The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed on July 15, 2010, and introduced some changes to the way retail investors participate in the foreign exchange market. The majority of these changes went into effect in October 2010. However, as with all sweeping legislation, there are many gray areas within the act that require some interpretation by forex market participants. The way the market interprets the act will impact whether it is beneficial to open a forex account overseas. Here we'll examine what forex traders now need to consider when looking to trade forex from overseas accounts.
An Overview of Forex Trading
Before the introduction of the internet, retail investors had difficulty participating in the forex market, primarily because foreign currency is not traded on a central exchange like the stock market. Forex trading occurs over the counter in decentralized worldwide markets; as a result, only large institutions were able to participate, because they had the resources to keep traders on-site. However, now that forex is traded electronically via the internet, even the smallest individual is able to trade forex. Despite the access to the market, forex trading carries with it many risks, but it is popular because individuals can also reap quick and pronounced profits.
One of the benefits of trading foreign currencies is that there is constant movement of prices in this 24-hour market, allowing active traders to move in and out of positions swiftly. As a result, funds need not be tied up for long periods of time. However, these constant price fluctuations also lead to a highly volatile market, where sudden losses can be experienced at any time. And since most traders leverage their trades, margin risk is extremely high. Traders benefit from the forex market in other ways as well. Trading currencies is tax-deferred and gains are taxed when withdrawn under the capital gains tax rate.
There are low transaction costs as many brokers offer no-commissions trading, but because this is a decentralized market, the specialist dealer sets the execution price. So, while the dealer may offer no-commission trading, he is not offering a pro-bono service! The dealer sets the execution price such that he makes a spread on the exchange. As such, the pricing offered by forex dealers can vary tremendously. Dealers also encourage traders to use high leverage so that their spread income is magnified. (For more insight, see How To Pay Your Forex Broker.)
New Regulations the Under Dodd-Frank Act of 2010
The Commodity Futures Trading Commission (CFTC) is the governing body authorized to regulate futures "look alike" contracts, which are traded over the counter but are settled based on the settlement price of similar, exchange traded contracts. The CFTC established new rules that regulate the forex market in August 2010. One of the main purposes of these new rules was to provide some much-needed investor protection, specifically as it relates to broker/dealers. In the U.S., broker/dealers must register with the CFTC and are subject to certain operational requirements, including recordkeeping and reporting guidelines. These requirements are similar to the requirements placed on the regulated traditional commodity contract dealers.
Secondly, intermediaries of the transactions will need to register and are subject to net capital requirements of $20 million, along with other risk disclosures. In addition, brokers that accept orders need to maintain a net capital requirement or enter guarantee agreements with the broker/dealers and can only have one guarantee agreement at one time. The CFTC has established anti-fraud regulations over all futures "look alike" contracts. Finally, the CFTC imposed leverage restrictions of 50:1 for major currencies and 20:1 for all other currencies. (To read more about the financial regulators, read Financial Regulators: Who They Are And What They Do.)
Does Opening a Forex Account Overseas Make Sense?
There are two main benefits to opening a forex account overseas. Circumventing the new regulations, in particular the leverage restrictions, can be accomplished this way, although it is unclear whether foreign entities will go against the U.S. government and allow higher leverage.
Another benefit to having a foreign account is the potential tax benefit. Forex trading is tax deferred, meaning gains are taxed at the capital rate when the gains are realized by withdrawing the funds from the account. Investors are now required to report all foreign accounts to the IRS as of January 1, 2011 and foreign financial intitutions will be require to report investors with asset exceeding $50,000 to the IRS starting in 2013.
Overseas Account Risks
The risks of opening a forex account overseas are several. Counterparty risk may increase as the broker/dealer used by these foreign intermediaries may not be of the highest standards. Detecting and preventing fraud by the dealer may be difficult and scams may be more common. Also, competition may not exist in foreign entities, so getting the best pricing may be to the advantage of the dealer and not the trader. In the same vein, the loss of protections established by the new CFTC regulations is perhaps the greatest risk. The CFTC's new regulatory role over the dealers, intermediaries and brokers participating in the forex market was established to provide the retail investor with protection from the prevalent scams and fraudulent practices common in this decentralized market. These protections are only extended to those that engage with and trade with registered entities. (For more on opening an account overseas, check out Overseas Investing No Protection Against Downturn.)
The Bottom Line
Opening a forex account overseas allows retail investors to trade like other foreign market participants - unrestricted by leverage and other requirements. However, in many cases, the risks may outweigh the benefits. A trader needs to determine whether the potential for higher leverage is worth the risks of forgoing the protections established by the CFTC.
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