Just as foreign currency trading is on the verge of going mainstream, regulators say they are preparing to launch an investigation into whether foreign exchange firms are using unfair trading practices to take advantage of retail investors.
In two weeks, the National Futures Association – a self-regulatory body that polices the futures industry much the way Finra oversees the brokerage business – says it will begin analyzing trades executed by its 16 member forex firms. The regulator will search for signs these firms are designing computer systems to take advantage of what's known in the industry as "slippage" – small price movements that happen between when a customer orders a trade and when that trade is actually executed. While some slippage is normal (currency prices naturally fluctuate 24/7), the NFA will be looking to see if trades are being executed only when the currency price moves in the firm's favor. This would indicate a firm may be violating NFA rules mandating fair business practices, says spokesman Larry Dykeman. The group can then assess fines, and in some cases may suspend or expel a firm from membership in the organization.
The investigation follows after the NFA issued two complaints in October against Ikon Global Markets and GAIN Capital, accusing both firms of taking advantage of slippage at their clients' expense (These complaints are internal matters, not lawsuits filed in a court.) Both firms settled without admitting or denying the allegations, according to the NFA: Ikon paid a $320,000 fine to the NFA and has stopped offering retail FX trading to U.S. clients; GAIN, which paid a $459,000 penalty, went public in December. A spokesman for Ikon declined to comment. A GAIN spokeswomen said the trades in question accounted for only .05% of its transactions, and that the company will continue to review its operations to ensure that "the interests of our clients and partners are fully protected."
Slippage is a slippery issue, and for individual investors, it's almost impossible to detect. Here's how it works: Let's say a retail investor places an order for euros at $1.335; he may find that by the time his brokerage firm executes the order, the rate has changed to $1.332. Does the customer get that new, lower price, or does the firm reject the order? Is the firm only executing an order when the price moves up in its favor, to say $1.338, and it can pocket the spread? "The market moves very quickly, and that's accepted," Dykeman says. "What we're looking for is fairness."
The price movements in question are tiny. But because currencies move within a narrow range of prices, and because even retail traders commonly use leverage, a tiny advantage can quickly add up. For example, a trader using 50-to-1 leverage could buy $100,000 worth of euros with just $2,000 in his account. If he placed an order to buy at $1.335, but instead paid $1.337, those euros cost him an extra $20. Within months, such spreads can mean millions of extra dollars for forex firms, experts say.
The probe comes at time when currency trading is becoming more popular for small investors looking for bigger returns. Average daily volume in retail forex trading grew 25% from 2008 to 2009, to $125 billion -- up more than tenfold from eight years ago according to consultancy Aite Group. But news of the industry probe could send those new forex clients in search of safer alternatives. "This is really a black mark for an industry that's trying to establish itself as more of a legitimate business," says Sang Lee, a managing partner with Aite Group.
Both the NFA and the Commodity Futures Trading Commission are also keeping mum about any additional investigations that may be ongoing. But when another forex trading firm, FXCM ( FXCM ) , went public in December, its SEC filings mentioned the Ikon and GAIN cases, and disclosed that FXCM had also been contacted by both regulatory agencies with requests for information about trade execution practices. An FXCM spokeswoman declined to comment by press time.
Regardless of whether regulators find cases of unfair trading, retail investors are still at a disadvantage when trading currency because forex is far from transparent, says Charles Rotblut, the vice president of the American Association of Individual Investors. For example, if a forex firm is acting as a market-maker – taking the other side of a client's trades – it's doubtful the investor is getting the best possible price, he says.
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