New Leverage Regulations: Protection or Discrimination?

Regulatory updates on forex and CFDs leverage added some bitterness to retail traders’ mojitos this summer.

The UK’s Financial Conduct Authority has adopted leverage caps for CFDs ranging from 2:1 to 30:1. Cyprus Securities and Exchange Commission required to differentiate clients by their income level and net liquid assets value.

A maximum rate of 50:1 on most popular pairs can be expected under the new CySEC regulation, but much lower than that on average.

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In other words, a playground with some steep slides gets closed for micro investors. They are being put in a sandpit.

For whom the bell tolls?

Only 5.5% of the forex market is represented by retail traders. However, this small group of market players attracts regulators’ ​disproportionate ​level of attention.

At first glance, it seems that leverage caps are just safety measures taken to protect individual traders ​—​ a plastic baby fork, given to small market players so that they can take part in a big-boys-and-girls feast.

This is interesting though, that higher leverage rate is acceptable for customers with bigger net income or expensive liquid assets. Looks like regulators are worried about the market risks of excessive leverage in relation to both, brokerages and their retail clients.

In 2015, when the Swiss National Bank ​unexpectedly removed the peg of 1.20 francs per euro, the currency rallied 30% versus the euro in just one day.

It resulted in numerous negative balances on forex traders’ accounts and kicked a few brokerages out of business.

​Thanks to Nassim Taleb financiers of all kinds, including large institutions, keep their guard up on “black swans”. The tendency to put the leverage – and, supposedly, risks – under control is obvious. But what is on the other end of the stick?

Liquidity is the new leverage

Numerous authoritative financiers criticize leverage caps as they dramatically decrease market liquidity. Why would that be important?

While regulators focus on balancing the markets with leverage restrictions, the opposite effect might take place as a direct result of such limitations. ​

Charlie Himmelberg, the Goldman Sachs Chief Markets Economist is concerned that HFTs tend to withdraw market liquidity when they’re faced with unexpected fundamental news.

“When that happens, it leaves a greater share of liquidity provision up to human traders, which would be fine if there was still a deep bench with spare risk-taking capacity. But that bench has thinned over the last 10 years”, — he explains.

Putting existing resources to better use

It is indeed difficult to argue the fact that excessive leverage can be harmful for capital. Risk is the other sharp edge of the leverage sword that retail investors raise to cut off their piece of the market pie.

Negative balance protection methodologies are to be applied along with access to highly leveraged transactions, — this is the solution that AAFX brokerage provides to support their decision to keep their leverage up to 1:2000 for their retail customers.

Stacking the large part of the capital on some financial ideas is often the part of the game. ​Stanley Druckenmiller​, the billionaire hedge fund manager, admits: “Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage.”

Such a view on financial markets’ risks may be the subject of criticism but isn’t it time to admit, there is a constant demand for a high level of leverage among retail customers. They want their silver cutlery instead of a plastic fork that regulators want to palm them off with.

For some of them leverage is a chance to significantly and quickly increase the initial small deposit that they don’t really mind losing in case their trading decisions are not correct. For others, access to highly leveraged trades can be a part of a strategy.

As an example, one can be using leverage to open numerous positions simultaneously, which can, in fact, diversify risks on small-sized accounts.

Moreover, the desire to have access to increased leverage does not necessarily mean that a trader is planning to use it in full until the statistical probability finds its way to prove you can’t profit on 100% of the trades.

Even the most severe opposer of leverage Warren Buffet tones down his criticism when it comes to profits. ​Berkshire Hathaway is known to be ​leveraging its capital by as much as 60% which results in outsized returns.

It is difficult to argue with one of Buffett’s famous quotes: ​“When you combine ignorance and leverage, you get some pretty interesting results.” On the other hand, would that be correct to assume ignorance is a necessary attribute of a retail forex trader? If not, then why regulators keep working on leverage limitations as if it was?

Disclaimer: The content of this article is sponsored and does not represent the opinions of Finance Magnates. 

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