Listen to the Article: Is A Leverage-Restricted FX Market Becoming the New Norm?

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Thanks to the relatively low transactional cost, the ever-increasing online trading, and the trending mobile trading, retail forex market has seen substantial expansion. In the meantime, however, the market is experiencing some violent changes, whether they are bringing pain or benefits, all FX brokers, traders and solutionists have to adapt to them no matter what.

We are seeing the following trends in the market based on what we have in our hands: First, the rise of AI and automated trading is playing an increasingly important role; second, the cryptocurrency is boosting the fierce competition across markets even fiercer; third, the FX market is anticipated to continue growing, the momentum howevever is declining, and; fourth, the regulations are only going to get more serious, and leveraged trading will be tied down even lower as a way to maintain healthy market activities.

So today, we'll take a dive into the question of whether the leverage should be strictly constrained in retail forex to dial down the level of speculation in the market, or perhaps let it take its course naturally and harness vitality from it?

How is Leverage Reined across Global FX Markets?

High-leverage seems particularly popular in currency pair trading in comparison with other investments, and traders often have access to leverages much higher than what they have in stock markets. It is not unsurprising to trade high leverages like 50:1 or 100:1, dwarfing 2:1 in securities and 15:1, what you normally see in options trading.

The gist of leveraged trading is OPM, Other People's Money, which means it is a way to borrow money to trade. As a matter of fact, many investors are leveraging their relatively low deposits to trade big, thanks to a lot of brokers' ultra high leverages and all sorts of bonuses they get from opening an account, and sometimes when you gamble big, you win big.

Pre-2010 leverages, when regulators were not taking this that seriously, were often seen as crazy as 400 and 500 times. I.e, you deposit 250 bucks and that makes you are a global FX trader with 100k available in your hand. Nevertheless, some regulators considered that not all market participants are benefited from such gigantic trading volume and liquidity, and more often than not only the intermediary agencies are making the money. Relevant investor behavioral studies suggest that forex traders are more inclined to demonstrate manifestations of overconfidence known as "behavioral distortions" as a result of leveraged investment returns, and naturally provoking highly speculative acts, leading to unbearable losses that go far beyond one's reasonable acceptance.

Take the U.S for instance, the Commodity Futures Trading Commission (CFTC) stepped in and capped the leverages available to U.S investors not over 50:1 (major currency pairs) and 20:1 (other currency pairs), in the authority of Dodd-Frank Act, a part of the then-Obama Administration's financial regulation package. In June, 2018, the European Securities and Markets Authority (ESMA) released a statement on carrying out limits on leverages offered by CFDs and binary options retail trading. In specific, CFDs trading, known for its leverages, is curbed at 30:1 (major currency pairs) and 20:1 (other pairs as well as major indices such as gold) for position opening. In 2019, the Cyprus Securities and Exchange Commission (CySEC) followed through and implemented almost identical limits. In addition, the Australian Securities and Investments Commission (ASIC) hacked off ultra-high leverages with a 2021 policy. Major brokers including Pepperstone, IC Markets, eToro and IG had to sink down their top limits from 500, 400, 200 to 30:1, a legally required maximum value.

There are, too, leverage constraint policies elsewhere. For example, the UK Financial Conduct Authority (FCA) rolled out a 30:1 maximum limit; 20:1 in Singapore by the Monetary Authority of Singapore (MAS), and; 25:1 in Japan by the Financial Services Agency (FSA).

Low-Leverage Impacts

The impact of constrained leverage on a broker's excess capital (i.e. a broker's funds outside the required amount for compliance purpose) is often reflected on the broker's trading volume and ROI performance. The impact on market liquidity, on the other hand, is reflected on the market prices and bid/ask spreads in interbank market. For a forex market where leverages are constrained, the policy itself imposes nothing on traders' behaviors, but low leverages lead to substantial trading volume decrease which, in return, affects a broker's excess capital. But in the meantime, with leverages under control, brokers are having second thoughts if they really wanna bolster client demand by all means, so now most investors are better protected.

- Impact on FX Brokers

In specific, some researchers have conducted empirical studies on the disparity between a pre- and post-constraint trading activities. The results suggest that the leverage constraint brought down roughly 23% monthly average trading volume (ADV), yet the overall monthly ROI for investors has picked up since certain high-leverage risk-takers now have less profits.

- Impact on Retail Traders

Similarly, it is believed that a low-leveraged market is where bid-ask spreads go up, while liquidity subdues. However, we are not seeing significant spread raise in leverage-restricted markets, nor are there proof on brokers planning to do so since regulators are putting a lid on the leverages they offer. So it is safe to say that leverage constraint is not changing the average trading contents of the forex market in a notable way, consequently the impact on the overall ROI has been minimum.

Final Thoughts

Fazzaco's opinion on whether we should curb the retail forex leverages is never a white-and-black question, because the purpose of restricting it is to maintain the order of the market and prevent highly speculative behaviors. It is inevitable that it may result in collateral damages where brokers are the victims, making the market become less energetic.

We believe that there is a reasonable alternative measure for regulators, and that is to send out warnings whenever a leverage is too high. Many of the industry believe that a gentle approach such as a message is much more helpful for the markets than harsh crackdowns. When investors are warned of excessive leverages, they not only will realize the potential risks, but brokers will also turn to other measures to stimulate client demand and avoid noncompliance issues.

Of course, it is worth pointing out that most of the brokerages that offer ultra-high leverages are usually holders of offshore licenses. Brokers licensed within major jurisdictions do not offer such options anymore.