Forex Magnates posted an article on FXGM, a Cyprus based forex broker caught up in that country’s banking debacle. I don’t know any specifics, but it seems likely that FXGM might be forced into bankruptcy. Bankruptcy scenarios usually result in traders receiving pennies on the dollar for their accounts.
My mission – the entire reason that this company exists – is to help traders find an automated edge to exploit around the clock. It’s an extremely challenging goal. It requires my 7 years of education in the school of hard knocks. I might be the world’s leading expert in what doesn’t work in trading.
That goal is so consuming and challenging that we often lose sight of the big picture. When you deposit funds with a broker, everything happens with the pretense that the funds are your money. You believe that you reserve the right to withdraw those funds at will, and that legally, those funds are your money.
I hate to be the Bad News Bear, but that understanding is emphatically incorrect. Deposits at most brokers are unsecured loans to the broker.
I hope you’re aware of this, because it’s the exact same situation with your bank account. The account is “yours” in the sense that it’s “your loan” to the bank. If the bank/forex broker goes belly up, depositors are among the first parties hit with losses (after the deposit insurance ceiling is breached).
That generally means that equity takes the first hit, followed by depositors, followed by the bond holders. If you apply that to a forex brokerage, it means that the owners of the brokerage are first in line to lose the value of their holdings. Once those losses exceed the amount of customer funds on deposit, you the Trader take the loss.
Trading is hard enough. Taking losses because a broker went belly up is sickening.
How to protect your trading account from a forex broker bankruptcy
Protecting your initial capital by choosing the right broker(s) is every bit as critical as choosing the right trading strategy to protect and grow the account.
Before we dive into specifics, I want to highlight that there is no fail-safe method to avoid getting caught up in a broker bankruptcy. The best that you can do is to mitigate the risks.
Choose multiple brokers – Don’t put all your eggs in one basket
The simplest tactic involves spreading your funds across multiple forex brokers. If you’re trading a $50,000 account, consider splitting that money between 2-3 different brokers. That may have been inconvenient in the past when everyone traded manually. Most of you use expert advisors today. Is it really that hard to open two copies of MetaTrader and let them run simultaneously?
Even without safety of funds, I encourage you to open multiple forex accounts. Different forex brokers use different liquidity providers.
Most traders get caught in the trap of thinking that the forex market is unified and that there is only one price for the EURUSD. There are hundreds of different prices for the most liquid instrument, EURUSD, around the world. The prices are generally very, very close together, but they are different.
The small differences between forex brokers really adds up for certain strategies. I remember visiting a private fund in Dubai back in 2009. The trader showed me account statements from different brokers running the same expert advisor. Losses of 10% at one broker compared to 50% profits at another broker.
Running to the alleged safety of the United States doesn’t make sense anymore. The US government, represented by the not-so-fine folks at the NFA and CFTC, have been asleep at the wheel for decades. Take note of their recent epic failures:
I know several customers that lost six figure accounts dealing with these brokers. The government claims that through its enforcement and regulation, it performs the due diligence that the trader would normally conduct.
The discovery of multiple accounting frauds, all in the hundreds of millions of dollars (MF Global was over 1 billion), exposes the situation for what it is: a farce. The CFTC and NFA are grossly incompetent at evaluating which forex brokerages are safe places to put your money.
That doesn’t mean to run off and put your money with some shoebox broker in Belize, either. The goal is to strike a balance between selecting a location where the rule of law still matters and where the banking system isn’t on the verge of collapse.
The events in Cyprus had absolutely nothing to do with the forex brokerage. The company got caught up in banking events that put the entire system at risk. The bank account (and its location) of your broker is a critical factor in your decision.
Here are some of the jurisdictions that I like for banking and forex brokers:
- Singapore – no history of banking failures. It probably has something to do with its severe criminal penalties. It’s harsh, but there’s no disputing that the rule of law governs the country. I would be inclined to take Singaporean claims of safety of funds at face value
- Chile. I’m a huge fan of Sovereign Man. Otherwise, I never would have considered the country were it not for their newsletter. Every report that I’ve read supports the idea of a stable banking system and a government that serves justice blindly.
- Australia – The government’s debt to GDP ratio is heavy but not impossible to service. Regulation also means something here, even if it’s heavy and burdensome. Pepperstone and Go Markets are two brokers that OneStepRemoved has done work for in the past. AxiTrader also sends us referrals on a consistent basis. ILQ is a true ECN that offers very low spreads to retail traders.
I trade my live accounts at Pepperstone, which I believe is the best endorsement that I can give. My personal money is on deposit with the company. They’re also on my list of recommended forex brokers.
Jurisdictions that I’m ambivalent towards:
- Switzerland – Yes, there are good banks in Switzerland. There is also the UBS and Credit Suisse crowd that required government bailouts and emergency capital. The Swiss brand is heavily tarnished
- Finland – the only EU country bent on kicking out the PIIGS from the euro. I wouldn’t want my personal money in any EU bank, but I suppose it’s the best of the worst if you want to trade in Europe. FinFX, a Finnish forex broker, also accepts US customers.
- New Zealand – a similar case to Australia. New Zealand seems to position itself as a Western safe haven for assets. The Cook Islands, which are known for its trusts, are a protectorate of New Zealand. I don’t know much about the regulatory effectiveness or the stability of its banks.
- United Kingdom – I honestly don’t like this option very much. The only reason that it makes the list is that the FSA appears to do a good job policing fraud and enforcing segregated accounts. The indebtedness of their banking system makes me extremely wary.
Jurisdictions where you’re nuts to put your money (assuming that you don’t live there). All of them have indebted banking systems up to their eyeballs. You risk getting Cyprused working with a broker here:
Trade on a line of credit
A line of credit is my favorite option. It eliminates most of the risk in a forex broker bankruptcy. Unfortunately, it’s also out of my league.
Starting a line of credit involves selecting a banking partner acceptable to both yourself and your broker. A number of legal agreements go back and forth, requiring time and effort from the broker’s legal team (i.e., it’s expensive).
Most brokers require a starting balance above one million dollars to consider accepting a line of credit from a bank. The time and effort involved with setting up credit lines under that threshold don’t make sense.
A line of credit is secured through a deposit at the bank of your choice. Say that you’re trading 5 million dollars and you believe that HSBC Singapore is a wonderful place to hold your money. You do just that. You open an account directly with the bank and inquire about establishing a line of credit secured through the cash deposit.
When you’re ready to open a new forex account, the broker may require that you deposit 10% with them. The remaining 90% stays at the bank via the line of credit. The bank and its capital assures the broker that any losses you suffer are covered by the bank. The bank then deducts the losses from your available balance.
Profits accrue at the broker. If you want to withdraw them, you simply pull the profits back into your bank account.
The 10/90 ratio is flexible and completely open to negotiation. These things don’t get set up all that often. 10/90 is more of a starting point for the discussion.
If you’re in the admirable situation of trading a million+ dollar account, then you have a tremendous opportunity to safeguard your funds at the bank of your choice anywhere around the world. The country of business where your broker operates becomes largely irrelevant. Contact me directly at firstname.lastname@example.org if you would like to arrange a line of credit between yourself and your forex broker.
The rules for safe guarding your forex deposits are simple. There are countless forex brokers to choose from. Instead of risking all of your money in one spot, it’s best to spread it around in countries with strong banks. You might also consider using one of our recommended forex brokers.
You are legally lending money to the forex broker when you open an account. The broker then legally lends your deposit to the bank. You can want to ensure that you’re lending your capital to businesses – the broker and its bank – that are extremely likely to pay you back.
The line of credit is the best option available. Instead of facing two counterparty risks, you largely remove the broker from the equation. You can then focus on your trading and let your broker focus on its primary service of providing excellent execution on your trades.