Matt Levine explains how FXCM, Alpari, et. al. screwed up.

[randomness]

Matt Levine has an entertaining piece in Bloomberg View on how all those brokers lost all that money when their retail speculators were losing their shirts:

Imagine being a retail foreign-exchange broker and letting your customers day-trade Swiss francs with lots of leverage. How much leverage would you feel comfortable giving them? Well, if daily moves are typically less than 0.1 percent, then that means that 95 percent of the time their positions will move by less than 0.2 percent in a day. So if you required 2 percent margin -- that is, you demand $2 of cash from them for every $100 worth of Swiss francs that they trade -- you'd feel pretty safe. That would mean that, 95 percent of the time, customers couldn't lose more than one-tenth of their equity in a day -- so if they lost money and skipped out on you, you'd be able to liquidate their positions without getting close to losing any of the money you'd lent them.

On the other hand when the euro/franc moves by 19 percent in a day, they're gonna get utterly smoked, and so are you. This is roughly the boat in which FXCM Inc. finds itself.

...

It's good to occasionally remember that a margin loan is a put: If you let your customer buy something for $100, and you lend them $98 of the purchase price, and then the price of the thing falls to $81, then guess what, you own the thing! Also you've lost $17. I mean, you can call the customer and ask for more money, it can't hurt. But you're not going to, like, feel full of joy and confidence while you're making that phone call.

Comments

[achinhibitor.livejournal.com]

Imagine being a retail foreign-exchange broker and letting your customers day-trade Swiss francs with lots of leverage. How much leverage would you feel comfortable giving them?

That made me LOL evilly!

It's good to occasionally remember that a margin loan is a put

Is it really a put, or is the customer legally obligated to make up the difference? (Neglecting whether you can actually make them do it.)

[r-ness.livejournal.com]

Is it really a put, or is the customer legally obligated to make up the difference?

That is an interesting question. It depends on whether the margin loan was non-recourse. I suspect the ones in this case are, because I haven't heard of the brokers going after the customers for more money.

It's a corresponding case to a non-recourse mortgage: if you default, your creditor takes the collateral, which in the case of the margin loan is the security being bought on margin. Sadly for the FX broker, that security is now worthless. The borrower can walk away without even having to send jingle mail.

[r-ness.livejournal.com]

David Evans’ piece on FXCM for Bloomberg deals with this exact point:

The 157-page prospectus for FXCM’s 2010 initial public offering warns of the disaster that could follow extreme market volatility, as happened last week.

“We may be unable to close out customer positions at a level where margin posted by the customer is sufficient to cover the customer’s losses,” the prospectus says.

Many businesses might sue customers who refuse to pay up. Not FXCM.

The prospectus goes on to describe what, in hindsight, might seem like a weakness in FXCM’s business plans: “Our policy is generally not to seek to pursue claims for negative equity against our customers.”

In other words, if customers run up big losses, FXCM will be on the hook.

I'd say that just about covers it.

[achinhibitor.livejournal.com]

I'd say that just about covers it.

Mmm, yeah. Though they were smart enough to put it in their prospectus, which means that the shareholders can't sue about it. The only question is how much of the stock has the founder managed to unload before the crash.

Though it's sort of an odd position to take with the customers. Did it somehow allow them to more easily attract customers? Usually retail customers don't pay enough attention to where the risk lies for unusual events, so I wouldn't think of it as a selling point. I wonder if there's some subtle aspect of this revolving around the fact that the customer's credit rating is not relevant to their account status -- all risk beyond they cash the customer has put into the account is borne by the firm?

Unlike stock or futures brokerages, retail foreign-exchange firms don’t have to keep customer and firm money segregated in separate accounts. Instead, they can commingle the funds. So if a firm goes under, investors have no priority in bankruptcy and their money isn’t protected by the Securities Investor Protection Corp.

Who gets into this market? Niv described FXCM’s typical client as a male, white-collar professional between 35 and 60. [Basically, gamblers.]

Jesus!

[r-ness.livejournal.com]

Did it somehow allow them to more easily attract customers?

I believe--and when I say I believe this I mean that because I have not extensively researched the policies of the various retail FX brokers--this practice is standard in the industry, partly competitive and partly practical.

Jesus!

What can I say? There are a lot of people who want to gamble but be able to say they're investing.

[achinhibitor.livejournal.com]

There are a lot of people who want to gamble but be able to say they're investing.

That reminds me of the old saw about "the business known as gambling" (running a casino) vs. "the gambling known as business" (speculative investing).

[drwex]

I'm not sure you can call this "screwing up". It's not like the CDS blow-ups of the last few years - this is like the titanic hitting an iceberg, a classic black swan.

That said, it's an extremely good example of why Bitcoin isn't going to find itself on a lot of FX venues anytime soon.

[r-ness.livejournal.com]

this is like the titanic hitting an iceberg, a classic black swan.

I entirely disagree. It was inevitable that the Swiss National Bank was going to be forced to end its euro peg. The only question was when, in the same way the Bank of England being forced to withdraw from the European Exchange Rate Mechanism was inevitable.

It seems pretty clear that the European Central Bank gave the Swiss National Bank an early heads-up about their QE announcement Thursday morning and that precipitated the Swiss action. In short, Mario Draghi told Thomas Jordan that a tsunami of over a trillion euros was coming, and Jordan made sure to move the Swiss National Bank out of the way.

That said, it's an extremely good example of why Bitcoin isn't going to find itself on a lot of FX venues anytime soon.

So true, and so overdetermined. :)

[drwex]

We may be splitting hairs here, but I think the claim that the Euro peg was going to end is both trivially true (nothing lasts forever) and unhelpful. Likewise I'm sure that mortgage interest rates are going to rise - once that happens it'll seem inevitable, but if you look at the past year even 30-year-fixed rates continue to tumble.

The probability of the peg ending on any specific day is nearly zero or nearly impossible to predict depending on how you look at it. I would also argue that the choice to make a flat-out end to the peg rather than a gradual increase in the exchange rate float amount was also hard/impossible to predict. SNB could just as easily have said something like "starting next month we will allow up to a 5% float, increasing by five percent per month for the subsequent three months after which time restrictions will be removed altogether."

Had they said that and exchanges continued to allow low-margin positions to continue then that'd be a screw-up. But instead they yanked the plug all at once and the ship hit the iceberg.

[r-ness.livejournal.com]

We may be splitting hairs here, but I think the claim that the Euro peg was going to end is both trivially true (nothing lasts forever) and unhelpful.

I think we're going to have to agree to disagree here because while it's true that nothing lasts forever it was fairly obvious to many observers that the peg wasn't going to last. The political pressures on the SNB were building and would not survive ECB quantitative easing. And QE in the eurozone was clearly coming.

(Disclaimer: I was long CHF, so I made a little money on this move. I did it in actual physical banknotes--Switzerland has some pretty cool-looking ones--so it hardly counts as "investment" as opposed to "holding onto some Swiss francs so I can get out of the airport without hitting a price-gouging cash machine on my next visit to Zurich".)

In any case, this isn't the only possible fx move that would blow them up, and they still allow low-margin positions, even now. Their business model doesn't make sense unless they give punters lots of leverage, because no one will play in their casino without it. The NFA just tightened it down to "only" 20:1 for CHF and 33:1 for SEK and NOK (and only in the States). But all other currencies? Unchanged.

Shorter answer is that their business model doesn't make sense without gamblers. So maybe it isn't so much as a "screw-up" as that the whole model is prone to occasional volatility events, and therefore needs much more capital than they planned for.

[achinhibitor.livejournal.com]

There's more to it than that. At this time, the SNB was trying to prevent the CHF from rising against the Euro, despite that all the fundamentals were driving the CHF up. The problem with such pressures is that they often follow the pattern of increasing pressure from the fundamentals being met with increasing pressure from whoever is intervening... Eventually the pressure becomes too much to resist, either because the costs to the intervenor become higher than the intervenor is willing to bear, or the intervenor runs out of power to intervene with enough force. At that point, the market very quickly snaps to approximately where it would have been on that date if the intervention had not been done at all, i.e., a huge making-up of change. Worse, as the situation develops, all the smart money starts betting on the ending of the intervention, which tends to increase the pressure on the intervenor, causing the end of intervention to come earlier than the fundamentals would lead you to expect.

This is the typical pattern for the breaking of currency pegs.

The subtlety in this case seems to be that in the early phases of the intervention, the CHF was being driven by panicked flow of money from the eurozone, and so the SNB could expect that after a few months the money flows would naturally reverse, and the CHF/EUR exchange would go back to what it was. But the pressure transitioned from being panic-driven to being driven by the fundamentals (the continuing weakness of the eurozone economies), which moved the intervention into the long-term-unsustainable category.

Of course, it's still hard to make money on this unless you have a few billion that you can invest for a few years, and go short on EUR and long on CHF.