On 15 January the SNB (Swiss National Bank) removed the floor on the EUR/CHF rate allowing it to float freely on the market. The Swiss Franc immediately appreciated by almost 20% catching most market participants by surprise both on the timing and the extent of the market reaction. Over the next days it became apparent that many clients of online FX-brokerage operators, with highly leveraged positions trading on margin, had been caught unawares with short Swiss Franc positions and had substantial losing positions. The unique configuration of the online leverage FX brokerage model throws up some intriguing insights.

More Regulations are on the way

Policymakers had their eye on online brokers even before the SNB action. The fallout and customer complaints (class-action lawsuits anyone?) will only serve to accelerate regulatory focus on this sector.

Expect regulators to impose restrictions on the amounts of leverage clients can be offered and the amount of capital online leveraged brokers need to hold.

Even though the brokers' business-model means that they are always, in principle, fully hedged, the recent extraordinary market movements highlight that, in abnormal market conditions, there are still some ways that the brokers can lose money. FXCM needed refinancing, for instance, not because of its own proprietary positions but to cover unrecoverable losses from clients. Plenty of small traders lost money. 

Expect political pressure to further protect these customers when they enter the 'casino' that is the FX market.

Online Brokers need new clients

The margin-trading brokerage model requires a continuous renewal of the client base. Most clients that enter the market end up losing money. A recent survey by the French regulator AMF found that 90% of clients lose money (averaging 11k€ each). A large number of the leveraged brokers' clients were believed to have positioned themselves against the SNB lifting the cap – they all lost money at the same time last week, many of them being wiped out completely by the magnitude and violence of the moves. Just like Monte Carlo's casinos, the brokers depend on active clients to trade and bring in the commission revenues. Clients have either been wiped out or are 'doubling down' to recoup their losses or sitting on the sidelines licking their wounds before getting back into the market. 

Expect to see increased marketing efforts to replenish the customer base, and lower commission revenues for the brokers in the meantime. 

Bye-bye liquidity

The move from a EUR-CHF rate of 1.20 was so aggressive that there was no liquidity and so almost no trades priced between 1.20 and 0.9. Clients with stop-loss orders to sell at e.g. 1.15 had their positions liquidated at 0.9 - not at all what a stop-loss is advertised to do. Clients have been left with positions closed out at the very bottom of the market far from the levels they may have anticipated and resulting sometimes in losses much greater than the margin posted. In some cases trades were subsequently revalued on the following days at even worse rates (set in isolation by the brokers) with even greater losses for the clients.

Expect to see legal proceedings against the brokers from clients unhappy with the fulfilment of their stop-loss orders and of the arbitrary setting of revaluation prices. Longer-term expect to see calls for increased regulation on best-execution in the FX market and better investor protection.

Read the small print

Not all FX-brokers are the same – particularly when a client's losses exceed the amount of the margin posted (the so-called "negative-balance protection"). Many clients presumed that their loss was limited to the amount of margin posted. Wrong! Some brokers' contracts stipulate "negative-balance protection" so that losses beyond the margin are explicitly covered by the broker (as is the case of FXCM which incidentally needed a 300m$ bailout) or they are vague which in effect means that they are often the liability of the client (these clients lost all of their funds posted as margin and furthermore have a negative balance on their accounts for which they owe more money to the broker). Yes, when you trade on margin it's possible to lose more than just the funds you post as initial margin. These clients are faced with paying further losses to the brokers, walking away from the broker (and facing legal recovery proceedings from the broker) or joining ombudsman or legal proceedings against the brokers. I have met with clients in both these categories (some clearly happier than others) and it is clear that the leveraged margin-trading system does not function under stress as the (retail) clients had expected (very few of whom had read or understood the small-print). Interestingly Saxo Bank reported an uptick in new clients joining last week – how many of these were clients of other brokers switching away from accounts with negative-balances?

Expect to see some long, drawn-out class-action lawsuits, and changes to general terms and conditions from any brokers offering negative-balance protection (clarifying or removing it altogether).

Time for M&A

Finally, the events have shown that some of the new entrants to the market have superb platforms that are attractive to clients and work well in normal, stable market conditions but fail under stress with poor controls or process. Many are now facing immediate funding and capital problems to cover losses, or will do so shortly, either as a result of legal actions from clients or because of weak future profitability.

Expect to see M& A activity – the perfect match could be an established bank with strong brand, capital, controls and process yet lacking an online footprint, buying a now-distressed online broker with good technology, platform and customers but lacking in funding, controls and risk-management expertise.

The leveraged brokers that survive will have to adapt their models and practices to the new set of realities brought home by this winter's actions of the Swiss National Bank. The fall-out is sure to last long after the snow has melted from the Swiss Alps.