By SARAH MORGAN
For the increasing number of individuals trading currencies, recent regulatory investigations highlight a little-known pitfall: Brokers typically trade against their clients, not for them.
In stock trades, brokers sell or buy stocks on behalf of clients, with getting the best price a priority. In currency trades, a retail foreign-exchange dealer is usually on the other side of a client's trade and the dealer quotes the price.
Dealers acknowledge the conflict in fine-print disclosures; critics say it isn't well-known by retail foreign-exchange traders, who now make more than $315 billion of daily trades. "They don't understand where sometimes the dealer may be acting against them," says John Jagerson, a co-founder of Learning Markets, an investor-education company.
Foreign-exchange dealers say this is a risk of trading in an over-the-counter market, and they are acting within the rules and regulations set by the Commodity Futures Trading Commission and National Futures Association, regulators with authority over retail currency trading.
"Your dealer is your trading partner, which is a direct conflict of interest," states one typical brokerage disclosure. It goes on to say that a dealer may offer any price it wishes, may show different prices to different customers, and that prices mightn't reflect prices available elsewhere. Similar language is common across disclosure documents for other foreign-exchange dealers.
"They just have to accept that risk if they want to trade," says Larry Dyekman, a spokesman for the NFA, the self-regulatory organization for the futures industry that all retail foreign-exchange dealers must belong to. He says NFA rules require dealers to fill a customer's order as close to the asking price as possible. But that asking price is simply the price the dealer has quoted to the trader. There is no requirement that it be based on prices available from other dealers or banks.
Investors don't face this conflict in the stock market. There, a broker must provide "best execution," a requirement that balances speed, certainty of execution and price. Other market participants also have responsibilities to traders: And if the Nasdaq Stock Market has a better price for a New York Stock Exchange-listed stock, the NYSE must pass the order to its rival exchange, and vice versa.
The different rules of currency trading may have cost one California pension fund $4.5 million, according to a Wall Street Journal analysis. The Los Angeles County Employees Retirement Fund alleges that banks made the trades at the least-advantageous price for the pension funds, and the Securities and Exchange Commission is reportedly looking into whether two banks properly explained to pension-fund clients about how they determine prices for currency trades.
The probe comes on the heels of a NFA investigation into the trades of its 16 member retail foreign-exchange firms. Among other practices, the organization wants to see whether firms take advantage of small price movements that happen between when a customer orders a trade and when that trade is executed. No complaints have been filed against any NFA member organizations for unfair trading practices since the probe began in February.
In addition to competitive forces that keep dealers from offering prices out of step with the rest of the market, regulatory scrutiny is moving retail currency trading toward the kind of transparency traders enjoy in the stock market, says Glenn Stevens, CEO of GAIN Capital Holdings, which offers retail foreign-exchange trading through Forex.com.
Professional currency traders can sidestep the potential for a conflict of interest on pricing by calling several dealers and brokers and asking for quotes before disclosing whether they are buying or selling, says Marc Menchel, an executive vice president of the Financial Industry Regulatory Authority. A retail trader with an account at a single foreign-exchange dealer trades only at that dealer's price.
Currency traders can avoid some of that risk by using limit orders, which direct a dealer or broker to execute a trade at a specific price, rather than a market order, which accepts the price currently offered, says Mr. Jagerson of Learning Markets. Wealthier retail traders also can consider currency options or futures, which are traded on transparent exchanges but generally have higher capital requirements than regular currency trades, he says.