This article is written by Ron De Luca who is a senior risk analyst at Mercer Capital Ltd., a NZ regulated forex brokerage.
An unexpected announcement by the National Bank of Switzerland (SNB) to de-peg the Swiss Franc from the Euro caused the Franc to climb approximately 40% in a matter of minutes. Many currency brokers who seemed like solid companies became insolvent or were at risk of regulatory issues due to lack of capital requirements. These companies included FXCM and Alpari. I will explain how the proper risk management of a forex brokerage could have prevented this.
When the SNB made the announcement, many investors that were short on the Swiss Franc received margin calls. Under normal market conditions, the brokerage can exit the trades with their liquidity providers at will. In this case, the market moved so rapidly that the brokers were not able to exit the trade when their clients had margin calls. This led to crippling loses for these currency brokers.
Most STP (straight-through processing) brokerages segregate client funds in one way or another and have an equal amount of money aggregated in the banks providing their liquidity. This event proved that having client funds 1:1 at the clearing banks is insufficient.
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The brokerages that weathered this crisis and came out as industry leaders are the ones that had more than the total sum of their trader equity allocated to the liquidity providers. This is not the regulatory capital requirements which can’t be used by the broker for operations, but rather a percentage of broker’s profits that remains by the liquidity provider. Some brokerages have 2:1 ratios while others have as much as 3:1. In this scenario, the broker will sustain losses in such a drastic moving market, but not enough to seriously affect the operations of the brokerage.
(correction: an earlier publishing of this post erroneously included OANDA with FXCM and Alpari as struggling brokers when in fact they had only suffered losses and weren’t near breach of their capital requirements)
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