Will Dodd-Frank end up killing the US forex business?

There was an article on Forex Magnates yesterday which brought into question the future of the US retail forex industry. The main focus of the article is the on-going debate in the wake of Dodd-Frank as to whether, and potentially in what manner, forex transactions should be forced into exchange trading. The big question has primarily to do with the swaps and forwards markets because they are the area where liabilities between and among banks exist that create the kind of domino effect that was the major issue during the recent financial crisis. That hasn't kept folks from extending the discussion to suggest that retail forex in the US could be forced on to exchanges as well.

The demise of the US retail forex industry has been declared on several occasions in recent years in the wake of the no-hedging, FIFO, and margin requirement changes implemented by the NFA and CFTC. So far, it's weathered the storm. The US brokers are now subject to considerable scrutiny, as we can see from the number of enforcement actions the regulators have made in the last couple years. If forex trading is required to go exchange-traded only, though, will that be the thing that finally kills the business?

On the one hand, forcing spot forex onto the exchanges could kill off a number of the current batch of US brokers. They would suddenly face considerable competition from futures brokers and/or stock brokers, depending on whether the forex contracts were considered securities or futures (most likely the latter). That said, several futures brokers are already in the retail forex space, so it's not like we'd lose everyone. Also, some of the bigger brokers could yet survive the change – if they want to, and don't just decide to leave the US market and focus on their overseas efforts.

And lest we thinking this just impacts the retail side of the business, consider that the same rules would apply (in theory) to banks. The inter-bank market is the main driving force in foreign exchange. If we were to go to an exchange model it would twist the knife in the gut of the forex bank dealing world that has been suffering for years thanks to the creation of the euro (reduction in the number of traded currencies) and the dramatic improvement in technology (most dealing is electronic these days). When I started in the business in the 90s, the spreads for the most active currency pairs were 10 pips and up. Volumes are up considerably since then, but we routinely see 1 pip spreads, and even narrower for the likes of EUR/USD. That's a major profitability squeeze for dealers.

That doesn't sound particularly good for the US broker and banking community, but it could be really good for the retail forex business overall. Consider the following potential benefits:

  • Single-source exchange rate pricing
  • Volume data from a centralized source
  • No opportunity for broker price manipulation

Many folks out there still look at retail forex as the Wild West of the trading world. Forcing it into an exchange-traded structure could very well open the market up to a much wider array of traders and investors. I, for one, would be very curious to see how things shook out.

All that said, this is not a cut-and-dried sort of situation. Foreign exchange is, basically by definition, a cross-national operation. That makes it VERY hard to implement any unilateral changes. It wouldn't be too good an idea to have US banks forced to do spot trades on an exchange here when not only their foreign competitors, but even their foreign offices, were trading off-exchange everywhere else. It would take a global arrangement to facilitate that sort of thing, and we're nowhere close to that happening.

That said, it could happen on the retail level. The retail forex business is largely a self-contained (and relatively small) structure with only limited interaction between it and the inter-bank market. That makes it easier to force into a new structure. But really the retail arena isn't the major focus of what the regulators are after in terms of avoiding hidden cross-liability linkages between the major financial institutions. As a result, we probably won't see anything major happen, so I'm not sweating it.


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