I have been covering the US Commodity Future Trading Commission’s (CFTC) efforts to revamp the regulatory structure that governs forex, since it was unveiled earlier this year. On August 30, the CFTC formally published the “final regulations concerning off-exchange retail foreign currency transactions. The rules implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Food, Conservation, and Energy Act of 2008, which, together, provide the CFTC with broad authority to register and regulate entities wishing to serve as counterparties to, or to intermediate, retail foreign exchange (forex) transactions.”

Not only has the CFTC clearly established its authority to be the primary regulator of retail forex, but it has also laid out specific regulations. Chief among them is limiting leverage to 50:1 for major currency pairs, and 20:1 for “other retail forex transactions.” [It's not presently clear which specific currency pairs will be classified as major].  Remember that the original proposal (which, along with my endorsement, generated vehement protest) called for a decline in leverage to 10:1. Due to negative feedback from traders and brokerages, which ascribed malicious political motives to the changes and argued that it would move the entire industry offshore, the CFTC backed down and implemented only a modest decline in leverage. However, it’s important to note that the National Futures Association (NFA) as well as individual brokers will have discretionary power in setting leverage limits lower than 50:1. There will undoubtedly still be some opposition from traders, but I think we can all agree that the new rule represents a fair compromise.

As for the claim that traders would/will move their accounts offshore, this will become largely moot, since all brokerages, regardless of nationality, will be required to register with the CFTC and subject to its rules/oversight. Of course, those traders that are so inclined will still find a way to circumvent the rules by shifting funds “illegally” to unregistered brokers, but they do so at their own risk and will have no recourse in the event of fraud. As Forbes noted, “It seems these new rules will put a stop to Americans trading retail forex offshore to evade CFTC rules. That trend picked up the pace in recent years and it may need to be reversed quickly.”

Brokerages must register as either futures commission merchants (FCMs) or retail foreign exchange dealers (RFEDs).  These institutions will be required to “maintain net capital of $20 million plus 5 percent of the amount, if any, by which liabilities to retail forex customers exceed $10 million.” While this rule will raise the barriers to entry for potential forex start-up brokerages, it will protect consumers against broker bankruptcy. In addition, “Persons who solicit orders, exercise discretionary trading authority or operate pools with respect to retail forex also will be required to register, either as introducing brokers, commodity trading advisors, commodity pool operators (as appropriate) or as associated persons of such entities.”

One final rule change worth noting is quite interesting: brokerages must “disclose on a quarterly basis the percentage of non-discretionary accounts that realized a profit and to keep and make available records of that calculation.” This calculation will be useful both in and of itself, and also in identifying any significant discrepancies between competing brokers. For the first time, we will be able to see whether forex trading is currently profitable (i.e. whether those that profit are in the majority or minority) and whether/how this profitability metric changes over time, in response to particular market conditions.

The new rules go into effect on October 18.

By Adam Kritzer

If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.

Since the S&P 500 is a pretty good proxy for risk it can be said that the Australian Dollar is a manifestation of investor risk appetite. When risk aversion was high, the S&P and the Aussie were low. When risk tolerance picked up, they rose. It’s funny how this came to be. It is probably best seen as a vestige from the credit crisis, whereby investors evenly divided assets into two classes: risky and safe. When you look at the performance of the Australian Dollar, it is pretty clear as to which side of the dividing line it was placed.

This is probably fair, since the Australian Dollar is a growth currency. According to the just-released Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the Australian Dollar is now the world’s fifth most traded currency (behind only the G4: Dollar, Euro, Yen, & Pound), having usurped that position from the Swiss Franc. In 2010, it accounted for 7.6% (out of a total of 200%) of all trading volume, primarily as a result of trading in the USD/AUD currency pair, which was the fourth most popular in forex.

Investors have come to see the Australian Dollar in somewhat contradictory terms. It is both stable and liquid, but its economy is unpredictable and inflation is usually above average. The current economic situation was strong, with GDP growth projected to exceed 3% in 2010. Its benchmark interest rate (4.5%) is the highest in the industrialized world, and may touch 5% before the year is over. On the other hand, its political situation is currently uncertain, thanks to an election that produced a hung Parliament and the recent resignation of its Prime Minster. In addition, while its trade balance is currently in surplus, it fell in July thanks to decreased demand from China. Analysts wonder whether it isn’t entirely dependent on China (directly via exports and indirectly via high commodity prices) to generate positive GDP growth.

Ultimately, investors don’t care about any of this. They care only whether the global economy is stable and whether another financial/credit/economic crisis is likely to occur. Even though any such crisis will probably spare Australia, the Aussie is punished by even the whiff of crisis because Australia is perceived as being riskier to invest than the US, for example. “The Australian dollar is going to stay heavy. Markets don’t like uncertainty,” summarized JP Morgan.

Sadly, it’s currently not worth parsing the nuances of trade statistics and monetary policy, because it has no bearing on the Aussie, though at least this makes my job easier. For the time being, the Australian Dollar will tick up if it looks like the global economy (principally the US) will avoid a double-dip recession. Otherwise, it is in for the same rough stretch as the S&P.

By Adam Kritzer

The frequency of my reports on the Chinese Yuan is admittedly much higher than it used to be. Why? Call it disbelief. More than two months have passed since China revalued its currency, and after a rapid 1% appreciation, the RMB has actually fallen back. Today, it stands only .5% higher against the Dollar compared to June 18. On a trade-weighted basis, it is actually 2.3% lower. What is going on?!

It can foremost be attributed to a disconnect between Chinese words and Chinese action. While The People’s Bank of China (PBOC) purportedly supports a stronger, flexible Yuan (”Adopting a more flexible exchange-rate regime serves China’s long-term interests as the benefits…far exceed the cost in reorganising industries and removing outdated capacities.”), in practice, it has prevented the currency from budging. On numerous occasions since supposedly allowing the RMB to appreciate, it has intervened in the forex markets through various shadow dealers to prevent this very outcome.

In fact, China has increased its purchases of South Korean and Japanese sovereign debt, ostensibly as part of its diversification strategy, but more likely to put upward pressure on those currencies. “Data from Japan’s Ministry of Finance show that China bought a net 1.73 trillion yen ($20.3 billion) of Japanese government bonds in the first half of this year, compared with a net sale of 5.9 billion yen ($69 million) a year earlier. That strong demand has been a key factor strengthening the yen in recent weeks.” This could have broad implications, since in the last quarter, China accumulated $81 Billion in new forex reserves, and seems intent on further diversifying out of US Dollar-denominated assets.

China’s general obstinacy towards in dealing with the Yuan is baffling to market observers, especially given the trade surplus of nearly $30 Billion in June, its largest since January of 2009. In fact, China can be seen moving backwards. It recently inaugurated a pilot program that will allow exporters to hold offshore accounts of foreign currency, which might be expected to relieve some of the upward pressure on both the Yuan and on China’s foreign exchange reserves: “If you don’t force firms to surrender their foreign-exchange proceeds, then they won’t be exchanged for renminbi, which is a source of appreciation pressure.” In this way, China can both limit speculative capital inflows (even by domestic investors) and inflation.

Foreign governments, led by the US, are still threatening action. Senators and Congressmen continue to harp on the issue (it is election season, after all), and are still threatening to slap a tariff on all Chinese imports. However, their efforts are being undermined by both the Department of Treasury (which refuses to label China a “currency manipulator”) and the Department of Commerce, which recently determined that the application of a broad-based tariff on all Chinese imports would violate its mandate.

I have always been cynical about China’s forex policy, on the basis that it is self-interested and disingenuous, and I think the fact that it remains pegged to the USD confirms that sentiment. In the end, China won’t bow to international pressure. It will only allow the Yuan to appreciate after it has determined that its economy won’t be negatively impacted, and even then, the pace will be glacial.

By Adam Kritzer