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

[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.