WHY I STAY AWAY FROM THE FOREX MARKET.

The real risk is in the decentralized structure of the forex market. If you deal in the regulated markets like stock and futures exchanges, the exchange guarantees the transactions done by members of the exchange. Opposed to this, the forex market is a dreadful OTC (Over-the-counter) market.

In the retail forex market it is entirely possible to deal with an entity that has no financial stability or credibility. Even though you may be paying your money into a Bank of America or HSBC account, your money is part of the assets of this small entity that is operating according to a highly lucrative business plan. There are obvious risks associated with this business.

Your broker is your counter party, in other words, your broker takes the other side of your position. I am sure you already see the problem. If you make money, they lose money. Now if your broker is Deutche Bank or HSBC, you won’t have one moment’s worry about this. But it isn’t. In most cases, the broker is a dotcom start-up technology company with a flair for Internet marketing.

Your broker can’t absorb the risk of you making 100 pips profit while his potential profit is capped by the spread to two or three pips. In the hands of a group of profitable traders, he will go broke, never mind broker, in no time. He needs to offset this risk with his own clearinghouse. This is a complex proposition. Usually the broker will have to shoulder some of the burden (loss - take some of the risk on board and keep it). Are you starting to understand now why some brokers take measures to make it difficult for news traders to make money and easy for everybody to lose money?

Measures like increased spreads, limitations on placing orders, declaring abnormal market conditions around data releases, no guarantees and so on. Allow me to explain to you in figures the risk to your broker’s profitability and thus counter party risk.

Let’s assume it isn’t the largest broker out there and its customers will probably open a few hundred live accounts of all sizes in a month. Most of these accounts will be real Mickey Mouse accounts of a few hundred dollars. From the brokers’ point of view let’s say there are $150,000 deposits this month in easy to get, very small accounts. Below you will see why I say the following: the broker knows exactly what percentage of that money will be in their profit account in a few weeks. Very small accounts have very high turnover. In other words, the broker’s statistics tell him that he has merely by the depositing of these funds already secured a $100,000 profit within the next few weeks. That’s a great feeling in anyone’s books. But now watch how this can turn rather quickly and why the broker needs to manage his risk carefully. He certainly doesn’t want that $100,000 for which he has worked hard and paid dearly (it costs much more to acquire than to retain a customer) to disappear.

A group of traders, unrelated to the newcomers, some with large accounts, zoom in on a data release. Depending on the release they are all going to simultaneously hit the same (buy / sell) button, highly leveraged. Let’s say the value of these intended trades are 25 million GBP (GBPUSD). That is about 50 million USD. They hope this data release will give them 40 – 60 pips on average. Let’s calculate the pip value in order to calculate the aggregate profit they hope to make in three minutes and the loss will be for the broker – their counter party. 50,000,000/10,000 = $5,000. So the broker’s risk is, say 50 pips at $5,000 per pip. That is a cool $250,000 down the drain. Almost two months’ easy money can be lost in the blink of an eye. Would you allow this kind of risk to threaten your money printing machine?

The broker simply can’t offset this risk of being one second late on a huge leveraged loss of tens or hundreds of thousands of dollars. He can’t transfer this risk to anybody at that stage. The liquidity everyone drools about in the FX market simply evaporates and the lack of liquidity like in any market is the reason for wild price gaps and fluctuations. The broker also has a big incentive to mess around by, for example, widening the spreads massively and gunning for stops in order to throw news traders off.

Your real counter party risk is that a small retail broker can become over-extended with these activities and go belly-up. In properly regulated environments, there are disclosure measures that limit the retail customer’s risk in this regard.

And the moral of all this? Counter party risk is pretty low as long as you stay amongst the regulated entities and the brokers manage their risks well, as they tend to do, considering their reaction to, for example, the threat posed by news trading and how they deal with it to protect themselves and indirectly their clients.

Courtesy of “Bird Watching In Lion Country”