When it comes to Forex, regulations are a must. Without them, Forex brokers would have no obligation to adhere to ethical business behavior, and the whole market would become a financial "Wild Wild West". So let’s dive in and find out what it really means when a broker claims that it’s “licensed and regulated”.
Like any financial institution, Forex brokers have to abide by certain rules and regulations. However, because the forex market is decentralized, there are many independent regulatory bodies that control regulations at a national level. Therefore, not all Forex brokers are subject to the same regulations. Forex brokers that are based in the UK, for example, have to follow completely different rules than those based in Japan.
So the first thing to do when you’re looking into the regulatory status of your broker is to find out which authority it’s regulated under and make sure that their license is valid.
That’s the easy part. However, since most brokers won’t tell you much more about their regulator besides name and license number, it’s up to you to find out how strict/relaxed the regulator is, and what measures you need to take to protect your funds.
So to make this process easier for you, we’ve broken down the most important regulations that you must look for, and also listed the regulatory bodies that enforce this regulation.
Trading and operations
Because of the inherent risks to capital involved in Forex trading, some regulators find it necessary to limit the trading options that brokers can provide to customers.
A common measure is to limit the leverage that brokers licensed under the regulator can provide for certain currency pairs, or in general.
Another common restriction is a ban on hedging.
This means that the broker cannot allow the customer to open a sell position if they are already holding a buy position on the currency pair, as the two positions cancel each other out. In which cases, the customer pays the spread to the broker but stands no chance of profiting on the trade.
Some regulators also require brokers to hold the currencies or commodities they are offering for trade as securities, a regulation that limits the risks of another credit default swap crisis, but at the same time limits the liquidity a broker can provide.
These types of regulations are both a blessing and a curse, in the sense that they protect novice traders from taking on risks that they may not be prepared for, but at the same time they restrict more experienced traders with a larger appetite for risk and for whom the ability to hedge (with the right stops and leverages) can be a solution to market swings.
Regulators who enforce these types of restrictions include:
US (NFA) –
no hedging, securities required on forex options, limit of 1:50 leverage on major currencies, 1:20 on exotic pairs.
Australia (ASIC) –
leverage limited to 1:25 on all currencies.
Japan (JFSA) –
leverage limited to 1:25 on all currencies.
EU countries –
brokers required to hold 100% of the traded asset for short positions on stocks and commodities (but not currencies).
To protect clients' funds, some regulators require brokers to have segregated accounts for operational funds and client funds.
This is a good idea as it prevents the broker from being able to dip into client owned capital to cover operational costs and thereby ensures that your funds are ready and available whenever you wish to withdraw them.
Regulators who enforce segregated accounts include:
Investor compensation funds
Certain regulators require forex brokers to deposit a predetermined amount into an investor compensation fund. This fund is set up in order to secure the client's interest in the event that the broker is unable to fulfil its contracts, i.e. to deliver the client's profits when the broker doesn't have the financial ability to do so.
If the segregated account regulation protects your deposited funds, this regulation protects your right to any profits made as a result of your investments.
However, investor compensation funds differ in how much they require forex brokers to pay into them, and how much they are willing to pay out on a client claim. Here are some examples:
The MiFID directive requires members to deposit at least 5% of their share capital
in an investor compensation fund which pays out up to €20,000 per client
the Investor Protection Fund requires investment firms to contribute ¥5 billion to the fund, and will pay up to ¥10 million per customer (±80,000 USD).
The FCA requires forex brokers to deposit into the Financial Services Compensation Scheme which reimburses clients up to £75,000 (starting from 2016).
The Securities Investor Protection Corporation (SIPC) compensates clients up to $250,000 in cash, however, it does not mandate membership of all brokers-dealers, and it is recommended to check on an individual basis.
Anti-money laundering measures
Forex brokers are prime targets for money launderers, since all they need to do is deposit the money in a trading account and then withdraw it for the money to appear legitimately earned.
This is why a large majority of regulators have put in place anti-money laundering measures to prevent the abuse of forex brokers for these purposes.
How does this affect you? Mainly it means that the forex broker is required to verify your identity before allowing you to withdraw any funds back to your bank account. In most cases you will need to provide a color scan of your ID, proof of address (utility bill) and scans of your payment method.
While this might be a bit of a hassle (albeit a small one), remember that it is for a good cause and that your broker is only complying with the law.