The foreign exchange market is by far the largest financial market in the world. In an increasingly globalized economy, the forex market’s importance to the average consumer cannot be underestimated.
Forex trading has traditionally been the exclusive domain of big banks and corporations, but recent trends have dispelled this notion. With the arrival of individual investors, regulation of foreign exchange transactions becomes essential.
Unbridled speculation market requires regulations
Transactions in the forex market can be classified into two types – commercial and speculative. A business transaction is supported by an underlying economic activity such as paying for an import or a loan to an entity abroad. A speculative trade takes place solely to profit from fluctuations in the price of currencies.
Speculative transactions far exceed commercial transactions in the area of forex. Therefore, they represent a larger share of forex trading volumes. The volume of foreign exchange transactions in the 1970s was only about six times the value of world trade in goods and services. But today, the daily forex trading volume amounts to $ 5 trillion.
The study also found that the increase in forex trading activity is largely due to “other financial institutions”. This is a broad category that includes small banks, institutional investors, corporations, insurance companies, central banks and retail investors. The two groups driving growth in this category are High-Frequency Trading (HFT) and retail investor online trading, respectively, accounted for 25% and 8-10% of the 1.5 trillion forex spot market.
The Importance of retail Forex regulation
Regulation in the forex market was virtually non-existent a decade ago. Still, retail investors’ rapid growth of forex trading has led to increased oversight and regulation. Regulatory bodies such as CFTC the Commodity Futures Trading Commission are in charge. Under the Commodity Exchange Act, the CFTC has jurisdiction over leveraged forex trading offered to retail clients in the United States. The Act only allows regulated entities to act as counterparties for foreign exchange transactions with retail clients. It requires all online currency traders to meet the strict financial standards enforced by the National Futures Association. (NFA).
For a retail forex trader, the greatest risk unregulated forex brokers the illegal activity or outright fraud. Fraudulent activity includes excessive commissions generated by churning accounts receivable, lobbying salespeople, Ponzi schemes and misrepresentation. With nearly 26,000 people in the United States who lost 460 million dollars to scams between 2007 and 2017, the increasing incidence of forex fraud led the CFTC to establish a special task force in 2008 to deal with this problem.
Strict rules introduced in the United States in 2010 to protect retail forex traders have succeeded in eradicating fraud to a large extent. In Japan, the world’s most active retail foreign exchange market, the Financial Services Authority (FSA) regulates all markets.
The FSA is pro-active in regulating retail forex trading. For instance, it decreased the maximum leverage available to retail forex traders to 25: 1 in 2011, after having reduced it to 50: 1 a year earlier. In the UK and mainland, Europe regulation is limited, and there are few limits on leverage.
The regulation of the retail foreign exchange market is just the tip of the iceberg. What about the issue of non-regulation of the gigantic institutional forex market?
Regulations also mandatory for institutional investors
The institutional forex market must also be regulated for several reasons, including:
The higher cost of hedging: The increase in currency volatility caused by excessive speculation leads to higher costs for companies and other traders to hedge currency risk.
Systemic Importance of Big Banks: Forex trading losses of companies and financial institutions are not predominant in the list of top countries. However, the potential for billions of dollars to lose on bad trades exist. Also, a massive loss incurred by a major bank could affect the global economy due to its systemic importance.
