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).