The record fines recently handed down to global banks for alleged manipulation of foreign exchange rates and front running of customer trades may seem like par after similar allegations for LIBOR and other benchmark rates. One might conclude it’s just another story about Wall Street excess and regulatory failures observed during the financial crisis. However, since these allegations are coming after regulators implemented the key provisions of Dodd-Frank, they probably won’t be the last shoes to drop.
For those fighting in the trenches, enforcement actions in forex markets are not news. As then-Chair of the Commodity Futures Trading Commission (CFTC), I testified before Congress in 2004 that retail forex had become the “fraud du jour” at that time, owing to the expansion of the internet and the decline in the dollar. We brought nearly 100 enforcement cases and levied over $1 billion in fines for alleged forex fraud, but lost a key court decision in CFTC v. Zelener. That decision rejected CFTC regulatory authority that had been granted by Congress in 2000 and put CFTC efforts to assert jurisdiction in the forex markets in limbo. While legislation in 2008 and the Dodd-Frank Act in 2010 reaffirmed CFTC jurisdiction in the retail forex market, regulatory efforts have focused on post hoc forex enforcement actions, and have not addressed the need for market standards to ensure transparency and curb questionable dealing practices at play in the retail forex market.
The central problems in retail forex stem from conflicts of interest between forex dealers and customers under the traditional “dealing desk” trade execution model. In the dealing desk model, the “house” acts as its customers’ sole counterparty and internalizes most of its clients’ trades, meaning that the customer’s loss is the house’s gain, and vice versa. This inherent conflict of interest results in a zero-sum competition between the house and the customer, incentivizing self-dealing and questionable dealing practices, such as customer profiling, excessive requoting, quoting off-market, and stop hunting.
Obstacles to price comparisons and price discovery for customers
Such dealing practices are exacerbated by the information monopoly inherent when the house acts as the sole price provider for its retail clients, and generally reserves the right to quote prices that are not derived from overall market supply and demand or referenced to any benchmark. Some dealer platforms engage in customer profiling – quoting different prices to different customers – to target less sophisticated customers. These market structures, combined with the lesser sophistication and experience of retail forex customers, create obstacles to price comparisons and price discovery for customers.
Retail forex has grown markedly since the early days of the internet when bucket shops proliferated and enforcement was the only recourse. Increases in capital requirements and limits in leverage have helped build a stronger industry where fraud and sales practice violations have decreased markedly. Electronic communication network and straight-through processing trade execution models used by some platforms level the playing field for investors and can eliminate the inherent conflict of interest – but these practices are not regulated in forex as they are in other markets.
As an economist, I am not known for a penchant for micromanaging markets, but the retail forex market has been an Achilles heel for too long—it is ripe for regulatory actions that adopt trading rules at least as strict as those imposed on every other asset class. The conflicts of interest inherent to many retail forex dealer platforms’ practices would draw immediate scrutiny in equity markets under National Market System regulations or in derivatives markets under Dodd-Frank regulations—indeed, the retail forex market’s trade execution opacity runs counter to rules and norms in all other major financial markets.
Counter to rules and norms in all other major financial markets
These rules and norms have developed in other financial markets because of the proactive initiative taken by their regulators in setting market standards. A good example for retail forex regulators to imitate would be that of the Municipal Securities Rulemaking Board (MSRB), the self-regulatory organization for municipal securities dealers. On Dec. 8 of last year, the MSRB announced that it had submitted a rule to the Securities and Exchange Commission (SEC), which the SEC subsequently approved, establishing strict best execution rules for dealers working with unsophisticated retail customers in the market. The rule was designed to enhance the transparency, fairness and price efficiency of the market with detailed but narrowly-focused requirements, which maximized customer gains while minimizing costs to the industry.
The retail forex industry’s self-regulatory organization, the National Futures Association (NFA), could similarly submit a well-designed rule to the CFTC for approval, demonstrating that industry groups recognize the importance of getting ahead of the curve. In the absence of NFA initiative, the CFTC could issue its own rule establishing transparency and execution standards for retail forex.
Regulators have failed to reach far enough
Regulators should proactively set transparency and execution standards to bring the retail forex market up to the standards set in the equities, fixed income, and derivatives markets. Retail forex dealers should be required to display third-party price quotes to all customers equally and without modification, so that investors can compare prices accurately, without delay, and without discriminatory treatment. For example, regulators could encourage price competition by requiring dealers to provide at least three independent price quotes to determine the best available price to fill customers’ orders—just as banks are required to in swaps markets.
Finally, regulators can improve the fairness and transparency of the retail forex market by requiring that retail forex dealers publish order handling rules that are fair and transparent to consumers, instead of the trade execution black box that customers often face today. This way, customers can know precisely what to expect in order execution, and regulators can hold dealers accountable to their own published rules.
While recent enforcement actions in the headlines are not focused on retail forex transactions, regulatory action in retail forex will make a real difference for investors. With the shift in the new Congress, many are looking for an opportunity to roll back regulatory overreach—but on retail forex, regulators have failed to reach far enough. Regulators should not miss the opportunity to get ahead of the curve and implement basic transparency and execution quality standards to curtail abuses—not just to prevent the next big financial scandal, but to establish basic norms of fairness in the market before one more small investor is taken advantage of.
