The Importance of Forex Regulation

The Forex market is the world’s largest financial market so far. In a globalized economy, the importance of the Forex market to the everyday consumer cannot be underestimated. The rate a currency can be exchanged in the Forex market determines the price consumers pay for products, vacations, the interest rate on deposits and loans and the rate of the return of our investments. Despite the importance of the Forex market, it continues to be largely unregulated.

Forex transactions can be classified into two types – speculative and commercial. A speculative transaction is a transaction taken merely to make profit from currency moves. A commercial transaction is a transaction that is backed by underlying economic activities, such as loan to an overseas company or payment for an import.

In the Forex market, speculative transactions widely exceed commercial transactions and account for larger portion of Forex trading volumes over the years.

Online Forex trading by retail investors has expanded in the past years, with transactions contributing from about 125 billion USD to 150 billion USD in daily Forex turnover. Apart from the evident risks such as large losses due to excessive leverage and fraudulent activities, Forex investors must be familiar with the following risk factors:

Information disadvantage: Retail investors are succumbed to disadvantages in the unregulated Forex market since they do not have access to information about large commercial transactions which is available only to the big investors who dominate the market. This information lack of balance makes it harder for the average retail investor to gain advantage over the professional investors.

Heightened Volatility: The rise in speculative activity, in particular high frequency trading dominated by algorithmic trading, might result in higher currency volatility, which increases the risk of runaway losses for the small investor or trader.

While the Forex market regulation was almost nonexistent in the past years, the swift growth of Forex trading among retail investors has led to regulation by commercial bodies such as Commodity Futures Trading Commission (CFTC). The CFTC has jurisdiction over Forex transactions in the US, and it requires all Forex brokers to be registered and meet financial standards set by the National Futures Association (NFA).

The biggest risk in non-regulated Forex trading is that of fraudulent activities, which include boiler room tactics, excessive fees generated by churning trading accounts, Ponzi schemes and misrepresentation.

With almost 27,000 US traders having lost 460 million USD in Forex trading between 2001 and 2008, the growth in Forex fraud cases led the CFTC to set up a dedicated task force to deal with the problem.

Strict regulations introduced in the US IN 2010 in order to protect Forex traders have exterminated Forex fraud in the US to a large extent. However, in other countries the regulation status has remained mixed.

In Japan, the Financial Services Authority (FSA) proactively regulates Forex transactions. One of its achievements is lowering the maximum leverage that is available to Forex traders to 25:1 in August 2011, after cutting it to 50:1 the year before. In the UK and continental Europe, regulation is limited and leverage has few limits, with levels reaching as high as 200:1.

For institutional traders, local central banks regulate Forex market. However, there isn’t any global regulator for the worldwide Forex market. There are several reasons why institutional Forex regulation is necessary:

High Hedging Costs: Increased currency volatility caused by excessive speculation results higher costs incurred by corporations and other commercial players for hedging currency risks

Preventing Enrichment of a Few at the Expense of Millions: Exaggerated or unjustified currency transaction can adversely affect a nation’s economy. Even though such moves may be supported by underlying economic fundamentals in some cases, in many other cases temporary weakness in a currency can be brutally exploited by speculators, sending it into free fall. This may result in capital flight and a prolonged recession rushed by severely higher interest rates in order to defend the currency.

A regulatory levy such as the Tobin Tax may restrain wild Forex speculation by retail and institutional traders and may offset the costs of more Forex regulation. However, any suggestion to introduce regulation for the institutional Forex market is likely to meet opposition by major currency traders. As a business owner or investor, you may occasionally have a justifiable need to trade Forex to hedge currency risk for your business or investment portfolio. But be watchful of the risks of speculative Forex trading.

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