An Overlooked Key to Trading Success

06/12/2013 6:00 am EST

Focus: FOREX

Forex traders devote a lot of time and energy learning and perfecting their trading strategies, but there's one more component of successful trading to which they should also pay attention, notes the staff at ForexTraders.com.

On a very average morning in March, many currency traders across the globe woke up to find their account balances frozen with little in the way of explanation as to why government officials had seized the two largest banks on the tiny island community of Cyprus. If you had an account with one of the 80 forex brokers set up to do business there, then you might have been impacted, if your broker had not segregated client deposits overseas with Tier-1 banks for safety.

Before you breathe a sigh of relief, many of these brokers were headquartered in other jurisdictions, choosing to operate their back offices on this welcoming island, where tax incentives and a lax regulatory environment were the major draws. Back in the United States, the National Futures Association (NFA) was reeling from $1.6 billion and $200 million in client deposit losses, respectively, from MF Global and the Peregrine Financial Group. In both cases, the management had combined client monies with operating funds, but in the latter case, the CEO had actually falsified daily reports back to regulatory authorities. The NFA has now implemented a daily electronic deposit verification system.

In each of these instances, best business practices were not followed. When client accounts are segregated from operating funds, they typically cannot be attached by creditors or seized by government officials. They generally receive special treatment, as “funds held in trust.” If Tier-1 banks that are very safe from a capital adequacy standpoint hold the funds, then you are much better off. If those banks happen to be in a developed country with stringent regulatory oversight rather than in some overseas tax haven, then your broker has your best interests at heart.

Why would a broker violate this “segregation” best business practice? To begin with, brokers, hedge funds, and investment banks are not commercial banks. Commercial banks can use customer deposits as collateral to borrow from their central bank, but these other three types of firms cannot. They typically leverage up or borrow on a short-term basis, using operating cash and invested capital as collateral. Under these conditions, the temptation is great to commingle funds, especially if the firm trades a great deal for its own account. This practice was also present to a degree when Lehman Brothers and other investment firms collapsed, preceding the Great Recession.

What are a few advanced tips to consider when choosing a forex broker or any broker for that matter? Here is a brief list:

  • Stay Domestic: Foreign brokers are more flexible and go to great marketing lengths to gain your favor, but dealing overseas is a nightmare waiting to happen. Most foreign brokers will no longer accept US clients, due to new registration, compliance, and reporting requirements. If you must, stay close to London, the center of the forex market;

  • Segregation Should Be a Must: Now is the time to ask a few penetrating questions of your broker. Where does he segregate your deposits? At what banks? Where are his operations? Who is liable for counterparty risk? If you get hesitation or the runaround, then draw your own conclusions;

  • Check for Capital Adequacy: The Commodity Futures Trading Commission (CFTC) publishes a table of registered brokers and their capital positions. It is easy to detect which brokers are safer than others;

  • Regulatory Oversight: Good regulators are your friends. Without them, why would you have any confidence in brokers from another locale?

Investing overseas, especially in foreign exchange, is high risk, and it starts with your choice of broker. Choose wisely and always monitor afterwards!

Further reading about forex brokerage information can be found at ForexTraders.com

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