As the retail forex and CFDs industry is awaiting the August 1st deadline for the implementation of the new regulatory rules mandated by the ESMA, the levels of uncertainty about what is to come are at unprecedented levels. Companies have been attempting to quantify the impact of the new regulations and model client behavior, but this herculean effort has proven to be very difficult.
Brokers have started to work on the ways in which they will use to tackle the new regulatory framework. While some market players have been actively looking for ways to move clients, offshore others have committed additional capital for M&A and new technology to gain a market edge.
While it is difficult to ascertain the impact of all variables stemming from the new ESMA regulations, some research related to the variation of forex brokers client behavior exists. Dr. Demetrios Zamboglou has advocated a quantitative approach to taking regulatory decision for some time now. Whether or not any science has been involved into the process which led to the drastic measures taken by EU regulators, the Microsoft-funded research of Dr. Zamboglou is at the core of his opinion on the matter.
How do you think that the brokerage industry will overcome the lower levels of leverage which the ESMA will mandate starting from August?
Retail foreign exchange (FX) brokers have been offering margin products to retail FX clients since the Internet made online trading possible. Contracts for Difference (CFDs) were created to allow FX brokers to incorporate leverage into the trading of various asset classes in order to make trading more accessible to a retail audience. They are simple contracts that can bear huge risks depending on the state of the market given a multiple.
The rationale that retail FX traders are prone to taking on higher leverage is based on the fact that leverage allows traders to open larger positions than their initial investment can support. Leverage offers traders the ability to increase their return but also to increase the level of risk in his or her trading portfolio – in other words, a higher risk for a higher reward.
The mathematics behind leverage is simple:
For every 1 unit of notional currency you deposit into your account you are allowed to purchase multiple times your original deposit. For example, a leverage of 100:1 gives a $100 account the ability to open a trade with a nominal value of $10,000. An account with a leverage of 500:1 facilitates a trade of $50,000.
Most brokers offer a range of leverage settings – most often brokers offer 500:1, 200:1, 100:1 but the most highly regulated brokers in the United States (US) and Japan, leverage has been set as high as 50:1 from of October 18, 2010, while Japan has a maximum leverage of 25:1 from August 2011 (as deemed necessary by local regulators).
Now, almost eight years after the US ruling on leverage, the European Securities and Markets Authority (ESMA) has decided to enforce stricter rules than those of the US on investment firms operating in the European Union. More specifically, ESMA is proposing a maximum leverage of 30:1, but not only that, the regulator has proposed to vary leverage in relation to asset volatility with leverage on some asset classes being set as low as 2:1 without any statistical or empirical explanation regarding the choice of leverage settings. It seems rather arbitrary and done without empirical study.
What has changed? Can retail FX brokers survive this leverage change?
Regulators are making the case that the new rules are being put in to protect FX and CFD traders, but many critics are claiming that these rules could put the majority of European FX brokers out of business.
The pivotal question for the future of the industry is whether an equilibrium can exist among brokers, traders and regulators.
Tell us more about your research into trading behavior which was also financed by Microsoft with a grant?
The Microsoft Grant will allow me to examine the relationship between traders and brokers within foreign exchange as an asset class, as well as how traders can maximize their ‘utility function’ whilst allowing the brokers to make sufficient margins to enable them to thrive as commercial businesses. Another key point of the investigation is assuming that brokers and traders are in equilibrium, where part must the regulators play to also fit in and maintain such an equilibrium.
For starters, let us first understand how the three participants can thrive and what are their aims are when operating in the industry:
- The brokers want to make enough money to cover their operational costs
- The regulator wants to have no complaints from customers and the general public
For the above to be achieved, the trader needs to:
- Understand the product he is trading, i.e., short-term, long-term as well as the risks
- Know that he is trading the best available price
- Have certainty that his account and deposit are protected
Translating the above questions in a hypothesis setting, I am able to obtain the following answers:
- Retail FX traders are intraday traders. Their trades occur within one day and the results validate this answer.
Retail FX traders like to use margin. The average margin utilization is around 35 percent of their net deposit and in my sample that accounts for an average leverage up to 70:1. So retail FX traders like to be engaged in margin operations when they trade FX.
In my sample, retail FX traders like to trade mostly EUR/USD with more than 60% of all trades occurring within EUR/USD.
Retail FX traders are engaged in intraday trading activity that is highly leveraged. One might argue, that these kinds of investments should only be advertised as short-term investments – so any advertising should make it clear that CFDs on FX are suitable for intraday traders.
For the regulator to be compliant with such kind of behavior, instead of having a risk warning that looks like the following:
Risk Warning: Your capital is at risk. Leveraged products may not be suitable for everyone. Please consider our Risk Disclosure.
The message should revert to something like this: Risk Warning: FX Leverage products are suitable as intraday investments. Losses can be greater than initial deposits.
The average retail FX trader is using 70:1 and now we would like to offer him something less, i.e., 30:1. In this way, he will never be able to achieve his optimal. One would understand the regulator protecting the retail FX investor such as closing positions early and not understanding the true nature of volatility.
Let’s take a closer look at volatility within the EUR/USD example dataset. On average on any given day the EUR/USD volatility is around 50 pips. Intraday traders should be able to manage a 50 pips movement on a given day. In practical terms, with an account balance of €1,000 and a leverage setting of 70:1, the trader can place a EUR/USD position with a value of €70,000.
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Working with the above 50 pip volatility assumption, he or she can lose 350 USD (7 dollars per pip x 50 pips). The reason that the EUR/USD is the most popular product is the fact that this the gateway for the Americas to trade with Europe and according to Bank of International Settlement (BIS) this accounts for in excess of 25 percent of the overall market.
How do you think a broker’s bottom line will suffer as the new leverage rules kick in?
As a rule, 75 percent of all traders lose money when they engage in retail FX trading, and my research is validating this result. My research shows that the winning traders account for only 22.7 percent of the entire sample. If now we are changing the leverage parameter this will influence two things:
- the average profitability per retail FX trade
- retail FX traders will have longer account longevity.
As a result, the Q1 2016 Retail Foreign Exchange Dealers (RFEDs) show that traders are to be more successful 32.5 percent of the time. The profits are skewed but still remain under 50 percent, which makes sense if you take into consideration spread and overnight position fees that account for 10 percent when trading FX margin products.
To investigate profitability in a retail FX broker, we take the following assumptions:
Assumption 1: Retail FX brokers make profits in excess of $100 per million (warehouse)
Assumption 2: Social FX brokers make profits in excess of $40 per million
Therefore, a retail FX Broker makes on retail trading a profit in excess of 100 USD per million and when it comes to social trading a profit of approximately 40 USD per million, making social trading the harder model from the two to survive (including marketing budget and operational costs).
If we now compare these results with US-based brokers, according to spread charges US brokers will make a profit somewhere in the vicinity of $60 per million, operating in a highly regulated environment that requires large operations costs and extensive restrictions in marketing capabilities.
The result shows that after the Commodity Futures Trading Commission (CFTC) announcement only 4 brokers managed to survive in the US and in accordance to the latest report the US brokers and in accordance to US retail futures commission merchants (FCM) assets are to be the following: Gain Capital, Oanda, Interactive Brokers and TD Ameritrade.
Therefore, a simple answer according to financial mathematics is ‘Yes’ – retail FX brokers will suffer greatly (as they have done in the US and Japan) and they will see this impact in their profitability.
How does a trader’s lifetime stretch over time when using different leverage levels?
The more leverage a broker offers, the larger the volatility (or risk) a trader can be exposed to. Since this is a restriction on risk, it will also be a restriction on profits.
In other words, traders will trade with smaller positions for longer amounts of time hoping that they will capture the returns they desire. The problem here is that the products they are predominantly trading (CFDs on FX) are not designed for intraday trading.
By decreasing the leverage amount, it will allow traders to hold positions in excess of a trading day where the typical behavior lies. So, the expectations will remain the same, but the trading horizons will increase beyond intraday.
Without any modeling being required the retail FX traders will try to capture the same profits, but it will take more than a day since the new rules will not allow them to capture the profits they are seeking. The new rules do not allow them to trade on average as they want so the risk-reward function will be reshaped.
According to my research, the impact on volatility and its dynamics is an exogenous fact that when it comes to trading skill, it affects trading performance. The reason is that trades do not account for market volatility when they build their trading models, i.e., do not consider extreme movements and focus more on the average when they model. On the other hand, what I found is that as volatility becomes seasoned traders learn to incorporate these volatility extremes in their new trading decisions (with seasonal volatility).
How do you think the market making brokerage model will suffer from the changes in leverage rules?
The market making model requires brokers to warehouse risk. This means the brokers benefit when the traders lose even if the broker is operating an STP (Straight Through Processing) model. Under this model, the counterparty that received the trade still benefits if the trader is unprofitable when trading the position.
Taking the US-based 50:1 leverage model as an example, profitability is almost half of what it used to be in Europe – which is a clear indication of brokers’ operations being detrimentally affected by lower leverage regulations.
If leverage is lowered to 30:1, monthly profitability is likely to be drastically reduced at European-based brokers, unless the trader trades excessively and the broker ‘normalises’ or offsets these lower earnings upon the end of the trader’s trading activity, i.e., if or when the trader loses his deposit.
So, it will make no sense to warehouse risk unless you have a strong Quantitative Team that will be able to analyze trading flow and decide when to ‘offset the flow’ or ‘segregate the flow’; hence enhancing the profitability. Although this may sound straightforward and relatively simple, hiring quantitative analysts to manage dealing desks is not a common occurrence in retail trading operations.
In my personal experience, I have only seen less than 1% of firms actually doing this in practice with such quantitative modeling usually outsourced to hedge funds, liquidity providers or specialist risk management solutions provided by top-tier banks. Such solutions often include a firm fee structure which can often deter many brokers or makes this option non-viable unless the flow is sufficiently high to warrant the added quantitative analysis.
If warehousing risk is not tended to with an appropriate team or overarching solution, the broker is likely to attract more skilled traders, and therefore, experience inconsistencies in profitability (month by month profits defer, high profitable months vs. highly unprofitable months).
As a result, profitability is likely to be undermined which in turn reduces the marketing budget and lead to fiercer competition for clients. On the client side, higher deposits will be required to maintain the same level of trading activity which further dampens profitability amongst FX brokers.
As food for thought, I believe that retail FX brokers should expand on cryptocurrencies if they want to survive but be extremely careful if they choose to warehouse risk since cryptocurrencies have the tendencies to move directionally to greater degrees than equities or FX.
In some respects, retail FX brokers have been left with no choice – they must adapt and widen their modus operandi to better account for risk, as well as, include new assets such as cryptocurrencies into their product offerings. If they fail to do so, they will struggle to survive.