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Market makers sometimes trade against their own clientsHow the FOREX Game Is Played There are two types of retail FOREX brokers: market maker and ECNs (Electronic Communications Network). ECN is similar in method to how the Interbank foreign exchange market worksorders are matched on a client-to-client basis. A large network of banks, institutions, and traders connect to the network, and orders are matched; there is no central clearinghouse for orders. If you wish to sell 50 million US Dollars (USD) against the Euro (EUR), you place your order and wait for someone who wants to buy. Typically, because of the huge volume of foreign exchange business, transactions are instantaneous. The market is said to be liquid. Nevertheless, your order technically requires a counterparty to be executed. ECN retail FOREX brokers build their own network and often tap in to the Interbank ECN. Market Makers Most retail brokersespecially the smaller ones accepting so-called miniaccountsare market makers. Market makers act as a de facto central clearinghouse for their clients. If you look closely at Market Maker web sites and their account documentation you will see a statement such as, XYZ-FOREX is the counterparty to all trades. Market makers typically guarantee execution at the price you want, assuming their data stream touches that price. There are exceptions, however, as discussed below. Market makers sometimes trade against their own clients. There is inherently nothing wrong with this; that is how they play the game. Trading against their clients performs several useful functions: (1) It provides liquidity; (2) it helps maintain an orderly market; and (3) it keeps their book from becoming too unbalanced. Because they are the counterparty to all trades, if they have 500 million USD on the buy side and only 50 million USD on the sell side (this is an exaggeration to make the pointbalance is rarely off more than 5 percent) market makers are at risk if the USD should fall sharply. Market makers often hand off large orders to an ECN or the Interbank market to maintain balance. Market makers are effectively bookmakers. In choosing a Market Maker broker, it is good to know how much net worth or liquidity they have in case they do suffer from an order imbalance. The CFTC (Commodity Futures Trading Commission) is working to set minimum net worth/liquidity requirements for market makers. But this is a work-in-progress, and FOREX today remains very much a caveat emptor enterprise. Market makers are often accused of running or harvesting stop-loss orders. To a limited extent this is in pursuit of the three legitimate functions listed above. However, if a broker-dealer harvests stops primarily as a profit center, traders are not happy. It is very difficult, if not impossible, to tell if a market maker is running stops at all andif they arethe motive. Such is the capitalist experience. Because of the lax regulatory environment the inner workings of retail brokers is more opaque than it is transparent. If you have access to multiple data streams, you can watch for stop harvesting. If one of the streams shows a sharp price spike resulting in a price several pips from the maximum or minimum of all the other streams, it is possibly a case of stop harvesting, especially if it is in an active market with good liquidity. FOREX markets are said to be fast especially after the release of a major news announcement. This means there is a dramatic increase in price movement and/or volatility. Market makers often dramatically increase their pip spreads (ballooning) for a short period of time under these conditions to maintain order balance. Pip spreads have been know to balloon from 2 pips to as much as 30 pips for one or two minutes after a Federal Reserve announcement. There are horror stories of ballooning 100 to 200 pips. Spreads also balloon during inactive market periods when liquidity is low. Traders should either avoid trading during these times or at least be aware of this phenomenon. Ballooning spreads should be a legitimate Market Maker function, but many traders believe some market makers use it as a profit center technique. Again, caveat emptor. Although not as big a problem as it once was, requoting (or dealer intervention) has been the bane of market makers. In requoting, a broker gives you a fill at a price not seen on their official streaming data feed. More than any other factor, requoting has driven traders away from specific brokers and from FOREX generally. Another form of dealer intervention that has frustrated retail FOREX traders is being put on manual. This means that your orders are executed by hand at the dealing desk. Some reviews claim traders have been put on manual when they are making too much money (remember the market maker is the counterparty to your trader). Some traders have claimed to have had their accounts frozen or closed for the same reason. Brokers do seem to be getting the message. Requoting is much less an issue than it was in the past. But to a large extent, the damage is done and the term market maker has negative connotations to traders. To this end many brokers now advertise they have no dealing desk (NDD) implying they are not market makers. What no dealing desk actually means and its functional affect is not clear. At the very least the line between market makers and ECNs is blurring, but the trend is certainly toward ECNs today. An NDD may simply refer to a fully automated dealing desk. It is certainly possible to imagine a broker profiting from traders without a dealing desk, by running them through an ECN of some kind. Dukascopy, www.dukascopy.com, promotes a third-way called a centralizeddecentralized clearing system. An interesting article on this approach may be found on www.e-forex.com in the January 2007 edition. If you trade the newsand I recommend against it for the beginning traderuse an execution tool such as www.secretnewsweapon.com. Even on an ECN platform, executions in fast markets may be off your price by many pips. A 5-pips slippage might not dramatically affect a day trader or a position trader, but it is a very significant cost to the guerilla trader or the scalper. At the highest level of foreign exchange trading, there are two games being played simultaneously. The first is simply attempting to determine what prices are going to do. There is a second, tactical level that is less visible, but very real. The tactical level demands that the trader (1) know what the other players are doing or planning to do; (2) keep the other players from knowing what you are going to do; and, perhaps most interesting, (3) feed the other players false information so their conclusions about what you are going to do or planning to do are incorrect. The typical retail FOREX trader need not concern himself with this tactical level, but should be aware of its existence. Most of the regulatory and order execution issues of interest to the retail FOREX trader stem from the fact there is no central clearinghouse for currency trading. It is difficult, if not impossible, to regulate an industry with no central locus. Consider the Internet as an example of that paradigm. Many web sites offer broker-dealer reviews. When reading these reviews keep in mind: (1) satisfied traders generally post less than unsatisfied traders; (2) the larger the broker-dealer, the larger its volume of complaints; (3) a small sample of reviews may not be meaningful; (4) seeing similar complaints on multiple web sites over several months increases the chances that the complaints are legitimate; and (5) small traders complain the mostand loudest and the largest broker-dealers get the overwhelming share of newbies. For reviews, see www.forexpeacearmy.com, www.forexrealm.com www. moneytec.com, www.goforex.net, www.forex-ratings.com, and www.forexreview.org. For others, see Google FOREX broker reviews, currency dealer reviews, FOREX broker complaints, and permutations thereof. FOREX trading remains a very laissez-faire industry; caveat emptor is the watchword. Retail FOREX. RegulationsCFTC Reauthorization Act of 2005 To reauthorize and amend the Commodity Exchange Act to promote legal certainty, enhance competition, and reduce systemic risk in markets for futures and over-the-counter derivatives, and for other purposes. Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, (a)In GeneralSection 2(c)(2) of the Commodity Exchange Act (7 U.S.C. 2 (c)(2)) is amended by striking subparagraphs (B) and (C) and inserting the following: (B) AGREEMENTS, CONTRACTS, AND TRANSACTIONS IN RETAIL FOREIGN CURRENCY (i) This Act applies to, and the Commission shall have jurisdiction over, an agreement, contract, or transaction in foreign currency that (I) is a contract of sale of a commodity for future delivery (or an option on such a contract) or an option (other than an option executed or traded on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a))); and (II) is offered to, or entered into with, a person that is not an eligible contract participant, unless the counterparty, or the person offering to be the counterparty, of the person is (aa) a financial institution; (bb)(AA) a broker or dealer registered under section 15(b) (except paragraph (11) thereof ) or 15C of the Securities Exchange Act of 1934 (15 U.S.C. 78o(b), 78o-5); or (BB)an associated person of a broker or dealer registered under section 15 (b) (except paragraph (11) thereof ) or 15C of the Securities Exchange Act of 1934 (15 U.S.C. 78o(b), 78o-5) concerning the financial or securities activities of which the broker or dealer makes and keeps records under section 15C(b) or 17(h) of the Securities Exchange Act of 1934 (15 U.S.C. 78o-5(b), 78q(h)); (cc) a futures commission merchant registered under this Act (that is not also a person described in item (bb)), or an affiliated person of such a futures commission merchant (that is not also a person described in item (bb)) if such futures commission merchant makes and keeps records under section 4f(c)(2)(B) of this Act concerning the futures and other financial activities of such affiliated person; (dd) an insurance company described in section 1a(12)(A)(ii) of this Act, or a regulated subsidiary or affiliate of such an insurance company; (ee) a financial holding company (as defined in section 2 of the Bank Holding Company Act of 1956); or (ff ) an investment bank holding company (as defined in section 17(i) of the Securities Exchange Act of 1934 (15 U.S.C. 78q(i))). (ii) Notwithstanding item (cc) of clause (i)(II) of this subparagraph, agreements, contracts, or transactions described in clause (i) of this subparagraph shall be subject to subsection (a)(1)(B) of this section and sections 4(b), 4b, 4c(b), 4o, 6(c) and 6(d) (except to the extent that sections 6(c) and 6(d) prohibit manipulation of the market price of any commodity in interstate commerce, or for future delivery on or subject to the rules of any market), 6c, 6d, 8 (a), 13(a), and 13(b) if the agreements, contracts, or transactions are offered, or entered into, by a person that is registered as a futures commission merchant or an affiliated person of a futures commission merchant registered under this Act that is not also a person described in any of item (aa), (bb), (dd), (ee), or (ff ) of clause (i) of this subparagraph. (iii)(I) Notwithstanding item (cc) of clause (i)(II), a particular person shall not participate in the solicitation or recommendation of any agreement, contract, or transaction described in clause (i) entered into with or to be entered into with a person described in such item, unless the particular person (aa) is registered in such capacity as the Commission by rule, regulation, or order shall determine; and (bb) is a member of a futures association registered under section 17. (II) Subclause (I) shall not apply to (aa) any person described in any of item (aa), (bb), (dd), (ee), or (ff ) of subparagraph (B)(i)(II); or (bb) any such persons associated persons. (C)(i)(I) This subparagraph shall apply to any agreement, contract, or transaction in foreign currency that is (aa) offered to, or entered into with, a person that is not an eligible contract participant (except that this subparagraph shall not apply if the counterparty, or the person offering to be the counterparty, of the person that is not an eligible contract participant is a person described in any of item (aa), (bb), (dd), (ee), or (ff ) of subparagraph (B)(i)(II)); and (bb) offered, or entered into, on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis. (II) Subclause (I) shall not apply to (aa) a security that is not a security futures product; or (bb) a contract of sale that (AA) results in actual delivery within 2 days; or (BB) creates an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business. (ii)(I) Agreements, contracts, or transactions described in clause (i) of this subparagraph shall be subject to subsection (a)(1)(B) of this section and sections 4(b), 4b, 4c(b), 4o, 6(c) and 6(d) (except to the extent that sections 6(c) and 6(d) prohibit manipulation of the market price of any commodity in interstate commerce, or for future delivery on or subject to the rules of any market), 6c, 6d, 8(a), 13(a), and 13(b). (II) Subclause (I) of this clause shall not apply to (aa) any person described in any of item (aa), (bb), (dd), (ee), or (ff ) of subparagraph (B)(i)(II); or (bb) any such persons associated persons. (iii)(I) A person shall not participate in the solicitation or recommendation of any agreement, contract, or transaction described in clause (i) of this subparagraph unless the person is registered in such capacity as the Commission by rule, regulation or order shall determine, and is a member of a futures association registered under section 17. (II) Subclause (I) shall not apply to any person (aa) any person described in any of item (aa), (bb), (dd), (ee), or (ff ) of subparagraph (B)(i)(II); or (bb) any such persons associated persons. (iv) Sections 4(b) and 4b shall apply to any agreement, contract, or transaction described in clause (i) of this subparagraph as if the agreement, contract, or transaction were a contract of sale of a commodity for future delivery. (v) This subparagraph shall not be construed to limit any jurisdiction that the Commission may otherwise have under any other provision of this Act over an agreement, contract, or transaction that is a contract of sale of a commodity for future delivery. (vi) This subparagraph shall not be construed to limit any jurisdiction that the Commission or the Securities and Exchange Commission may otherwise have under any other provision of this Act with respect to security futures products and persons effecting transactions in security futures products.. (b) Effective DateClause (iii) of section 2(c)(2)(B) and clause (iii) of section 2 (c)(2)(C) of the Commodity Exchange Act, as amended by subsection (a) of this section, shall be effective 120 days after the date of the enactment of this Act or such other time as the Commodity Futures Trading Commission shall determine. SEC. 102. ANTIFRAUD AUTHORITY. Section 4b of the Commodity Exchange Act (7 U.S.C. 6b) is amended (1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and (2) by striking `SEC. 4b. and all that follows through the end of subsection (a) and inserting the following: SEC. 4b. CONTRACTS DESIGNED TO DEFRAUD OR MISLEAD. (a) Unlawful ActionsIt shall be unlawful (1) for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity in interstate commerce or for future delivery that is made, or to be made, on or subject to the rules of a designated contract market, for or on behalf of any other person; or (2) for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery, or other agreement, contract, or transaction subject to paragraphs (1) and (2) of section 5a(g), that is made, or to be made, for or on behalf of, or with, any other person, other than on or subject to the rules of a designated contract market (A) to cheat or defraud or attempt to cheat or defraud the other person; (B) willfully to make or cause to be made to the other person any false report or statement or willfully to enter or cause to be entered for the other person any false record; (C) willfully to deceive or attempt to deceive the other person by any means whatsoever in regard to any order or contract or the disposition or execution of any order or contract, or in regard to any act of agency performed, with respect to any order or contract for or, in the case of paragraph (2), with the other person; or (D)(i) to bucket an order if the order is represented by the person as an order to be executed, or is required to be executed, on or subject to the rules of a designated contract market; or (ii) to fill an order by offset against the order or orders of any other person, or willfully and knowingly and without the prior consent of the other person to become the buyer in respect to any selling order of the other person, or become the seller in respect to any buying order of the other person, if the order is represented by the person as an order to be executed, or is required to be executed, on or subject to the rules of a designated contract market unless the order is executed in accordance with the rules of the designated contract market. (b) ClarificationSubsection (a)(2) of this section shall not obligate any person, in or in connection with a transaction in a contract of sale of a commodity for future delivery, or other agreement, contract or transaction subject to paragraphs (1) and (2) of section 5a(g), with another person, to disclose to the other person nonpublic information that may be material to the market price, rate, or level of the commodity or transaction, except as necessary to make any statement made to the other person in or in connection with the transaction, not misleading in any material respect.. |
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