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Leverage in Currency Markets Takes its Toll on Brokers

David Becker
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Leverage in Currency Markets Takes its Toll on Brokers

The Swiss central bank last week abandoned its minimum exchange rate of CHF 1.20 per euro, which had been in place since 2011. The change in the central banks view came just ahead of this week’s European Central Bank meeting where Mario Draghi is expected to announce a full blown quantitative easing program. The SNB’s action generated chaos in the currency markets creating far reaching affects which included substantial losses and the potential for bankruptcy for some retail currency broker’s.

The SNB cut its deposit rate by 50 basis points to -0.75% from -0.25% previously and the target range for the three month Libor was cut to -1.25% to -0.25% from -0.75% to 0.25%. The SNB has spent billions in defending the currency cap, but the situation changed significantly since the SNB first introduced the measure. For once, the EUR was remarkably steady against the USD for a long time, despite a weak economy, partly due to the more conservative monetary policies in the Eurozone, with the ECB apparently prevented from QE by the prohibition of monetary financing as stipulated in its mandate.

However, with Draghi now pushing for sovereign bond quantitative easing, while markets speculate about Fed exit steps, the situation has changed and as Jordan highlighted, the depreciation of the single currency against the USD also had implications for CHF as long as the currency cap was in place. Adding this to the pressure from increasing safe haven flows as the Russian crisis intensified it was clear that the introduction of a negative deposit rate in December would not be sufficient to stem the increased pressure on the cap and that defending it would become a costly and ultimately futile exercise.

In the light of international developments, the SNB clearly had little choice but to cut its losses and abandon a policy that was increasingly difficult to keep in place and promised to be a very costly exercise in the future. In a change of tactic, the SNB is now hoping that a further lowering of interest rates will make Swiss assets even less attractive and thus limit future flows into the CHF.

The shock of 30% move in the EURCHF reverberated around the currency world. In the immediate aftermath it became apparent that a number of retail currency brokers could experience regulatory capital issues, as the leverage that they supplied to their retail clients generated unexpected losses.

The issue of leverage for companies such as FXCM, was that many of their clients blew through their account equity, and their broker was unable to sell their clients positions in the EURCHR fast enough to avoid losses. The leverage that FXCM employed in the United States was a robust 50-1, but brokers outside the United States although theoretically the losses are not the brokers but in fact their clients, but it is unlikely that these retail currency brokers will be able to retrieve these funds.

Leucadia National Corporation and FXCM announced that Leucadia would provide $300 million in cash to FXCM which will permit FXCM to meet its regulatory-capital requirements and continue normal operations.

Alpari UK Limited is also under pressure. The board of directors announced that they are urgently considering all options including a sale and are liaising closely with the FCA.

The move by the SNB was a surprised to market participants, and sheds light on the practice of heavily margined securities. Not since the financial crisis has there been a situation where heavily levered players felt the brunt of such a surprise move. What could likely come is additionally regulation that will reduce the margin that will be offered to retail investors for currency transactions.

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