and it requires that all online Forex dealers be registered and meet the strict financial standards enforced by the National Futures Association (NFA).

On the institutional level, banks, which are responsible for 95 percent of daily FX trading, are heavily regulated. The U.S. Federal Reserve and the U.S. Treasury Department are highly attentive to regulation in the Forex industry and monitor brokers carefully for evidence of manipulation.

Forex Regulation-Why?

Why is regulation in Forex so important? The objective of regulation is to ensure fair and ethical business behavior. Under current regulatory contracts, all foreign exchange brokers, investment banks and signal sellers are required to operate in strict compliance with the rules and standards laid down by the Forex regulators or their activities can be deemed unlawful. These bodies must be registered and licensed in the country where their operations are based, which ensures quality control standards are met. they are Brokerage houses are subject to periodic audits, reviews and evaluations which force them to maintain the industry standards. In addition, regulated Forex brokers must keep a sufficient amount of funds to be able to execute and complete foreign exchange contracts concluded by their clients and also to return clients’ funds intact in case of bankruptcy.

Should a regulatory agency find a broker infringing on its guidelines, it can use a wide range of enforcement powers – criminal, civil and regulatory – to protect consumers and to take action against firms or individuals that do not meet acceptable standards. It can publish notices that are important to ensure the transparency of decision made by the authority and inform the public thereby maximizing the deterrent effect of enforcement action. Some regulators issue alerts about financial services firms and individuals, based both overseas and in their local areas. Of course, there can be no assurances that any action taken by a regulatory agency such as the FCA in the UK will result in a payment or return of funds or securities even where formal disciplinary actions are taken and sanctions imposed.

Many of the actions taken by regulatory agencies against the brokers covered under their authorities can also be applied to non-regulated brokers that find themselves in similar situations by police and other enforcement agencies but their mandate is limited and is less likely to be imposed leaving investors with reduced recourse in the event fraudulent behavior. Forex regulators operate within their own jurisdictions but often work together in pursuit of duplicitous activities. In fact, in the European Union a license from one member state covers the whole continent. Over the years regulators around the globe have tried to organize some sort of universal regulatory umbrella. MiFID (Markets in Financial Instruments Directive) was introduced in the UK in 2007 and has been the cornerstone of Europe’s financial regulatory regime since then.

The MiFID regulation is now being revised to improve the functioning of financial markets in light of the financial crisis and to strengthen investor protection. The changes are currently set to take effect from January 3rd, 2017, although discussions are taking place between the European Commission, European Parliament and the Council of the European Union about the possibility of implementation being delayed. The new legislation is known as MiFID II and includes a revised MiFID and a new Markets in Financial Instruments Regulation (MiFIR).

There are, however, powerful voices working to lobby against the wholesale Forex market coming under a wide regulatory cover. The Association for Financial Markets in Europe (‘AFME’), an industry body, has come out against the MIFID II strict regulations and has published a paper recently stressing that “unintended consequences” could result in over-regulation of the Forex industry which would prevent brokers from serving their traders comfortably.

Local Approaches

At the moment, there is no uniform approach globally when it comes to this market. The regulatory industry continues to act on a local level with each broker applying for regulation in a chosen location and some organizations are more active than others. In Japan, one of the world's most active retail Forex market, the Financial Services Authority (FSA) regulates all markets including retail foreign exchange. The FSA is proactive in regulating retail Forex trading and has reduced the maximum leverage that can be made available to retail Forex traders several times in the last few years. In the United Kingdom where the FCA (formerly the FSA) is the main regulatory agency and in most of continental Europe, there are few limits on the amount of leverage offered.

CySEC, the financial regulatory agency of Cyprus, is part of the European MiFID regulations but it has attracted a number of overseas firms who wish to take advantage of what is seen as light regulations and an easy way to get a license without having to meet the stringent requirements that are imposed by other European financial regulators. Presently, relative non-regulation of the institutional Forex market continues to pose ongoing risks to the retail investor which includes higher currency volatility and discrepancies in available public information. Despite the difficulty and expense for brokers to function under an authorized regulatory body, there are many worthy brokers that choose to do so and these should be considered above all others. Traders have a wide selection of regulated brokers in their own jurisdiction or in other regions as well and they will find all the same features—and more—with regulated brokers as with non-regulated ones.

When it comes to selecting a Forex broker, one of the most important factors to look for is whether or not it is covered by a reputable regulator. The surge in regulation Forex brokers opening their doors these days has increased the likelihood that many of them are operating without any regulation or bona fide supervision. Since the Forex market is decentralized and operates with no central exchange or clearing house, it is the regulatory bodies that are assigned the task of acting as watchdogs for their respective markets and providing financial licenses to organizations that are of good standing and have enough funds to run a brokerage business.

Why is regulation so important? The foreign exchange market is the world's biggest financial market with close to $4 billion in trades conducted each day. Forex has in the past been regarded as the exclusive domain of large banks and corporations but this has changed of late and Forex is now increasingly traded via Forex brokers, leading to the need of increased scrutiny and regulation.

The regulation process is burdensome and takes time to complete so many brokers choose not to bother with the undertaking. What makes the procedure even more difficult is that the regulatory environment is not the same in all locations. What is surprising is there are mostly local regulatory organizations rather than one broader one across Europe and each EU member country has its own set of individual rules and legislation concerning the regulation of financial services in that country.

CySec, FCA and MIFID

There are certain major regulators stand out from the crowd and are recognized as trustworthy by both Forex brokers and Forex traders. The most recognized FX regulatory bodies in Europe are the Cyprus Securities and Exchange Commission (CySEC) and the Financial Conduct Authority (FCA).

Both of these organizations comply with the Markets in Financial Instruments Directive, or MiFID. MIFID allows Forex operators from one EU country to conduct business with all other European Economic Area (EEA) countries. A broker that declares it is EU regulated is saying that it follows MIFID rules. However, the extent of Forex regulation varies among the different countries, so regulation in one territory could be more stringent than in others.

MiFID regulation provides traders with some degree of protection although it does not cover all measures. It stipulates the need for some amount of mandatory investor compensation in the form of a refund of deposited funds should the brokerage claim bankruptcy. It also summaries minimum capital requirements needed by the broker and the need for segregated client and operator funds.

Brokers choose to set up their business in Cyprus under the CySec regulation for several reasons. The rate of corporation tax (currently a flat 10%) is the lowest in the EU and this is very attractive. And with its large and advanced financial sector, Forex providers find the business environment on the island to be quite favorable. In addition, since Cyprus is a member of both the EEA and the EU, Cyprus-based FX operators find themselves under MIFID regulation which provides a minimum standard of protection to those domiciled in Cyprus despite doing business in different countries.

United States

The regulatory structure of the U.S. is considered to be one of the strictest in the world. The Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act (CEA) has jurisdiction over leveraged Forex transactions offered to retail clients and permits regulated entities to act as counterparties for Forex transactions with retail customers. It requires all online Forex dealers to be registered and meet strict financial standards enforced by the National Futures Association (NFA). U.S. regulators expect total transparency from Forex operators and they are required to publicly release a wide range of data, including profitability of the firm’s traders, the number of genuine accounts registered with the company and more. Because of the heavy regulation, only a limited number of foreign brokerages are permitted to do business in the U.S. or offer trading opportunities with American citizens. Some Forex operators who have tried opening brokerages in the U.S. have been forced to close their doors or leave the country.

Belize

Another popular tax haven for Forex operators is Belize. Besides the tax benefits, this island provides regulation under the International Financial Services Commission (ISFC) which offers traders several of the basic protection clauses and makes strict accountability demands of FX brokers doing business in the region.

United Kingdom

Forex brokers doing business in the UK can choose to be regulated by the Financial Conduct Authority (FCA) which recently assumed the responsibility of the Financial Services Authority (FSA.) They can also be registered with FSA UK, but be regulated in their home country. The EEA Authorized status is given to firms that are authorized in another European Economic Area (EEA) state and have been given a "passport" by FSA UK to provide cross border services to UK citizens according to MIFID.

Turkey

Turkey’s regulatory agency, Capital Markets Board (CMB), or SPK -Sermaye Piyasası Kurulu in Turkisk- is quite stringent and not many Forex brokers have been able to meet its criteria and receive permission to operate in the country. In January, 2016, CMB introduced several changes for companies smaller than $6620, limiting maximum leverage to 50:1 for the most popular trading pairs such as EURUSD, USDTRY, and EURTRY and gold; Maximum leverage for other currency pairs was changed to 25:1. For companies larger than $6620, the max leverage for the EURUSD, USDTRY, EURTRY pairs and gold was set at 100:1, with the remaining currency pairs seeing a cap of 50:1 leverage.

Australia

The regulation of retail Foreign exchange has been in the hands of ASIC (The Australian Securities and Investment Commission) since 2006. Brokerages operating in Australia must hold an Australian Financial Services license and the Australian regulator lists a number of criteria for firms wanting to acquire an AFS license. The requirements are pretty stringent and it is generally agreed that ASIC does a good job at protecting Australian clients.

Russia

Russia and other CIS countries currently do not have a regulatory framework for the provision of certain over-the-counter financial services, such as Spot FX and CFD trading. RAFFM, the Russian Association of Financial Markets, is just one of the many self-regulatory organizations that have been set up to try and reassure customers when dealing with unregulated brokerages who have a strong presence in the region. RAFFM has only four member companies making it one of the smaller self-regulatory organizations (CFRIN is considered the region’s premier self-regulatory organization) and does not have a strong reputation, with many criticizing the neutrality and usefulness of the organization. However, the Russian government is working on regulating the provisions of retail FX and CFD trading in the country, which would put an end to companies basing themselves offshore and using self-regulatory organizations to coffer legitimacy, at least in Russia.

Israel

The last few years have seen an increase in Forex and CFD trading in Israel and the country’s financial markets regulator, the Israeli Securities Authority (ISA) has been introducing new regulatory stipulations in order to tighten reporting, provide transparency, limit leverage and other aspects required by Forex operators in other countries. New regulations have gone into effect just recently that introduced important protections and that help bring Israeli regulation in line with regulatory definitions elsewhere in the world. In addition, firms currently regulated in other jurisdictions will be required to gain an ISA license if they want to solicit clients based in Israel.

Beware No-Regulated Brokers

For a retail Forex trader, the biggest risk of non-regulation is that of illegal activity or schemes. Fraudulent activities include excessive commissions generated by “churning” customer accounts, high-pressure “boiler room” tactics, Ponzi schemes and misrepresentation.

Although good regulation removes the likelihood of illegal activities occurring, it does not guarantee that a broker will be totally honest and above board. Keeping an eye on your broker is necessary with any account anywhere in the world.

Cina Coren
Cina Coren is a former Wall Street broker and financial advisor. She holds a Master's degree in Communications and spent many years writing for international news outlets and journalistic publications. Today, Cina spends most of her time writing internet articles and blogs, and reading various newspapers to stay on top of the news.

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