There is a popular belief that lemmings (rodents with sharp teeth from the Arctic) regularly jump off cliffs to their death. Unfortunately for this story it's a misconception - lemmings don't do that - not on purpose anyway. However in the true spirit of financial journalism we will not let that fact get in the way of a good story therefore we will draw a parallel to lemming-like behaviour in the investment world.

It's called foreign exchange trading. Whilst fx trading is regularly promoted as a get rich quick scheme with numerous testimonials from individuals who have been able to leave their jobs and "trade successfully" the reality is, surprise, quite different. Of course anyone with half a brain and ten minutes to research the subject would discover that there is no free lunch, in fact, as one LA Times reporter put it, "foreign currency trading is easy - an easy way to lose money".

However the existence of big companies in NZ, Australia and globally serving the retail fx market suggests that there is a large and recurring supply of human lemmings happily willing to take the plunge.

This week we will dig the dirt on fx trading using research on the topic from some of the world's largest regulatory authorities.

Advertisement

First off let's look at how trading fx works. The foreign exchange market is huge - turnover is some US$5 trillion a day. So it's a very liquid market and that itself is important as a good rule of thumb is that market efficiency is proportional to liquidity - the more something gets traded the less likely it is to be mispriced.

This is common sense too - there are untold experts forecasting which way the US$ is going to move so all the public information there is will be factored into the price. So to make money trading fx you not only need information that no one else has, you also need to interpret how that information will impact the fx market. Doesn't sound easy does it? But it is say the fx trading firms - all you need is a graph to determine the trend and you are on your way to your first million. Sounds reasonable, not.

How the retail fx trade works is the lemming, usually a male lemming, attends an "intensive" course on trading fx, principally involving understanding the terminology, charting trends and getting to grips with stop loss orders etc. Nothing complex. He is then told that because he is so clever just investing with his own money isn't "leveraging his skills" and that he can borrow additional funds to make serious money.

This is why small mistakes translate to huge losses. Leverage levels overseas apparently get to 200x the client's equity and the US regulatory authorities have legislated to prevent fx firms from encouraging people to leverage their position past 50x.

Various regulators around the world require companies providing retail fx trading platforms to record their clients' transactional history. Recently the French version of our FMA, the Autorité des Marchés Financiers (AMF), launched a detailed study of the actual performance of French based fx platforms because they were "concerned by the number of complaints by clients trading forex and losing significant sums". Over a four year period and looking at the accounts of almost 15,000 active traders the AMF found:

• That 89 per cent of clients lost money
• The average loss was almost NZ$20,000
• Total losses were more than NZ$300 million

If losing money is "success" then fx trading could be for you. A key finding according to the AMF's investigations was that trading losses did not decrease as investors became more experienced - the most active traders simply lost their money more quickly. Such results are entirely consistent with the theory that the foreign exchange market is efficient and that trading skills are difficult if not impossible to learn.

But losing money on fx is not just a French thing. The regulatory authorities in other countries report that most people lose trading fx. In the US a Los Angeles Times report refers to a research document issued by the Commodity Futures Trading Commission which found that between 72 per cent and 79 per cent of the customers at two of the largest fx platforms executed losing trades.

The LA Times article quoted a University of Southern California Business Professor and former Chief Economist at the Securities Commission who said that "the business model for forex trading is to burn the customer and then find another one".

The Commodity Futures Trading Commission report disclosed that customer turnover at the largest US fx platform was 4x higher than that of an ordinary retail stockbroker and most of its customers at the end of the year were different from the ones at the start of the year. A recent Bloomberg report reckoned that the average life of a retail fx trader was four months.

Note that most people playing the foreign exchange game lose money in normal times. But the fx market can get volatile and that's when extraordinary losses can be incurred. We had a good example of the unpredictable nature of the fx market a few weeks ago when the Swiss Franc rose in value dramatically. This impacted a lot of retail fx traders because one favourite trade was to borrow the Franc at a low interest rate, convert those funds into a higher yielding currency and pocket the interest rate differential.

Note that this strategy, like most strategies, wasn't initiated by the retail client rather it was promoted as a no brainer by the platform provider on the basis that the Swiss Central Bank was supressing the value of the Swiss Franc and interest rates in Switzerland were zero. Incidentally the strategy has been likened to "picking up pennies in front of a steamroller" in that whilst the investor pockets the small interest rate differential he or she runs the risk that the funding currency appreciates, ie sooner or later the investor takes his eye off the steamroller and gets run over.

That's what happened when the Franc appreciated and the losses were so great that they not only wiped out the retail clients, in some cases they wiped out the firms providing the fx platform as well.

The other problem with fx trading is that the companies providing the retail trading platforms seem to go bust on a regular basis. This wouldn't be an issue if client funds were segregated but overseas in unregulated countries often they are not so when the platform ceases to exist it usually takes the money of those customers who haven't lost the money themselves with them. Globally the sector tends to attract shady characters based in tax havens with no regulatory oversight, no physical address who can disappear with the click of a mouse.

All in all not very satisfactory. One former executive from the US Regulatory Authority summed things up well when he said "the best way to regulate the industry would be to ban it".