Risk - FX and Hedge Fund Style
March 21st, 2007 by Justin
The question of whether margin FX trading is simply too risky for most investors has become more resonant as the FX market continues to boom at the retail level. One reason why risk is of particular concern is because the growth is predominantly in the retail market, which is seen by regulators as being less sophisticated and prone to using non-risk capital to trade. This discussion becomes very interesting when juxtaposed with what is happening in the world of Hedge funds. As hedge funds have grown over the years, a parallel discussion to that of FX has developed over the need to protect hedge fund investors from the risks of their alternative investments, and the SEC is currently working to raise the minimum financial requirements that make someone an accredited hedge fund investor.
The discussion is interesting because, in terms of the investor type, the typical FX self-trader and the typical hedge fund investor could not be more different. To illustrate: It is possible for someone with zero investment or trading experience whatsoever to open a margin FX trading account in a few minutes with a broker, to fund the account by maxing out on a credit card, and to start trading away that same day. Odds are that the FX trader will not only not make any money, but that she will lose her entire initial investment, sooner or later.
To invest in a hedge fund, on the other hand, one must be an accredited investor, meaning among other requirements that one must have at least 1 million USD in net worth. This is so because someone with 1 million dollars or more is considered “sophisticated” enough to understand the risks of hedge fund investments (unregulated by the SEC, NASD or any other federal regulator) and is able to sustain the loss of their (large) investment capital. Hedge funds on average do better than mutual funds, so the typical investor will make at least some money. In the worst case, they will not lose their entire investment.
Speaking with the head of a hedge fund database provider last week, he told me that the industry is battling against pressure to raise the minimum net worth that defines who an accredited investor is. The SEC apparently wants to raise the net worth minimum from 1 million to 1.5 or 2 million USD! When speaking with the media, this man pointed out that in the retail FX market, inexperienced traders can lose their rent money in 10 minutes. He said that if anyone should be regulated it should be the FX brokers, not the hedge fund industry. He has a point.
As far as investor protection goes, it should be a priority to protect FX traders against scams and to make sure every client understands the level of risk they are taking. the CFTC and the NFA oversee FX trading but the CFTC is truly a futures regulator trying to regulate the spot FX market, and the NFA is a voluntary self-regulated industry body. Any individual should know that she will likely be among the 95% of FX traders who lose their total investment. Once these truly vulnerable investors are protected we can worry about Hedge funds and their millionaire clients.
