Regulation Plays a Major Role in FX Trading
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.
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.
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.
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’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.
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 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.
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.