Backgrounder: FOREIGN CURRENCY EXCHANGE (Forex/FX) Trading
March 29, 2012
Staff of the members of the Canadian Securities Administrators (CSA) have identified an increase in foreign exchange (Forex/FX) trading services being offered to investors in Canada, by both Canadian as well as foreign firms.
The CSA is warning investors against dealing with unregistered firms offering Forex investments and alerts investors to the significant risks involved in Forex trading.
Forex trading can be extremely risky. Investors are advised to get expert advice from a registered professional before participating in Forex trading or purchasing a Forex-related investment.
What is Forex?
Forex, FX, or foreign exchange is essentially the trading of foreign currencies. Forex is usually traded as matched pairs in lots of 100,000 (standard), 10,000 (mini), or 1,000 (micro) units of a base currency. Each of these lots is traded as a Forex contract, which is a binding agreement to buy or sell a set amount of a particular currency in exchange for another.
What is the Forex market?
The Forex market is a worldwide market for the buying and selling of currencies.
Forex trades at a market price determined by supply and demand at the time of the transaction. The bulk of Forex trading is between institutions (banks and other large financial institutions) on the “interbank” market. Retail investors typically trade Forex through the over-the-counter markets created by those with direct access to the interbank market. In the over-the-counter market brokers and dealers negotiate directly with each other to determine the relative values of different currencies.
A Forex contract will typically settle (i.e. require the physical exchange of currencies) two working days after it is made. Since most currency trades are speculative and traders do not want to actually take delivery of the currency, dealers often automatically “expire” open positions (existing Forex contracts) at the end of each week day and move the settlement date of the Forex contract forward two more business days (i.e.). In Canada, this process, known as the “rollover”, takes place at the end of each trading day, around 5:00 P.M. Eastern Time.
Forex Dealers vs. Forex Brokers
Forex dealers quote the investor a price at which they are willing to provide a particular currency (i.e. enter into a Forex contract). Dealers essentially make their money through spreads and fees. Dealers may deal with investors directly or through brokers, or both.
Forex brokers may serve as agents for investors in the Forex market and, in some cases, try to find the best price in the (Forex dealer) market for an order. Forex brokers usually make their money by charging a commission or mark-up fee on the price of the currency obtained from a Forex dealer.
Use of Trading Platforms
Most dealers provide electronic trading platforms – usually online – as a means through which investors can directly complete their trades. Some brokers may promote a particular dealer’s platform, and rely on the dealer’s management of that platform for trading, while retaining some form of advisory role to the investor (these are referred to in the Forex industry as Introducing Brokers or “IB’s”).
What are the risks?
No matter how it might be marketed, Forex trading is complex, volatile, and highly risky. Political or economic events, market psychology, as well as other factors, can all affect currency prices. Success in speculating on how these factors influence a currency’s value requires an expert’s ability to monitor and interpret complex data. In addition to these inherent risks, though, investors should be alert to several other concerns relating to specific dealers, brokers, platforms and account structures.
Conflict of Interest
It is important to understand that retail Forex trading is a “zero-sum” transaction where one party profits and the other loses. This means that, if your dealer is also the counterparty to your trade, your losses become the dealer’s profits. This is a conflict that may affect the advice you receive.
More than 70 per cent of the Forex market is speculative. Speculators who buy and sell a currency don’t usually plan to hold it and in fact, bet on profiting from changes in its market value. Even knowledgeable and experienced traders can suffer significant losses when market conditions change.
No Central Exchange or Clearing
There is no central exchange or clearing house for Forex transactions. This means that there is no single exchange rate (price). Instead, there are many different rates, depending on the dealer involved in the trading. It also means there is no financial institution that will guarantee payment of your profits if you do make a successful trade.
Use of Leverage or “Margin”
Forex trading usually involves leverage, which means trading with borrowed money. Using leverage is an extremely high-risk way to invest. For example, if your Forex account allows a leverage ratio of 100:1, you can trade $100,000 worth of currency with a deposit of only $1,000. If the currency you purchased goes down by just 1 per cent, you lose your entire $1,000 deposit. If the price continues to drop, you can lose much more than your deposit and end up owing money. Some investors are pressured into borrowing much more than they can afford to lose, with the allure of large potential gains. If the hoped-for gain turns out to be a loss, the magnified effect can be financially devastating.
Limited Resources of Non-Institutional Investors
Forex trading is dominated by banks, insurance companies and other sophisticated institutional investors. These institutional investors have access to extensive research, computerized trading and large amounts of capital to weather short-term losses. Most Forex trading occurs between these large institutional investors on exclusive markets. Retail investors cannot match these resources when they engage in Forex trading.
Aggressive Marketing Tactics
Forex marketing can be very aggressive and aims to make individual investors feel they can be expert Forex traders and make large profits quickly. Seminars and software programs cannot replace the need for research and expert knowledge in Forex trading. Don’t be fooled by expensive products that claim to make Forex trading and analysis easy for everyone.
Extensive Fees and Transaction Costs
Trading in the spot Forex market has a short time frame (usually two business days) and involves cash. While a trade itself may be profitable, investors can still lose money because of overnight fees, referral fees, and other transaction costs.
You can also lose money on Forex trading through fraud and other schemes. You should be aware of the potential for fraud and avoid offers to trade Forex associated with any of these characteristics:
- a guarantee of little or no risk and high investment returns;
- dealers or brokers that are not registered with the provincial or territorial securities commissions, and typically are based outside of Canada where it is difficult or impossible to protect or retrieve funds;
- an unwillingness to discuss the past performance or track record of the specialist traders who will purportedly handle your money;
- an unwillingness to identify specialist traders or traders located in offshore jurisdictions who will purportedly handle your money; or
- high-pressure sales techniques to buy a Forex investment, to purchase software or take courses related to Forex trading.
The risk of loss for individual investors that trade Forex contracts can be substantial.
How can you protect yourself?
If you are considering participating in the Forex market, you need to fully understand the market and its unique characteristics.
You should limit the money committed to Forex trading to only the entire amount you can afford to lose. You should also be aware that the use of leverage (e.g. remortgaging your home) or other strategies may result in losses greater than the amount of your initial investment.
You should carefully consider your own financial situation and consult a registered financial adviser knowledgeable in Forex trading, and fully investigate any firms offering to trade Forex for you, before making any investment decisions.
Check registration status online or by telephone with the provincial or territorial securities commissions and Investment Industry Regulatory Organization of Canada (IIROC) and avoid using Forex dealers or brokers who are not registered (no matter how great their platforms may appear).
Where can I learn more?
The CSA has created a Forex resources page on its website (http://www.securities-administrators.ca/investortools.aspx?id=1041). You can find additional information on the CSA website including alerts and notices issued by other regulators and organizations, details of the regulatory requirements for those offering Forex services to Canadian investors, and contact information for staff of the various regulators.
Please refer your questions to any of the following:
Alberta Securities Commission
Suite 600, 250-5th Street SW
Calgary, AB, T2P 0R4
Saskatchewan Financial Services Commission
The Manitoba Securities Commission
Toll Free (Manitoba only): 1-800-655-5244
Inquiries & Contact Centre
Ontario Securities Commission
Analyste experte en réglementation – pratiques de distribution
Autorité des marchés financiers
Tel: 514-395-0337, ext. 4786
Director, Policy and Market Regulation
and Secretary to the Commission
Nova Scotia Securities Commission
New Brunswick Securities Commission
Superintendent of Securities
Prince Edward Island Securities Office
Manager of Licensing, Registration and Compliance
Office of the Superintendent of Securities
Government of Newfoundland and Labrador
Louis Arki, Director, Legal Registries
Department of Justice, Government of Nunavut
Deputy Superintendent, Legal & Enforcement
Office of the Superintendent of Securities
Government of the Northwest Territories
Frederik J. Pretorius
Manager Corporate Affairs (C-6)
Dept of Community Services
Government of Yukon