In our last lesson we began a new module on choosing a forex broker, with a look at why this process is so confusing for traders new to the forex market. In today's lesson we are going to continue our free forex trading course, with a look at two of the most important factors to consider when choosing a forex broker, regulation and financial stability.
As we touched on briefly in our last lesson, the regulatory environment for the retail forex market is different from that of the futures and equities markets. While most countries have had regulations in place which govern activity in the futures and equities markets for quite some time, as the retail forex market is relatively new, its regulations are still evolving in many countries, and in some countries do not exist at all.
As the InformedTrades community is made up of traders from all over the world, I would love to be able to go into the specifics of regulations for each country. Unfortunately however this would not be feasible from a time standpoint, so I am going to instead give a framework that traders can use to evaluate the regulatory environment in any country, by walking us through how I would evaluate a US Brokerage Firm. For those who have knowledge of, or questions on, the regulatory environment in other countries, I encourage you to post in the comments section of this lesson on InformedTrades.com.
To make a long story short, the retail forex market came under the Jurisdiction of the Commodities Futures Trading Commission (CFTC) with the passing of the Commodity modernization act in 2000, and is currently going through some changes after the recent passing of the farm bill. The industry body that currently enforces the laws set by the CFTC is the National Futures Association (NFA), and if you go to their website National Futures Association - NFA is a regulatory service provider for the derivatives markets, you can read about all the different requirements that firms offering retail forex trading in the United States have placed on them. Also on this website, in the upper right hand corner of the site, is a link that says "Broker/Firm Information".
If you click this link you can enter the name of the firm that you are researching and see who the owners of the firm are, as well as any complaints or actions that the NFA and/ or CFTC has taken against the firm. One thing to keep in mind here is that, as we covered in our last lesson, there are many firms with very few clients who offer forex trading, so it is important to consider the size of the firm when researching complaints, so you can make sure you are comparing apples to apples.
You will see a report with all the US Futures and Forex firms listed on the left hand side. Then, scrolling across the top there are 2 columns that are important to us. The first is the column that says "Net Capital Requirement". This is the amount of funds that the firm is required to have in liquid assets, or in other words assets that are easily convertible into cash. This number is set by the CFTC to make sure that a firm has enough cash on hand to cover itself if something goes wrong. If a firm drops below this requirement, the CFTC will step in and shut the firm down in order to protect client funds.
Now that we understand this, the next logical question that many traders will ask is, how close is the firm they are trading with, or considering trading with, to falling below their "Net Capital Requirement"? On this same page you should see a column that says "Excess Net Capital" which gives us the cushion that a firm has, before they would get into a potentially troubling position.
The last thing that it is important to keep in mind here, is that the CFTC has recently upped the Net Capital Requirement to a minimum of $20,000,000 for all forex firms, a level which will be phased in over the coming months. With this in mind, it is important to be sure that the firm you are trading with not only has plenty of excess capital to meet current requirements, but also future requirements.
If you are considering opening a forex account with a Non US Firm, then I strongly encourage you to do your research into what the regulatory environment is in that firm's country, so you can make sure that the neccessary protections are in place to protect your capital, in the event that the firm you are trading with runs into financial difficulty.
That's our lesson for today. In our next lesson we will look at how to evaluate the next factors many traders consider before opening a forex brokerage account, execution and transaction costs.
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Risk Disclosure: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.