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Adolfo Levano
Collin Hull
English 2010
March 12th, 2015
Regulating the Foreign Exchange Market
Government regulations in the United States are meant to increase
investor confidence, protect those who are in business, and pursue and
punish those who break the law, but when
government starts interfering with business
transactions it makes the market less efficient
and oversteps the purpose of government,
wasting taxpayer dollars. This government
intrusion is commonly seen in the foreign
Figure 1.1: Chart showing
the relative value of the
Euro vs. the U.S. Dollar
(Missionforex.com).

exchange market where currencies are

exchanged by major banks and every day

investors. Investors trade these currencies in online platforms where they

view charts of currency pairs such as the Euro vs. U.S. Dollar chart as seen in
Figure 1.1. While trading in the foreign exchange market sounds simple, it is
actually quite complex. As Ashraf Laidi states in his book, Currency Trading
and Intermarket Analysis: How to Profit from the Shifting Currents in Global
Markets, trading currencies is also about assessing shifts in economic and
market dynamics so as to better predict central bank policy changes and
make profitable decisions in currency markets accordingly (Ladi).

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Originally, large financial institutions or wealthy investors were the

major players in the foreign exchange market because it takes a significant
amount of money to make a reasonable profit because currencies such as
the dollar likely will not move more than one cent per day. However, in
recent times through the internet and computer programs, average people
can invest in the foreign exchange market by using what is called leverage.
Leverage is used in the foreign exchange market to increase the investors
buying power. Certain brokers offer up to 200:1 leverage on the investors
money. This means that an investor can put 500 dollars into the foreign
exchange market and trade with a margin of 100,000 dollars, allowing
greater profit but also greater risk. Figure 1.2 shows a visual example of
100:1 leverage. According to the currency trading School of Babypips,
Leverage is a double-edged sword, and has spurred a lot of controversy
especially with regards to government regulation (School of Babypips). In
January of 2015, the Swiss National Bank removed their price floor and
stated that they would stop buying Euros to help their currency, which
caused the value of their currency to decrease by a much bigger margin than
normal. This was an unprecedented and very unexpected move. Many Forex
investors that were caught on the wrong side of this trade lost large sums of
money because of how high their leverage was. Some trading brokers went
out of business or had to close doors since they couldnt meet regulatory
reserves to continue doing business (Alice Ross). A U.S. Firm, FXCM, used a
300 million dollar emergency line of credit because its customers owed them

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225 million dollars after this event (Juliet Samuel). The United States
government reacted by adding additional regulations to the foreign
exchange

market industry, this time moving passed just regulating

criminal behavior.
An economy functions better with a fair

market
Figure 1.2: Graphic depicting 100:1
leverage for foreign currency trading
(Cash Back Forex).

system and government can help ensure

markets are fair. Some economists
argue that markets and especially the

foreign exchange market would function more efficiently if there was no

government involvement whatsoever, however without regulation, there will
be people taking advantage of other people. According to The Legatum
Institute on their article Values Matter for Prosperity, Countries that have
strong familial bonds, charitable intent, and high levels of trust are also the
wealthiest. The Legatum Institute also references a study by Rose in 2011
that found that In more trusting societies, transaction costs are lower as the
risk of opportunistic behavior falls (Legatum Institute). The role of
government is to prevent and prosecute opportunistic behavior in the foreign
exchange market so that the market can function efficiently with the lowest
possible transaction cost.
Some people are afraid that a dramatic move in the foreign exchange
market such as what happened in January of 2015 could cause negative
repercussions in the U.S. economy; however that could be true with any

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industry in the United States. The fact of the matter is that if a forex firm or a
financial institution goes bankrupt because of using or giving too much
leverage to their investors and did not take the necessary precautions, that
company should fail. That is the principle of supply and demand in
economics. Instead of government intervention, companies should develop
their own policies and procedures that would protect them from any type of
financial catastrophe.
Government intervention that exceeds basic fair play regulations leads
to a less efficient market. Richard Epstein from the University of Chicago
wrote an article called "The Dangers of "Investor Protection" in Securities
Markets. Epstein argues that based on principles of economics, regulations
actually add to the cost of doing business which makes the market less
efficient and less profitable. He also points out that regulations are often
followed by more regulations and people will expect and resist not just the
one regulation, but the others they expect will be following soon. Epstein
points out that because of supply and demand forces, regulating the foreign
exchange market in the United States will lead investors to trade with
companies outside of the United States and the United States economy
would miss out on financial opportunities (Epstein).
When the government starts regulating the amount of risk that
individuals can take, it moves beyond the powers that government was
intended for at the cost of tax payers. Ive been trading in the foreign

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exchange market for a couple of years with a company in Finland mainly

because of the leverage that is allowed. Before I started working with this
company I researched their legitimacy and found that they were trustworthy.
At the beginning of this year, government regulations stopped allowing this
company to work with American citizens so by the end of January I had to
change brokers. I do not feel that the government has the right to tell me
which companies should hire to trade my money. I prefer to take
responsibility for the amount of risk I am taking when I trade and not have it
dictated to me by the government. The constitution of the United States
establishes personal liberties and the governments responsibility to secure
the blessings of liberty to Americans. I consider it part of my personal
liberty to decide where to invest my money and how much risk to take
(Constitution).

Proposal
The role of government in the foreign exchange market should be
limited to ensuring a safe market by detecting fraud, whereas individuals and
brokerage firms should be responsible for assessing appropriate risks. The
problem is that the foreign exchange market has a lot of volatility. Currencies
are tied to current events and all across the world things are happening in
countries every day that affect their currencies. The government sees this
volatility and wants to avoid events such as what happened in January 2015,

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where an unexpected policy decision of the Swiss Central Bank caused

investors to gain and lose millions of dollars in a split second and put several
firms out of business.
The solution however is not government involvement or government
regulation, but the solution
lies with firms themselves
managing and regulating their industry.

Foreign

exchange market brokerage firms have

different risk management

tools that they can use to protect

themselves and avoid going

out of business when large shifts

One way to do this is

happen in the market.

Figure 1.3: Diagram showing margin call

protocol (Interactive Brokers LLC).

by using a margin call.

According to day trading expert, Adam Milton, Margin calls are only received
when a trade has lost so much money that the exchange wants more money
as collateral to allow the trade to continue (Milton). In many cases the firm
will cut off a trade when it reaches a margin level so that investors cannot
end up with huge debts. Figure 1.3 shows a diagram of a margin call
protocol. Some investors dont like this approach because they think that the
market will rebound and that they can make the money back or end up with
a smaller loss. Firms might lose some business with this tool depending on
where they place their free margin.

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Another tool that can be utilized by foreign exchange market firms to

manage risk is decreasing the amount of leverage that they offer to an
investor. The firm that allows less leverage could be less popular with
investors and lose business but when dramatic events like what happened
with the Swiss Franc, those firms will amass less investor debt and be less
likely to go out of business.
One firm that did not go out of business after the events caused by the
Swiss Central Bank was FXCM. They managed to stay in business because
they had a 300 million dollar emergency line of credit. This is another tool
that is available to firms in case of this type of catastrophe. Maintaining an
emergency line of credit might be expensive but it can save a company from
going out of business.
Risk management tools such as leverage, margin calls, and emergency
lines of credit are available to foreign exchange market firms. These tools
can help firms to stay in business in the long-run, however there will be firms
that choose to be more risky and not use these strategies. If the government
does not get involved then firms are responsible for managing their own risk;
there would not be a bailout if they fail and this would allow the economy to
respond to economic market forces. Some firms will still choose to not use
loss mitigating tools in the hopes of making more money. If another huge
unexpected shift in the market would occur, they may go out of business but

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that is the natural consequence of their business decision and market forces
at work.
The problem of volatility in the forex market should be handled by
firms, investors, and economic principles. If firms manage risk they will be
prepared and ready to handle shifts in foreign exchange market and
investors can continue to make their own decisions and make money in an
efficient market.

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Works Cited
Alice Ross, Miles Johnson, and Philip Stafford. "Swiss franc jolts currency trading."
Finacial Times 15 January 2015.
Cash Back Forex. Leverage, Lots And Margin. n.d. 8 March 2015
<https://www.cashbackforex.com/en-us/school/tabid/426/ID/435512/leveragelots-and-margin>.
Constitution, U.S. "Preamble." 17 September 1787.
Epstein, Richard A. "The Dangers of "Investor Protection" in Securities Markets."
Texas Review of Law & Politics (2008): 411-424.
Interactive Brokers LLC. Margin. n.d. 9 March 205
<https://gdcdyn.interactivebrokers.com/en/index.php?
f=marginnew&p=overview1>.
Juliet Samuel, Tommy Stubbington, Chiara Albanese. "Forex Brokers Under Scrutiny
After Swiss Move." The Wall Street Journal (2015).
Ladi, Ashraf. Currency Trading and Intermarket Analysis: How to Profit from the
Shifting Currents in Global Markets. Hoboken, New Jersey: John Wiley & Sons
Inc., 2008.
Legatum Institute. "Values Matter for Prosperity." Principles of Prosperity: Social
Capital (2014): 29-30.
Milton, Adam. About Money. 2015. 8 March 2015
<http://daytrading.about.com/od/mtoo/g/MarginCall.htm>.
Missionforex.com. Web Crossover System. 2015. 16 February 2015.
School of Babypips. Leverage and Margin Explained. 2015. 7 March 2015
<http://www.babypips.com/school/undergraduate/senior-year/the-number-1cause-of-death-of-forex-traders/leverage-defined.html>.