The following is an excellent article from the January 26 – February 1, 2015 issue of Bloomberg Businessweek written by David Evans on page 40 titled “Foreign Exchange: Leverage Cripples a Currency Broker” and I quote:
“Leverage Cripples a Currency Broker”
Photographer: Ben Hider/NYSE Euronext via Bloomberg
Drew Niv, founding partner and chief executive officer of FXCM, center, attends the opening bell ceremony at the New York Stock Exchange on Dec. 2, 2010.
Drew Niv built his brokerage firm, FXCM, into a profit machine by turning the global foreign-exchange market into a playground for day traders. Using leverage to amplify their bets, customers could profit from even minuscule currency moves. Of course, they could lose big, too. Niv was aware of the dangers. “Leverage is the enemy,” he said in a May 2014 interview in his office near Wall Street. “The big move, it’s what kills you.”
The big move just arrived. On Jan. 15, the Swiss central bank abandoned its policy of limiting the value of the Swiss franc to €1.2 and let its national currency float freely. The decision shocked currency markets, sent the Swiss franc soaring, and blew a $225 million hole in FXCM as customer losses mounted. Shares of FXCM plunged as low as 98¢ on Jan. 16 before trading was halted and Niv grabbed a financial lifeline from Leucadia National, owner of the investment bank Jefferies Group. Leucadia will earn interest of as much as 17 percent on the $300 million loan and can force a sale of the brokerage, keeping at least half of the proceeds beyond the loan amount, FXCM said in a Jan. 19 statement.
FXCM’s reversal of fortune has laid bare the risks the brokerage and its more than 230,000 customers were taking. For most individual investors, trading currencies is a fool’s game. About 72 percent lose money, according to the National Futures Association. Until now, FXCM tended to win even when its customers lost—partly thanks to commissions, and partly because it often takes the opposite side of client trades. In disclosure statements mandated by the U.S. Commodity Futures Trading Commission, customers are told in capital letters, that “WHEN YOU SELL, THE DEALER IS THE BUYER. WHEN YOU BUY, THE DEALER IS THE SELLER.” The statement continues, “As a result, when you lose money trading, your dealer is making money on such trades.”
“They want to trade as a hobby and often aren’t allowed to trade at work. FX, you can do it in the middle of the night, you can do it after dinner.”—Drew Niv
The danger for the broker is that customers can lose more than they have in their accounts—thanks to leverage. Leverage usually refers to using borrowed money or derivatives to magnify bets. In the foreign exchange market, it means that traders can choose to wager on the movements of large amounts of currency even if they don’t have enough cash in their accounts to cover potential losses. In the U.S., the CFTC allows leverage of 50 to 1. Most of FXCM’s customers are overseas, where regulators allow leverage of as much as 200 to 1. Using 200 to 1 leverage, someone with $1,000 in an account who thinks the dollar will increase against the yen can make a $200,000 bet. If the dollar appreciates by 2 percent vs. the yen, the trader earns 2 percent of $200,000, or $4,000. If the dollar falls 2 percent, the trader loses $4,000—more than the entire value of the account, and the broker could be out $3,000.
FXCM’s woes were amplified by a curious policy: When investors lose more than they have in their accounts, it doesn’t try to collect. As the company says on its U.K. website, “Is there a debit balance risk? Can I lose more money than I deposit? Not with FXCM. It is FXCM’s policy to credit accounts to a zero balance when debit balances occur as a result of trading.” Such leniency is not universal in the industry. Interactive Brokers Group says that several of its clients ran up negative balances after the Swiss franc move. Chairman Thomas Peterffy says the company will seek to recover those funds from its clients. He is puzzled by FXCM’s policy. “When you say on your website that you’re not going to collect any losses in excess of deposits,” he says, “then you’re basically providing a guarantee against loss.” Niv and FXCM didn’t respond to requests for comment.
Niv described FXCM’s typical client as a male, white-collar professional age 35 to 60. “They want to trade as a hobby and often aren’t allowed to trade at work,” he said in May. Unlike the stock market, the currency market allows for online trading 24 hours a day, five days a week. “FX, you can do it in the middle of the night, you can do it after dinner,” he said. And they’re an optimistic bunch. Aite Group, a consulting firm, surveyed individual foreign-exchange traders in 2011 and found only 11 percent expected to lose money. Forty-one percent expected to earn monthly returns of more than 10 percent.
In an effort to keep such players from getting in over their heads, the National Futures Association has banned the use of credit cards to finance currency trading in the U.S., effective Jan. 31. According to FXCM’s 2013 annual report, 29 percent of its customers worldwide used plastic to fund their accounts. And leverage remains a powerful force in this market. On Jan. 20, with the aftershocks from Switzerland’s shift still reverberating, FXCM’s U.K. website said the company was still offering customers leverage of as much as 200 to 1.
The bottom line: FXCM was forced to borrow $300 million after clients using leverage of as much as 200 to 1 were hit by the Swiss shock.