Let me ask you something. Suppose one day you decided that you wanted to get a tattoo (see Tattoo Regret: Why The Majority of Middle-Aged Americans Are Deciding to Blast Away Their Ink) and you went to a tattoo studio. And the next day you regretted your decision, and decided to get it removed from a laser clinic. Now my question to you is if you found out later that I own both the tattoo shop as well as the laser clinic, do you think there is anything wrong with that?
In my admittedly very small sample size, people said no. It was they who decided to get the tattoo, and it was they who decided to get it removed. But I argued with a twinkle in my eye, what if I knew from experience that you were more than 80% likely to regret getting a tattoo, and will want it removed soon after, would I still be wrong? And does it bother you that I am making money twice from you on essentially the same product--the first time to put it on your body and the second time to remove it? It’s fine. It was still my decision both ways they explained. And does it matter that I didn’t tell you that I own both businesses? No, it doesn’t matter.
While I am not about to get a tattoo (I am too rational for that), I am pondering this due to the most recent shattering news in the US retail forex industry that FXCM, the largest US retail forex broker, is exiting the business in the US because their co-founders have been fined $7 million and barred by the CFTC for misleading their customers. Click here to read the CFTC’s order filling.
In the press release, the CFTC explained that “FXCM engaged in false and misleading solicitations of FXCM’s retail foreign exchange (forex) customers by concealing its relationship with its most important market maker, and by misrepresenting that its “No Dealing Desk” platform had no conflicts of interest with its customers.”
So why were the co-founders fined 7 million USD and asked to forever withdraw from registration by the CFTC? Did they steal money from their customers? No, they did not. First, FXCM did not disclose the relationship of their market maker to the regulators (NFA). And second, making matters worse, they misrepresented their “No dealing desk” platform to customers when in fact the majority of their trades went to a related market maker. In simpler words as noted by the CFTC, their actions were defrauding their retail forex customers, which is a very serious matter. This is very different case than in the tattoo illustration, where it doesn’t really matter if I own both the laser shop and the tattoo shop. But in the financial world, any deemed conflict of interests must be declared openly to both the public and the regulators.
The obvious question you might ask is why does FXCM want to send their “no dealing desk” orders to their own market maker? Similar to my imaginary tattoo shop where I have “prior knowledge” that most people will regret getting a tattoo and want to have it removed, FXCM knows that most retail trades will be losers. With this knowledge, I can thus set up a laser tattoo removal shop, and brokers can thus choose to take the other side of the trade and most likely win. Is it wrong to take the other side of the trades when they have profited once from the commission of the trade? Is it wrong to set up a tattoo removal shop when I already make money from you inking tattoos on your body? It is not. Does it sound strange though? Yes, it does.
My silly tattoo shop is quite a primitive parallel example to the forex business, and there are many holes to poke at the comparison. For example, in the tattoo/laser shop example, both times the customer chooses the decision, verses in the case of FXCM, customers did not choose to have their trades sent to the related market maker. I am writing this because I think it is important as both investors and people in this industry to be made aware and to think about our fiduciary duties to whom we serve.
In forex, most retail investors lose money. (Reference FXCM and OANDA’s Profitability Analysis.) Why? The reasons are many, but one important factor we cannot ignore is that unlike stocks, forex is highly leveraged (e.g. 50:1). So if you win, you win big. In the same fashion, if you lose, you lose big. The financial business is really like no other. We are in the risk vs. return business. We are not selling you a car for you to drive or a product which you consume. Instead, we are selling you an adventure which guarantees you nothing except uncertainty. Customers are given access to trade products with different risk vs. return profiles, while we the firm chooses which customers to onboard with the same unwritten rule of risk vs. return considerations. One might therefore conclude that due to the “variability” of what a customer might get from any financial services, especially a highly leveraged product, from winning big to losing his pants and somewhere in between, an independent regulating body plays an important role to make sure that all the parties are playing according to the rules and that it is a fairly level playing field. I know people in the industry like to whine about the current overregulated environment, and it is true that extreme regulation will make everything come to a standstill, but I am sure all of us will agree that some regulation is important for the marketplace.
I was talking to a friend who was originally from China and moved to the US for several years, who made good income from trading forex. I asked him why he traded in forex in the US, and why he didn’t open an account in China instead. He said that it is because he fundamentally believed that the US government/regulators would always do the right thing and he trusted them. They may not get it right at first, but it would be always good in the end. That says a lot doesn’t it?
RISK DISCLAIMER: Trading in futures products entails significant risks of loss which must be understood prior to trading and may not be appropriate for all investors. Past performance of actual trades or strategies cited herein is not necessarily indicative of future performance. The information contained herein is provided to you for information only and believed to be drawn from reliable sources but cannot be guaranteed; Phillip Capital Inc. assumes no responsibility for errors or omissions. The views and opinions expressed in this letter are those of the author and do not reflect the views of Phillip Capital Inc. or its staff.