Series 34 – Retail Off-Exchange Forex Exam​ Key Study Note Set Two

Herstatt risk, also known as settlement risk, arises in foreign exchange transactions when one party in a currency trade pays out the currency it sold (e.g., USD) but does not receive the currency it bought (e.g., EUR) due to time zone differences or the failure of the counterparty. This creates a situation where one party has irrevocably transferred funds without receiving value in return, leading to a potential loss of the principal amount. Operational risk contributes to Herstatt risk through failures in internal systems or processes that delay or prevent settlement. Settlement risk is the broader category encompassing Herstatt risk, referring to the general risk that a counterparty will not fulfill its obligations. Mitigation measures include Payment versus Payment (PvP) systems like CLS (Continuous Linked Settlement), which ensures that both legs of a foreign exchange transaction are settled simultaneously, eliminating the time lag that creates Herstatt risk. Regulatory frameworks, such as those established by the Basel Committee on Banking Supervision, emphasize the importance of robust risk management practices, including monitoring and managing settlement exposures. Furthermore, regulations under the Commodity Exchange Act (CEA) require Futures Commission Merchants (FCMs) and Retail Foreign Exchange Dealers (RFEDs) to implement risk management systems to address settlement risks.

The Fisher Effect posits that nominal interest rates reflect the real interest rate plus expected inflation. The International Fisher Effect (IFE) extends this concept to currency exchange rates, suggesting that differences in nominal interest rates between two countries are indicative of expected changes in their exchange rates. Specifically, a country with a higher interest rate is expected to experience currency depreciation relative to a country with a lower interest rate. Limitations of these theories include the assumption of efficient markets and the neglect of other factors influencing exchange rates, such as political stability, trade balances, and investor sentiment. Deviations from these theories can occur due to market inefficiencies, central bank interventions, or unexpected economic shocks. When actual exchange rate movements deviate from IFE predictions, traders may adjust their strategies, potentially exploiting arbitrage opportunities or re-evaluating their currency positions based on revised expectations. Understanding these deviations is crucial for effective risk management and profitable trading in the Forex market.

The Balance of Payments (BOP) is a systematic record of all economic transactions between a country and the rest of the world over a specific period. It comprises the current account (trade in goods, services, income, and current transfers), the capital account (capital transfers and acquisition/disposal of non-produced, non-financial assets), and the financial account (investments, loans, and reserves). A surplus in the current account indicates that a country is exporting more than it imports, potentially leading to currency appreciation. Conversely, a deficit suggests higher imports, which could lead to currency depreciation. Imbalances in these accounts can create pressure on exchange rates. For example, a large current account deficit may weaken a currency. Governments can implement various policy measures to address these imbalances, including fiscal policies (adjusting government spending and taxation), monetary policies (adjusting interest rates and money supply), and trade policies (imposing tariffs or quotas). Central bank intervention in the foreign exchange market is another tool, although its effectiveness can be limited. The Commodity Exchange Act (CEA) and related regulations do not directly govern BOP management but influence Forex trading activities related to these imbalances.

The Bank for International Settlements (BIS) serves as a forum for international monetary and financial cooperation and acts as a bank for central banks. In the global Forex market, the BIS plays a crucial role in promoting financial stability by providing a platform for central banks to discuss and coordinate policies related to exchange rates, reserve management, and international capital flows. It also conducts research and analysis on Forex market trends and risks, contributing to a better understanding of market dynamics. The BIS contributes to international cooperation by facilitating dialogue and information sharing among central banks, helping to prevent and manage financial crises. Its limitations include its dependence on the cooperation of member central banks and its lack of direct regulatory authority over Forex market participants. While the BIS sets standards and guidelines, it relies on national regulators to implement and enforce them. The BIS does not directly enforce regulations under the Commodity Exchange Act (CEA) but provides a framework that influences global regulatory approaches.

Sterilized intervention refers to a central bank’s action of buying or selling its currency in the foreign exchange market while simultaneously neutralizing the impact of this intervention on the domestic money supply. This is typically achieved through offsetting open market operations, such as selling or buying government bonds. The objective is to influence the exchange rate without altering domestic interest rates or inflation. Unsterilized intervention, on the other hand, involves buying or selling currency without any offsetting measures, directly affecting the money supply and interest rates. Challenges and limitations of sterilized intervention include its limited effectiveness if market participants believe the intervention is not credible or sustainable. The intervention may also be offset by other market forces or capital flows. Additionally, the effectiveness of sterilized intervention can depend on the size and depth of the Forex market. While sterilized intervention is a tool used by central banks, its impact on retail Forex trading is indirect. The Commodity Exchange Act (CEA) and related regulations focus on the conduct of Forex dealers and brokers rather than central bank policies.

Economic indicators provide insights into a country’s economic performance and are closely watched by Forex traders. Key indicators include employment figures (e.g., unemployment rate, non-farm payrolls), consumer spending data (e.g., retail sales), inflation rates (e.g., CPI, PPI), and GDP growth. These indicators influence currency valuations because they reflect the overall health and prospects of an economy. Strong economic data typically leads to currency appreciation, while weak data can cause depreciation. Traders react to the release of economic data by adjusting their currency positions based on whether the data meets, exceeds, or falls short of expectations. High-impact data releases often trigger significant market volatility. Strategies employed include trading the “news” by taking positions immediately before or after the release, using technical analysis to identify potential entry and exit points, and employing risk management techniques such as stop-loss orders to limit potential losses. Forex dealers and brokers must provide accurate and timely information to customers, and the Commodity Exchange Act (CEA) prohibits the dissemination of false or misleading information related to economic indicators.

Exchange rate volatility refers to the degree of fluctuation in currency values over a given period. High volatility indicates significant and rapid price swings, while low volatility suggests more stable currency values. Volatility significantly impacts Forex trading strategies and risk management because it can amplify both potential profits and losses. Factors contributing to increased volatility include economic news releases, political events, central bank interventions, and unexpected global events. To manage the risks associated with volatile currency movements, traders can use various tools and techniques. These include setting stop-loss orders to limit potential losses, using leverage cautiously, diversifying currency positions, and employing hedging strategies to offset potential losses. Technical analysis, including the use of volatility indicators such as Bollinger Bands and Average True Range (ATR), can help traders identify periods of high and low volatility. Forex dealers and brokers have a responsibility to provide risk disclosures to customers, as outlined in NFA Interpretive Notices, and to ensure that customers understand the risks associated with Forex trading, particularly in volatile market conditions.

The theory of purchasing power parity (PPP) suggests that exchange rates between currencies are in equilibrium when they equalize the purchasing power of each currency. In other words, a basket of goods should cost the same in different countries when measured in a common currency. There are two versions of PPP: absolute and relative. Absolute PPP states that the exchange rate should equal the ratio of the price levels of two countries. Relative PPP states that the change in the exchange rate should equal the difference in the inflation rates of two countries. However, PPP has several limitations. It doesn’t account for transaction costs, tariffs, and other barriers to trade. Non-tradable goods and services, such as haircuts or real estate, can cause deviations from PPP. Furthermore, differences in productivity, consumer preferences, and government policies can also lead to deviations. In reality, exchange rates are influenced by a multitude of factors, including interest rates, economic growth, and political stability, making PPP a simplified and often inaccurate predictor of exchange rates. The theory of PPP is referenced in economic analysis but is not a regulatory requirement under the CFTC or NFA.

Sterilized intervention refers to a central bank’s action to influence the exchange rate without changing the monetary base. This is typically achieved by simultaneously buying or selling foreign currency in the forex market and conducting offsetting open market operations in the domestic bond market. For example, if a central bank wants to weaken its currency, it might sell its currency and buy foreign currency. To sterilize this intervention, it would simultaneously sell domestic government bonds, which would reduce the domestic money supply and counteract the expansionary effect of the forex intervention. The effectiveness of sterilized intervention is debated. Some argue that it has limited impact because it doesn’t change the overall money supply or interest rates. Others believe it can be effective under certain conditions, such as when it signals the central bank’s commitment to a particular exchange rate policy or when it coordinates with other central banks. Empirical evidence on the effectiveness of sterilized intervention is mixed. The impact may also depend on the size and credibility of the intervention, as well as market conditions. There are no specific CFTC or NFA rules directly addressing sterilized intervention, as it is a monetary policy tool used by central banks.

Conflicts of interest can arise for an RFED in several ways. For example, the RFED may profit from trading against its customers or by providing unfavorable pricing. The RFED might also have an incentive to delay order execution or to execute orders in a way that benefits the firm at the expense of the customer. To mitigate these conflicts, NFA rules require RFEDs to disclose potential conflicts of interest to customers. NFA Compliance Rule 2-36(e) requires that promotional material and websites of forex firms disclose that “the firm may act as the counterparty to the customer.” NFA Rule 2-4 requires members to observe high standards of commercial honor and just and equitable principles of trade. RFEDs must also have policies and procedures in place to ensure fair and transparent order execution. This includes providing best execution, which means executing orders at the most favorable terms reasonably available under the circumstances. Furthermore, RFEDs are subject to regulatory oversight and are required to maintain adequate capital and internal controls to prevent and detect conflicts of interest.

Herstatt risk, also known as settlement risk or principal risk, arises in cross-border transactions when one party in a financial transaction pays out funds in its currency but does not receive the corresponding funds from the counterparty in return. This risk is named after Bank Herstatt, a German bank that failed in 1974 after it had paid out Deutsche Marks but before it received US dollars in return. Herstatt risk can be mitigated through various mechanisms. One approach is to use payment-versus-payment (PVP) systems, such as CLS (Continuous Linked Settlement), which ensures that both legs of a forex transaction are settled simultaneously. This eliminates the time gap between the payment and receipt of funds, thereby reducing settlement risk. Another mitigation strategy involves using netting arrangements, where payments between counterparties are netted against each other, reducing the overall amount of funds that need to be transferred. Strong risk management practices, including credit risk assessment and monitoring of counterparties, are also essential. While not directly mandated by CFTC or NFA rules, sound risk management practices are expected of regulated entities.

NFA rules outline specific requirements for forex transactions to ensure fair and transparent trading practices. Regarding order execution, RFEDs must provide best execution, meaning they must execute customer orders at the most favorable terms reasonably available under the circumstances. This includes considering factors such as price, speed, and likelihood of execution. RFEDs must also have policies and procedures in place to prevent front-running or other forms of market manipulation. Confirmation procedures are also crucial. NFA Compliance Rule 2-36(c) requires that forex firms provide customers with confirmation of each transaction, including details such as the currency pair, trade size, execution price, and any fees or commissions charged. These confirmations must be provided promptly after the transaction is executed. Additionally, NFA rules require RFEDs to maintain accurate records of all transactions and to provide customers with monthly account statements summarizing their trading activity. These requirements aim to protect customers and promote integrity in the forex market.

In retail off-exchange forex trading, mark-ups and mark-downs refer to the difference between the price at which the RFED obtains the currency and the price at which it offers the currency to its customers. A mark-up is added to the purchase price when the RFED is selling currency to the customer, while a mark-down is subtracted from the sale price when the RFED is buying currency from the customer. These mark-ups and mark-downs represent the RFED’s compensation for providing its services. While there isn’t a specific NFA rule that dictates the exact amount of mark-up or mark-down an RFED can charge, NFA Rule 2-4 requires members to observe high standards of commercial honor and just and equitable principles of trade. This means that mark-ups and mark-downs must be reasonable and transparent. RFEDs are expected to disclose their pricing policies to customers and to avoid charging excessive or unfair mark-ups or mark-downs. Regulatory scrutiny focuses on whether the RFED’s pricing practices are fair and not exploitative.

The Dodd-Frank Wall Street Reform and Consumer Protection Act significantly impacted the regulation of retail off-exchange forex trading in the United States. It expanded the CFTC’s authority to regulate over-the-counter (OTC) derivatives, including forex transactions. The Act clarified the CFTC’s jurisdiction over retail forex transactions, bringing greater regulatory oversight to the industry. One key aspect of Dodd-Frank was its focus on protecting retail customers. The Act imposed stricter capital requirements on RFEDs and enhanced disclosure requirements to ensure customers are informed about the risks of forex trading. It also granted the CFTC broader authority to pursue enforcement actions against firms engaged in fraudulent or manipulative practices. However, the CFTC’s jurisdiction is not unlimited. The Act also addressed jurisdictional limitations, particularly concerning transactions that occur outside the United States. The CFTC’s authority generally extends to transactions involving U.S. persons or that have a direct and significant connection to U.S. markets.