Why We Should Have Seen the FXCM Inc. (FXCM) Mess Coming

What the recent FXCM Inc (FXCM) crisis tells us about investing, markets, and systemic risk

by Adam Warner

Published on Jan 20, 2015 at 8:50 AM
Updated on Apr 20, 2015 at 5:32 PM

I've never traded currencies in my life, but … yowza, what a scary week.

"The Swiss National Bank shook markets Thursday when it loosened its grip on the Swiss franc, and the fallout from the surprising move continued Friday.

"Trading in currency brokerage firm FXCM, which caters to retail traders, was delayed at the open after shares plummeted 88% in pre-market trading to $1.49 apiece. After dropping 15% to $12.63 Thursday, the broker said the 'unprecedented volatility' in euro/franc pairs resulted in massive losses for clients, who subsequently owed FXCM about $225 million, leading to a negative equity balance that could put the company in breach of regulatory capital requirements."

Apparently, forex traders can leverage their positions as much as 50:1. Hard to believe that could come back to bite someone, but guess what? Trading is a risky business. I love the phrase "unprecedented volatility." Do brokerage/clearing firms only hold capital up to "precedented" moves? Because if that's all that's required, it's pretty much a time bomb waiting to go off. We've seen "tail," or "multi-sigma," or "whatever you want to call it" in pretty much every asset class over the course of time. And if we haven't seen it in an asset class, rest assured, we'll see it someday.

I tweeted that I find it ridiculous that you can trade currencies at 50:1 leverage, but can't bet on a football game. And I do find that ridiculous, but I wanted to make something clear: I have no problem with the trader part. I was a market maker for many years. In order to allow you to do your ostensible "job," which is to provide depth and liquidity to the marketplace, you were given "market maker margin." I'm not sure it was 50:1 at the time, but it might have been. It was high enough that you could take very large positions before you had to worry about capital concerns.

No, my problem is with the FXCMs of the world and a system that allows them to underwrite all these accounts without enough capital. Accidents happen in any trading business. No one can really predict where or when, but they do occur. And it's always the same "who could have imagined…" response. So yeah, "imagine" now about the next one. It will happen.

In listed options world, we have brokerage/clearing firms that make good on their customers' trades, and then we have the Options Clearing Corporation (OCC) making good on the clearing firms, so one bankruptcy presumably won't ripple through and shut down the whole system. A systemic meltdown doesn't look like it's in the cards in this currency mess, but still -- that's a pretty big hit on FXCM Inc (NYSE:FXCM) and some others. Hopefully, this thing doesn't snowball.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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