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The Brokers (re) Evolution: The CEO's reply

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Drew Niv, CEO at FXCM: "The new NFA regulatory changes will lead to a consolidation of the retail forex industry"

Fri, Sep 21 2007, 14:07 GMT
by Marina Schiaffino

FXstreet.com

Drew Niv, CEO at FXCM,  has been the second top executive to answer the second questionnaire that Francesc Riverola, CEO & Founder of FXstreet.com, sent regarding new NFA requirements and their potential impact on the FX industry. [ View the full interview ]

1 - What is your opinion on the recent NFA regulatory changes? How do you view the implementation of these new measures for FDMs?

We believe the new NFA regulatory changes will lead to a consolidation of the retail forex industry. The consolidation will benefit FXCM, since we easily meet the new proposed regulations.

The proposed regulations will require that firms have at least $5 million in net capital. However, the requirement for brokers with large amounts of customer capital could be substantially higher. We estimate that as many as 20 firms would not be able to meet this requirement if enforced today.

The forex industry in the long term will benefit from having a smaller number of better capitalized brokers. In essence, a broker with more firm capital is less likely to make imprudent decisions that would put its funds and its customer funds at risk.

Although these new regulations are good for the industry, the resulting short-term changes may be difficult for clients whose brokers do not meet the new requirements. We hope that the NFA will make every effort to facilitate an orderly transition as brokers make new arrangements to enable their clients to trade through firms that meet the new requirements.

2 - The new proposal also calls for the use of proper and uniform accounting methods and tightens internal controls. Do you think this measure could affect your company's business in some way?

No. FXCM’s accounting practices will not be affected by the new proposed regulations. Our own business standards led us several years ago to adopt the practices specified in the new proposed regulation.

For the last six years, FXCM has been audited by major accounting firms which audit public traded companies. Our financial statements comply with international GAAP standards.

To live up to these higher standards, we have had to maintain a highly trained and professional staff of accountants and internal auditors. We believe only a large firm, such as FXCM, can make the type of investment in financial integrity which will now be required of all FDMs by the new proposed standards.

3 - Do you consider these measures could be a breathe of fresh air that could result in more investors joining the FX Market?

Yes. The FX market has been growing at an incredibly fast pace. However, its momentum could be slowed if one or more brokers became insolvent. These new proposed rules significantly reduce the probability of that happening. Thus, the proposed new rules help protect the future of the industry.

My personal opinion is that the emerging credit crisis will have a major impact on equity markets. As profitability in trading stocks becomes more difficult, there will be a mass of traders into forex. We do not want those traders’ first opinion of forex trading to be of an industry in need of regulation.

"The forex industry in the long term will benefit from having a smaller number of better capitalized brokers. In essence, a broker with more firm capital is less likely to make imprudent decisions that would put its funds and its customer funds at risk."

4 - Switzerland has recently started a similar process, what is your opinion about it?

Switzerland’s regulation of the forex market has lagged years behind the world’s other major financial centers. The recent insolvency of a Swiss trading firm, TradeX, highlights the dangers of dealing with a broker based out of Switzerland, where there is currently minimal regulatory oversight. As Switzerland moves to correct these problems, it will help the world-wide forex industry.

Every time a major country embraces regulation of retail forex trading, such as Japan in 2005 and the United States in 2000, the industry has grown.

5 - Would your company be on the bid side if some firms were not meeting new requirements? What is your company's policy on acquisitions of smaller firms?

FXCM is in discussions with several small and mid-sized FDMs who are concerned about their ability to meet the new proposed requirements. We are interested in purchasing the client accounts of these firms, or finding a mutually beneficial relationship with them.

The FXCM Group is uniquely positioned to accept and service the books from other brokers. We have 1) A global footprint with offices in the Americas, Asia and Europe; 2) A staff of over 500 capable of handling the migration of a large numbers of client; 3) over $100 million in group capital to fulfill the capital requirement associated with servicing these new clients.

A forex broker seeking a buy or an IB relationship must first of all consider the buyer’s ability to pay. Brokers will have thousands of clients trading many millions of dollars; the buyer will be obligated to rebate millions of dollars to them. The brokerage firms must satisfy themselves that the buyer can afford to do that – in fact, has been routinely doing that for years.

Also: The broker must be assured that the buying firm can absorb thousands of new clients, service them well and, in order to continue to continue to receive revenue from their trading, keep them as clients.

The most important reason that many FDMs are considering a relationship with FXCM involves trust. In blunt terms, FXCM can always be trusted to pay the firm’s owners the revenue their accounts earn – in full and on time. FXCM has been working with Introducing Brokers for over eight years. In fact, our very first Introducing Broker continues to refer business to us.

Our No Dealing Desk business Model is ideally suited to processing a large Introducing Broker book of business. Under our No Dealing Desk system, our monthly revenues, in the form of pip markups, are an exclusive reflection of trade volume: if we do X volume, we book X pips. And the revenues of our IBs move in perfect concert with our own, since they are rebated an exact percentage of total volume.

The revenues of a market-making broker, on the other hand, are not only dependent on volume, but may vary significantly depending on the quality and effectiveness of the broker’s traders as well as market volatility. Therefore, if the FDM allies with a market maker, and that market maker suffers a losing month, yet still owes a volume rebate to the IB, the IB may encounter difficulties in collecting everything it is owed.

6- How do you see the M&A market in the Forex industry? Do you expect important corporative movements in the next months?

Six. The M&A market in forex is particularly tough for several reasons.

• · No common standards – for software platform, accounting standards, back office procedures. It makes integrating an acquisition much more difficult than a firm in the equity industry, for example, where standards are shared.
• · Recent market volatility meant rising volumes and profits for most firms. August was one of the best months in FXCM Group’s history – we had over half a trillion in trading volume – and we suspect that other firms also did very well. This recent success, I believe, will make owners of smaller brokers reluctant to sell. As a founder of a forex firm, I completely understand their feelings and their attitude. It is very tough to exit now. However, as the new proposed regulations come closer to enactment there may be a major re-assessment.
• · Many private equity firms and venture capitalists are eager to fund profitable forex firms. But they are in search of the fastest and surest payout, and will tend to ignore all but the largest and most competitive forex firms on the market. Furthermore, they realize that even those large FDMs have been put in a weak – and perhaps ultimately desperate -- bargaining position by the new proposed regulations, and will negotiate accordingly. If past is precedent, at contract time the deal will become much more one-sided, and full of pitfalls for the forex broker owner. Private equity firms are expert at negotiating terms that are extremely profitable for them but costly for the business owner.

The illusion of private equity firms lining up to invest in the business may give the owner false hope that buckets of cash are theirs for the taking. I believe that once the FDM owner is discouraged by the private equity experience, actual M&A activity between forex brokers will intensify.

"FXCM is in discussions with several small and mid-sized FDMs who are concerned about their ability to meet the new proposed requirements. We are interested in purchasing the client accounts of these firms, or finding a mutually beneficial relationship with them."

7 - For many, the very business model of Forex brokerage firms that needs to be decided is whether or not such brokerage houses can take opposite trading positions to those held by their customers, i.e., trading 'against them', which contradicts traders' well-being. What is your company position on this? How do you hedge your customers' trades?

We believe that No Dealing Desk model is best for both trader and broker, and FXCM is totally committed to it. Over 99.9% of our business is conducted on this model.

FXCM was primarily a market maker until the end of 2006, when we took a 180 degree turn to the agency execution model. So we know the market-making business. Currently, many of our competitors believe that because volatility has returned, market making is the more profitable business model. That is true -- in the short term. Long-term, however, the no dealing desk system is better for both the broker and the client, for several reasons.

• · Better Execution During News Events & Market Volatility. In the past few years, clients have become much more focused on trading news events -- those turbulent times when it is most difficult to make prices. By aggregating large bids and asks from the large banks, we solved that problem, and the proof is that since we inaugurated no dealing desk our trading volume during news events has grown immensely. Market makers, however, have an especially tough time during news trading, because if they honor all prices they will lose money. (When we were market-making we certainly lost money during the big market moving news events.) Remember too that the market-maker’s prices are removed from the real market, and so they must protect themselves by offering created prices. We avoid the problem by having the world’s largest banks streaming their prices through us.
• · Lower Spreads. We can now review our policies relating to prices and markups above the best bid/offer we get from the banks, and we’ve introduced fractional pips to further tighten spreads. In the next few months we will continue cutting the cost of trading pairs across the board. And we have launched numerous incentive programs to provide additional discounts to high-frequency traders.
• · Greater Opportunity to Scalp the Market. Many traders favor short-term scalping strategies. For scalping to be profitable for the client, the market maker must lose. So either the market maker takes the loss or disallows the strategy. With no dealing desk we are able to accommodate scalpers – but of course we clearly warn them of the risks involved.
• · Aligned Broker-Trader Interests. The no dealing desk strategy has aligned FXCM’s interests with those of our customers. Since it is in our interest for them to trade more, we want them to increase their profits and account sizes. We have studied which trading behavior is most profitable for the retail trader, and have discovered that most retail clients are less successful when they trade pairs with large swings – especially GBP/USD. They are much more profitable with the quieter, range-bound pairs like EUR/CHF, EUR/ GBP and AUD/NZD. To give our clients an extra incentive to trade the more successful pairs, we have been aggressively reducing our markups on these pairs to make their spreads the tightest of all the currencies we offer.
• · Easier Implementation of Programmed Trading. We can now accommodate more black box traders, both those with high-frequency systems and those with break out systems. The change to no dealing desk allows us to service a large new group of traders who never thought of trading through us when we were market-makers.

8 - Would you like to add something else?

The major reason for the proposed regulations is that the NFA and the industry realizes that we must provide more funds security to forex traders. The new proposals are a major step forward, but I think we all realize they don’t go far enough.

I am proud to say that FXCM is in the vanguard of the movement to convince the US Congress to pass legislation extending funds segregation to the forex industry. In fact, we have even established a Political Action Committee to support and coordinate the actions of this Safety of Funds initiative, and we have convinced three other large FCMs to add their names to our petitions. We are urging every firm in our industry to join us in this effort.

FXCM already has the ability to offer our clients segregated forex accounts. Thanks to our British subsidiary, accounts with Forex Capital Markets LTD (FXCM-UK) are fully segregated in accordance with United Kingdom financial regulations.

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Published on  Tue, Oct 2 2007, 15:20 GMT