A New Refuge for Day Traders?

By Robert Hunter
April 27, 2000

PERHAPS YOU'VE SEEN the commercials on CNBC or the streaming ad banners on the Internet promising big profit opportunities in currency trading. "Commission-free! Trade 24 hours a day! Interbank prices! While you're thinking about it, others are doing it!"

What could be more seductive to beaten-down day traders who still fancy themselves as financial whizzes but have seen their once-juicy assets wither on the vine?

Since 1996, more than a dozen currency-trading sites have gone live, many in just the last year, and many more are still in development. While most say they cater primarily to corporations, money managers and institutional investors, they've been more than willing to let individual investors swim with the financial sharks. So willing, in fact, that they're letting George Soros wannabees open accounts with as little as $1,000 in capital.

"We got a huge influx of business in the last couple of weeks when the Nasdaq tanked," says Josh Levy, director of marketing at currency broker Matchbook FX. "Guys called up saying 'I'm really hurt. What am I doing trading equities? Let me open an account and trade currencies.'"

What draws investors to the online currency markets? For many, it's the constant fluctuations, the instant market reaction to news and economic events. Others like the 24-hour trading schedule, which allows caffeine-fueled traders to swap yen for dollars or dollars for euros at ridiculous times of the day.

But mostly it's the leverage. Online currency brokerages let individual investors take big punts in currencies with shockingly little up front. All sites vary in their minimum margin requirements, but — believe it or not — 4% is the most conservative out there. Some sites, with margin requirements of 0.5%, let investors jack up their leverage ratios to 200 to 1. (By comparison, stocks can be traded with up to 50% margin, a leverage ratio of 2 to 1.) Such leverage is necessary, the online firms argue, because the currency markets are so massive — some put daily trading volume at $1.5 trillion — and daily currency swings so small that it takes huge positions to reap any kind of rewards. On virtually all of the dozen-plus sites operating today, $100,000 is the smallest position a trader can take. (Remember, with a 200-to-1 leverage ratio, that position would require only $500 in cash.)

The paradox is striking: the smaller the account, the greater the leverage needed to play in the market. One bad dollar-yen position at $200,000 could blow out a $1,000 player in short order. All it would take is a move of 50 basis points (or 0.5%) in the yen — something that can, and does, happen daily.

If it were easy to make money trading currencies, this wouldn't be much of a problem. But currency trading is complicated and the deck is virtually always stacked against novices. It takes many professional traders years to become profitable; for every George Soros out there (and there's only one), there are thousands of tyro traders who've been burned in the foreign exchange markets. Currency brokers admit that only a delicate mixture of trading zen and market experience will see traders through the market's choppy and changeable waters. Traditional trading strategies — fundamental analysis, technical analysis and especially momentum trading — fail equally for most beginners.

To complicate matters, online currency marts are completely unregulated. When a day trader takes a stock position, he or she is at least reasonably confident that the Securities and Exchange Commission is actively patrolling the markets to protect against fraud and market manipulation. No such authority oversees the currency markets, mainly because they're international in scope and thus politically difficult to regulate. The result: A financial Wild West, where the industry's rogues and knaves can prey on unsuspecting traders at will.

There have been rumblings lately that the Commodity Futures Trading Commission is preparing to step in to regulate the markets, perhaps in the next year or two. If it does, it might have something to say about the industry's basic trading practices, which serve brokers' interests far more than those of investors.

The most common trade-execution system, known as the dealer or market-maker model, involves the brokers themselves acting as counterparties to the customers. Sites using this approach are frequently — and usually derisively — called "bucket shops." In this case, the investor trades directly with the broker, who then lays off his currency exposure onto another investor, thus "bucketing" the trade.

Here's the rub: most online currency brokers control the prices (or bid-asked spreads) at which they'll execute a trade. In the typical scenario, a customer who wants to trade, say, $100,000 for the equivalent in yen must request a price quote from the dealer. The dealer is happy to provide one — after having studied the customer's portfolio and trading history to guess which way he or she is playing and revising the price accordingly. This practice, called "shading," ensures that the dealer locks in the biggest profit possible, at the trader's expense.

Moreover, while some sites offer a "window" period in which the price is locked, other unscrupulous dealers often revise their quotes upward at the last minute, saying "the market has moved." This practice doesn't have a formal name, but rip-off would suffice.

"The dealer model is predicated entirely on gouging the customer," says Matchbook's Levy. "They know who you are and can guess with 90% confidence what you're about to do when you call them up and request a price. They try to lock in wider spreads with every deal."

So while many of these sites lure investors with promises of zero-commission trades at interbank rates, they're actually charging handsome fees in the form of wider-than-necessary spreads — and customers are none the wiser because they don't have access to the interbank markets. Brilliant traders can still make money via the dealer model, but far less than they could in a true two-way market.

A few brokers, such as Matchbook and MG Financial, offer a trading model for currencies much like the one that electronic communications networks (ECN) Instinet and Island use for equities. The ECN-like model allows traders to post bids and offers directly onto the trading screen, where everyone can see them. The brokerages make money by charging fees to complete trades. Predictably, however, these deals aren't cheap. Matchbook and MG charge up to $5 to "passive" traders, whose posted bids are accepted, and up to $15 to "aggressive" traders who take someone else's bid. Since most currency day traders are in and out of the market many times a day, those costs can add up quickly.

Some online currency brokerages say they're trying hard to make sure that they attract only appropriate customers. Many now provide copious amounts of free educational material and require new investors to trade with a demo account before going live. "The last thing we as a company would want," says Levy, "is to be responsible for some 60-year-old grandmother losing a significant percentage of her net worth because we opened an account for her knowing she was undercapitalized, undersophisticated and underexperienced."

Most sites also claim to screen potential investors before signing them up. At Global Forex Trading, for example, traders must have a net worth of at least $25,000 and an annual income of $25,000, with at least $5,000 in risk capital available. Other sites are even more stringent. Zsolt Sapy, president of Global Exchange Networks, says his firm requires an annual income of $100,000, with a net worth of at least $200,000. And previous experience trading commodities or options helps.

"It's easy to turn away clients," he says. "We do it weekly." His worst applicant? It had to be the unemployed guy with an income of zero and a net worth of $15,000 who wanted to open up an $8,000 trading account.

A new site, Gain Capital, hopes to become the Charles Schwab of online currency trading when it goes live sometime next month. "We're trying to add a new level of professionalism to the market," says Mark Gallant, the firm's president. While the site will act as a market maker, it plans to broadcast its prices live for anyone to act on. "I won't know that you've dealt on my price until after you've dealt," he says. "So there's no way for me to tell that you're about to deal on my price and therefore shade you lower accordingly." Trades will be executed commission-free, and various charting and other tools will be provided free as well.

But that doesn't mean the currency market will become easy prey for displaced equity day traders. "Anyone who's lost their shirt [in stocks] should think twice," says Matchbook FX's Levy. "They're obviously not good traders."