26 Dec The Regulation of Foreign Exchange (Forex) Brokers
Given the present climate of economic malaise and seemingly endless stories of malfeasance in the banking sector, one would expect that the foreign exchange market would have been on the regulators’ radar. Yet many foreign exchange brokers have been spared the brunt of regulatory oversight and, with respect to regulation, the global landscape is very much uneven.
Without a doubt, the global regulatory environment has become a lot more stringent in recent years as authorities attempted to take preventative action to avoid the kind of carnage caused by economic crises and bank implosions. The forex market is an obvious target. Due to its attractive returns, the forex market has experienced a massive boom, receiving outsized inflows of capital. This has tempted many institutions to jump on the bandwagon and capitalize on profits offered by a growing market that is additionally a low-cost one. This has in turn attracted the attention of regulatory bodies.
Yet while many forex brokers have taken to those jurisdictions where strong regulatory control confers upon them the much-needed legitimacy sought by forex market participants, other jurisdictions have not kept up with the growing demands of the forex market for stricter regulation.
The situation in Europe and in the USA
Regulators in the US and Europe have zoomed in on the derivative segment of the forex market. In the US, for example, the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 has given the regulators the wherewithal to monitor retail off-exchange foreign exchange transactions. The Commodity Futures Trading Commission (CFTC), which oversees National Futures Association (NFA for short, it is a self-regulatory body for the US derivatives industry), now requires that online forex brokers catering to US-based clients be registered with the CFTC as futures commission merchants. The new registrant as a retail foreign exchange dealer (RFED) has also been introduced.
To respond to the aftermath of the banking crisis and to crack down on unscrupulous operators, regulation has also been strengthened with respect to the way that brokers handle clients’ money. Brokers who wish to operate pooled trades and/or solicit orders must be registered with the CFTC as one of the following four: an associated person, an introducing broker, a commodity pool operator, or a commodity trading advisor (CTA).
In the UK, the regulators have also been on the move. Forex contracts, for instance, have been designated as a derivate product.
The case of Cyprus
The need for proper and sound regulation has also made this island in the Mediterranean an attractive place for forex companies. While Cyprus benefits from its geographic location as well as the low operating costs and attractive taxation it offers to those who seek to do business there, its stellar regulatory environment, buttressed by EU rules and legislation (e.g., the Markets in Financial Instruments Directive – MiFID for short), has been instrumental in attracting forex operators, particularly from the Middle East and Asia. While retail forex trading has grown by leaps and bounds in a number of Middle Eastern countries, industry abuses have forced regulators there to introduce legislation that has hampered the ease of doing business domestically. The regulatory body in Cyprus understands how to balance the need to offer protection to those involved in forex activities with the need of forex market operators to work in an environment that does not, by dint of onerous regulation, deter forex market operators from providing services to clients. For example, it might take as little as three months to obtain a forex license to operate in Cyprus.
Absence of uniformity and clarity in the regulation of the forex market: the problem of different jurisdictions
One of the reasons why it is something of a challenge for forex brokers to obtain licenses in some countries is the lack of a clear distribution of roles in terms of forex market regulation. For example, a number of countries have struggled to determine the body that should be primarily responsible for overseeing the forex market. In Cyprus, for instance, both the central bank and the country’s securities commission have tried to step in, failing to realize that relevant regulation is under the purview of MiFID.
As the market continues to grow and become increasingly complex, the challenges for regulatory authorities will become more pressing still.
In Europe and the US, there has not been much uniformity in forex market regulation. Europe has preferred a top-down approach, introducing general rules intended to filter down and apply to individual situations. The US has been doing the opposite, creating rules for individual situations that then combine together to form a broad regulatory framework. However, in both regions regulation has become stricter and more comprehensive.
Forex brokers also have to reckon with the European Markets Infrastructure Regulation (EMIR), which will widen the scope of regulation for forex market operators. While the full ramifications of EMIR are unclear at this point, there are concerns that higher compliance costs for forex brokers are on the way. In fact, higher compliance costs have already led to a number of companies to seek registration in countries that combine a solid regulatory framework with lower costs, e.g., in Australia and New Zealand. However, even that kind of geographic mobility is becoming more difficult, as both the US and Europe have attempted to increase the scope of regulation beyond national borders. For example, as the over-the-counter (OTC) derivatives market is under the purview of the Dodd-Franks Act and MiFid, forex brokers operating on this market need to fulfill the capital requirements prescribed by the relevant legislation.
In the EU, it has also been possible to provide services in one jurisdiction while being licensed in another, as only anti-money-laundering legislation had a supranational dimension. And while attempts have been made to make legislation in the EU more uniform, the interpretation of such legislation has varied from country to country, as the authorities have tended to allow national rules to supersede the supranational ones. These variations are also a factor of the ability and experience of a given regulator to meet the challenges and complexities of a burgeoning market that is constantly in flux. Generally, obtaining a license in a country with a sophisticated regulatory body, though it might involve much red tape, has tended to make it easier to operate in other EU countries as well.
The Asian situation
Retail forex trading volumes have ballooned in Asia. The regulatory landscape, however, is patchy. Hong Kong and Japan have a strong regulatory environment. This owes much to the fallout from the banking crisis; in particular, the bankruptcy of Lehman Brothers, which has despoiled a number of local investors, has led to a growing need for tougher regulatory control. Since then, Hong Kong, Singapore and Taiwan have been working to improve the existing regulatory framework of the forex market with a view to protecting investors in the future. The experience of the debacle has made both regulators and forex market operators warier.
Forex brokers that have obtained the necessary licenses in top-notch jurisdictions (e.g., in the US or the UK) have an easier time obtaining licenses in Asian countries, especially if they come armed with good reputations.
While the fundamental requirements of regional regulators are identical, actual rules depend on the country. The regulatory environment is very strict in Hong Kong and Japan (the capital requirements for obtaining the so-called Type 3 license in Hong Kong are exacting), but Taiwan’s rules governing the forex market are known to be complex and hard to navigate – at least, for foreign operators. Thailand, on the other hand, has recently introduced sophisticated yet transparent legislation. Considering that the retail forex market shows no signs of slowing down, the need for greater regulatory oversight is likely to accelerate in the future. For forex brokers operating in Asia, as in the most sophisticated jurisdictions such as the US and the UK, this will entail meeting the costs associated with proper compliance and disclosure, handling of data, and the fulfillment of all capital requirements.