An on-going discussion on the forum has highlighted an issue that I’m sure is close to every trader’s heart. Just how secure are the funds the trader has on deposit with a Futures Commission Merchant (FCM) here in the United States? Here’s a summary I hope will not only be informative but put this concern in its proper perspective. With respect to the security of one’s funds, there are at least three issues that need to be taken into consideration – bankruptcy, fraud, and severe market fluctuations the latter of which should probably be paired with the individual’s trading habits.
It’s a matter of fact that in the United States when an FCM declares bankruptcy trader funds are at risk. The National Futures Association’s “Retail Forex Transactions: A Regulatory Guide”, makes that very clear: “[Forex Dealer Members] may not represent that forex funds deposited with a Member are ‘segregated’ or given special protection under the bankruptcy laws.”
If you have been led to believe or have been assuming that in the event of a US based FCM bankruptcy proceeding you’re going to be in a position to reclaim the funds you have on deposit, think again. Your funds become the FCM's funds for all intent and purpose and, judging from the experience traders have been having trying to recoup their funds from Refco, you’ll be lucky after a year of litigation to get more back than a few cents on the dollar. The over riding factor here is that off-exchange traders are not afforded special protections under current US Bankruptcy law.
When it comes to fraud, most brokerage firms carry a fidelity bond to protect both themselves and their trader clients, but the coverage is not without limitation. While the coverage offered varies from one broker to the next, there’s no fidelity bond in existence that could have covered the massive losses experienced by traders when Refco was forced into bankruptcy last October. Are trader funds at risk? Yes, but only if the extent of the fraud exceeds the face value of FCM’s fidelity bond and this, historically, has been a rarity.
With regard to the final category, it may come as a surprise to many that a trader’s risk may not be limited to the amount of money deposited in his/her account. In a volatile market, the inexperienced trader who jumps into a highly leveraged news trade with or without the entry of a stop loss, can find himself putting not only his/her entire account at risk but be required to make additional deposits to cover losses.
So what’s one to do?
1. Avoid maintaining an account balance that exceeds your trading needs.
2. Accept the fact that bankruptcy and fraud are a fact of life and that there’s no guarantee that the FCM you deposit your funds with won’t eventually become insolvent or be defrauded and it really doesn’t make a bit of difference how much money they report having to meet capitalization requirements if massive fraud is involved. When Refco filed for bankruptcy last October it reported to the CFTC that same month that it had $284,858,885 in excess net capital. Didn't mean much then. Doesn't mean much now.
3. Don’t’ trade the news unless you know what you’re doing and, if even if you do know what you’re doing, make sure you enter a stop loss. The stop loss itself, won’t guarantee a fill if the market goes ballistic, but it affords you the means to avoid unlimited losses that may go well beyond meeting a simple margin requirement.
4. Lastly and most importantly, make sure you read and understand your trading agreement so you know exactly what is at risk if the market goes south on you. If after reading that portion of your agreement you don’t have a clear understanding of the FCM’s policies in regard to extraordinary losses, call the FCM and make sure you understand the full extent of your obligation. With some FCM’s it’s possible you could be required to make an additional deposit to cover your losses.
Note: A word of thanks to the members of the forum who contributed to the discussion this past week. It has been extremely informative.
Recommended Additional Reading
Think You've Been Trading the Forex? Think Again
Advantages and Disadvantages of Non-Dealing Desk Trading
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