Aarhus School of Business – Aarhus University

Trading in the Bucket Shop

By Carlos F. Rocha P.

Carlos Supervisors Prof. Paul K. Andersen

Prof. Carsten Tanggaard01-02-2012

IndexIntroduction.........................................................................................................................................3

PART I................................................................................................................................................6

THE MARKETS, STRUCTURE AND PARTICIPANTS.................................................................6

The Markets, Structure and Participants.........................................................................................7

Forex............................................................................................................................................7

CFD’s..........................................................................................................................................9

Markets Structures.........................................................................................................................12

Forex..........................................................................................................................................12

CFD’s........................................................................................................................................13

Participants....................................................................................................................................14

Clearing House..........................................................................................................................14

Prime Broker.............................................................................................................................14

Introducing Brokers and Money Managers...............................................................................15

Money Manager Profiling.........................................................................................................18

PART II.............................................................................................................................................20

MECHANICS OF THE TRADE......................................................................................................20

Mechanics of the Trade.................................................................................................................21

Important concepts....................................................................................................................21

Before Trade Execution.............................................................................................................27

Open Position............................................................................................................................28

Trade Liquidation......................................................................................................................34

PART III............................................................................................................................................36

OPERATIONAL MODELS..............................................................................................................36

Operational Models.......................................................................................................................37

Key steps in clearance and settlement.......................................................................................37

Broker Model............................................................................................................................38

Market-Maker Model................................................................................................................39

Central Counterparty Model......................................................................................................41

How do brokers, market makers and bucket shops make money?................................................43

Why is this model so followed and profitable?.............................................................................45

Comparing the Models..................................................................................................................47

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Routed Execution to an ECN or a Liquidity Provider – Broker Model....................................47

Market Making Model...............................................................................................................48

Central Counterparty Model......................................................................................................49

PART IV............................................................................................................................................52

REGULATION IN DENMARK.......................................................................................................52

Institutions in Denmark.................................................................................................................53

Financial Business Act..................................................................................................................54

Securities Trading Act...................................................................................................................55

Book-entry and registry.................................................................................................................59

Executive Orders...........................................................................................................................60

Executive Order on Risk-Labeling of Investment Products......................................................60

Executive Order on Investor Protection in connection with Securities Trading.......................60

PART V.............................................................................................................................................62

OPPORTUNITY AREAS.................................................................................................................62

PART VI............................................................................................................................................69

CONCLUSIONS...............................................................................................................................69

2

IntroductionDuring recent years, the Retail Foreign Exchange (Forex) and Contracts For Difference

(CFD’s) markets have become a center of attention to many traders worldwide who seek a

“fast and easy” way of profiting with spread betting and some financial instruments’

speculation by electronic trading, through financial intermediaries that give access to these

markets. Unfortunately, most of such traders find it hard to obtain lucrative results due to

ignorance whether they are investing or speculating through legitimate intermediaries or

through Bucket Shops.

This market access given to the final user, either natural or legal person, is mainly obtain

throughout an intermediary, which can be catalogued as broker – a firm that communicates

the bid and ask prices to potential principals, investors or traders, and arranges transactions

as agent for a fee without acting as counterparty in the transactions1 -, as dealer – a firm

that enters into transactions as a counterparty on both sides of the markets in one or more

products2 – and as market-maker – a firm that can act as a broker, a dealer3 or match trades

throughout its clientele.

Bucket Shops have been around for more than a century, initially in the United States as

businesses that would offer stock investment possibilities to the public without the real

execution of trades in the stock exchange but merely “thrown into a bucket”, or kept in

house, acting as the counterpart at all times without informing the customer and

transforming the purchase into a bet on the price movements of stocks. The basic principle

to make money was easy and simple, by customers losing their money. In the beginning of

the twentieth century, the telecommunications infrastructure was ideal for this kind of

business since the stock market, represented by the New York Stock Exchange, kept

quotation tickers to its members and agents in order to maintain the appropriate flow of

information to the real participants, however bucket shops always found a way to get

1 Report on OTC derivatives: Settlement procedures and counterparty risk management – Bank for International Settlements2 Report on OTC derivatives: Settlement procedures and counterparty risk management – Bank for International Settlements3 This definition is used under Broker-dealer in Securities Lending Transactions: market development and implications – Bank for International Settlements

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quotes in real time or at least pretend those prices shown at their location were real;

without information access as we have today, the general public was not able to obtain

their own quotes but had to rely on the prices provided by the agent, in this case the bucket

shop. The act of bucketing an order meant that the bucket shop operator would take the

customer’s order but never execute it but “play the bank” as in a casino expecting the

customer to lose his money4. By doing business this way, it is evident a conflict of interest

that would result in the publication of a fake stock price in order to profit from investors.

Nowadays, many financial intermediaries use the same business model to reach new and

inexperienced investors by giving virtual access to international financial markets and

encourage them to trade as much as possible.

In 1906 the concept of Bucket Shop was defined by the US Supreme Court as: "[a]n

establishment, nominally for the transaction of a stock exchange business, or business of

similar character, but really for the registration of bets, or wagers, usually for small

amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or

delivery – final transfer of a security or financial instrument5 - of the stock or commodities

nominally dealt in."6 Although this definition involves some banking products like credit

default swaps and other cash settled options, this paper will focus on the markets

mentioned above, Forex and CFD’s.

The Bucket Shop concept described above is focused on the stock exchange businesses

that are unable to provide the final user with a legal trading in an established exchange.

The FX market is a decentralized market where there is no real place of exchange as other

markets, although trading its instruments is legal. Due to the nature of this market, with

rules of no delivery makes brokers, dealers and market-makers to fall under the Bucket

Shop definition of the US Supreme Court, although the retail forex activity does not

contemplate this position. For purposes of this paper, I will refer to Bucket Shops to those

intermediaries, brokers, dealers and market-makers, which by means of manual or

technological resources, and even though legally constituted, plays the bank expecting the

customer to lose his money, by avoiding the proper clearance of traded orders, quoted and

4 "Bucket Shop Secrets," New York Times, July 9, 19225 Delivery versus Payment in Securities Settlement Systems – Bank for International Settlements6 Gatewood v. North Carolina, 27 S.Ct 167, 168 (1906)

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executed price manipulation, cancelation of trades which resulted in profit to the customer

and usage of unfair trading incentives to its agents that will become a conflict to the

interest of the client.

This paper is divided into 6 parts where is expected to explain the different aspects and

processes involved in the retail foreign exchange and CFDs trading activities.

Part I is intended to explain the foreign exchange and CFDs markets, their basic structure

and there is an emphasis to the participants such as Introducing Brokers and Money

Managers, whom act as agents for intermediaries and are an important factor upon ethical

issues in these markets.

Part II explains the different mechanics involved in the trade, factors that traders face in

every order they make and could be the difference between a profitable and a losing trade.

Part III describes and explains the different models that intermediaries can follow when

orders are executed and where can be routed upon the intermediary’s core business.

Part IV highlights the most important regulatory institutions in Denmark and its laws

regarding the possible activities financial undertakings can do and the rules that apply to

the proper trading in the foreign exchange and CFDs markets.

Part V deals with a discussion of the current relevant legislation in Denmark and the

topics covered in Parts I – III.

Part VI is dedicated to the conclusions of this paper.

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PART I

THE MARKETS, STRUCTURE AND PARTICIPANTS

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The Markets, Structure and Participants

ForexThe forex market, is a global decentralized market where currencies trades are made, it is

the largest market in the world averaging a $4 trillion daily turnover7, has the best liquidity

and a two-way trading exchanging one currency for another. There is no brokerage

commission and intermediaries’ payments are by the bid and ask spread offered to the

traders. Participants can range from central banks in charge of government currency

policies, industrial and commercial companies whom use of the market is primary to actual

currency exchange, financial institutions that provide alternative instruments based on

currencies to trade and institutional investors, investment managers and individuals whom

seek a profit throughout direct speculation of price movements and spread betting. The

number of direct and indirect participants can reach the hundreds of millions every day.8

The retail forex market is based on the speculation on the price movement of currencies by

using high leverage and a non-delivery policy. What makes this market attractive is the

possibility to trade with “borrowed money” in order to be able to get in with a larger

position and enjoy the benefits of a large profit with a small capital. This tool can also

represent a potential danger to the trader’s account; the same way it can bring large profits,

it can also damage the account with large losses.

Price changes are usually in response to economic policies and news given by

governments; central banks are in charge of a country’s currency policies, economic

indicators and political news can make an impact to the offer and demand of a currency.

The forex market offers a variety of instruments where participants can trade freely

according to the market’s rules and characteristics. Among those instruments we can find:

7 The $4 trillion question: what explains FX growth since the 2007 survey? – Bank for International Settlements8 Currency Overlay

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The spot market

Currencies for immediate delivery are traded in this market; exchange can be physical or

electronic – electronic trade can be divided into two main categories: manual, where

instructions are executed by humans on an electronic trading platform, and automated,

where instructions are executed by computer algorithms, with little or no human

intervention (still subject to human monitoring)9, the actual exchange of the currencies is

handled through the banking system and generally occurs two days after the trade is

agreed10. In 2010, the Bank for International Settlements released a report on global foreign

exchange activity where spot transactions represented a 30.2% of foreign exchange market

turnover11.

The futures market

This market allows participants to trade currencies at a certain agreed price and future

date12. This kind of trade has certain restrictions, if compared to the spot market, since it is

necessary to wait until the expiring date to realize the trade, there are options for a

secondary market trade when one of the parties doesn’t want to wait until the agreed date

and trade the contracts with an alternative party. This market can be used by companies

with obligations in other currencies and try to lock those obligations at a certain price and

date to avoid potential losses due to price movement. It is also possible to use this market

for speculation and spread betting. When trading in the Over-The-Counter (OTC) market,

this instrument is denominated forward since these contracts are not traded in an exchange

but directly between a dealer and its customer13. In 2010, outright forwards and FX swaps

represented a 62.5% of foreign exchange market turnover14.

9 High frequency trading in the foreign exchange market – Bank for International Settlements10 Guide to Financial Markets – Fourth Edition – The Economist11 Report on Global Foreign Exchange Market Activity in 2010 – Bank for International Settlements12 Guide to Financial Markets – Fourth Edition – The Economist13 Guide to Financial Markets – Fourth Edition – The Economist14 Report on Global Foreign Exchange Market Activity in 2010 – Bank for International Settlements

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The options market

Currency options give the holder the right, but not the obligation, to acquire or sell a

currency at a specific price during a certain period of time15. This means that the trader has

the option to capitalize the trade when obtaining a profit but losses can be limited to the

commission he pays when executing the trade. In 2010, options and other instruments

represented a 6.4% of foreign exchange market turnover16.

CFD’sThe CFD is financial contract in which the difference between the agreed fixed price of an

asset and its prevailing market price is periodically credited to the counterparty in the

money. Since there is no transfer of principal, a CFD covers hedging or speculative

needs17. CFD’s are based on the speculation of the price movement of stocks by using a

moderate leverage and a non-delivery policy, and don’t have any fixed time period or

expiry date18. When trading a stock exchange in normal conditions, the buyer of a share

obtains the right to hold the title of that share of a company, injecting his capital into the

company’s and become part of the shareholders of that particular company allowing him to

obtain dividends and other rights that come attached from the tenancy of such share. When

trading in the CFD’s, the trade will not reach the exchange and therefore no tenancy of the

titles is ever made, the investment becomes a virtual bet on the price movement of the

share “purchased” although the money will not reach the company intended to invest in,

the investor can still speculate from the movement of the price of that particular stock,

without giving the benefit of the trade to the stock price. When trading small or large

volumes of capital on CFD’s, the stock price in the exchange will never show the volume

traded within CFD’s providers.

15 Guide to Financial Markets – Fourth Edition – The Economist16 Report on Global Foreign Exchange Market Activity in 2010 – Bank for International Settlements17 Securities Lending Transactions: Market Development and Implications – Bank for International Settlements18 Doctors should consider CFD’s

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Traders have also been attracted by the leverage of CFD trading, an element which present

a potential to make large profits in a short space of time. The flip side of the coin is that

CFD trading losses are magnified in the same way and so can exceed a trader’s initial

investment19. According to analysis carried out by financial research organization

Investment Trends, CFD trading numbers grew from 18,000 to 25,000 in 2010 – a rise of

38%20.

CFD trading allows traders to speculate on markets without owning the underlying

shares.21 This meant CFD traders were able to sidestep the time consuming and expensive

exercise of borrowing stock to trade on a declining market22.

When trading in a stock exchange, titles are switched between participants, one of the risks

involved in the trading is the counterpart risk, whereas when prices are changing rapidly,

the possibility to exchange titles may be low, on both bull and bear movements.

If a stock’s price is increasing, the possibility to find a participant who is willing to sell

those share lowers, making investors to either offer a higher price for those shares or wait

until it is possible to acquire such titles. If a stock’s price is decreasing, the holder of the

titles might look to get rid of the titles and avoid losing money on that price decline,

possibly will have to accept a price offer under the current stock price. When trading

CFD’s, that risk disappears since there is no exchange of titles and only a virtual trade is

made allowing an investor to place his trade on whatever price is shown, independently if

it is a bullish or bearish market.

When comparing the markets movement between a stock exchange and the foreign

exchange we can see that the prices tend to move more at an exchange in terms of

percentage than in currencies – stock market movements can result of changes in price of

10 – 15% or more in a day, while currencies have a smaller daily change -, resulting in a

lower leverage provided by brokers to CFD’s investors. The leverage given is usually up to

10:1, allowing the investor to obtain a purchase power 10 times his capital.

19 City Index; 38% raise in CFD trading20 City Index; 38% raise in CFD trading21 Brief history of CFD trading22 Brief history of CFD trading

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The virtual trading of stocks in the CFD’s market does not require standard lots to place in

the market but amount of contracts with the stock value of 1 contract equals 1 stock,

although brokers may set policies of standard amounts of stocks you can purchase and

leaving odd numbers of stock traded out of possibility. A broker may ask the investor to

place orders on volumes of 10, 100 or 1000 stocks.

CFD’s give the advantage to trade products where some investors could not reach due to

capital, nationality, etc; it also allows and avoids practices that could be considered illegal

such as inside trading and front running.

Insider trading is possible due to the fact that since the trade made in this market is virtual,

investors with advantageous information are able to avoid detection of placing trades since

the trade is never executed in the exchange and registration of the information of that one

who made the trade is never provided.

Front running involves a broker using information of his customers when large orders are

to be executed or by pending orders that will result in a price movement due to that trade,

allowing the broker to place orders in that particular stock knowing that when executing

the customer’s trade will bring an immediate benefit to the broker. Since the trades made in

CFD’s market will not bring any change in the current stock price, front running would

result into no benefit to the broker.

One of the biggest criticisms towards the CFD’s market is that the money invested in these

instruments will not bring any benefit to the stock issuer, and such investment will not

allow the issuer to use that money upon the company’s activities.

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Markets Structures

ForexAs mentioned earlier, the foreign exchange market has a decentralized nature, where no

official exchange place is found and trades are conducted throughout a global Interbank

Network where central banks and large financial corporations connect each other to

exchange currencies by offering different buy and sell prices, these prices can be streamed

to other financial institutions and give access to more participants in the exchange process,

or use the prices as reference for their own retail forex services.

The Currency Overlay presents us the next diagram of the basic structure of the market23:

Figure 1

23 Currency Overlay

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The diagram above represents the basic structure of the forex market; there could also be

more participants in between some of the ones mentioned there.

Financial institutions and traders can use arbitrage in order to obtain a profit from the

different prices the same currencies are traded in two or more intermediaries24.

CFD’s The CFD’s market’s structure is less complex than Forex’s, since prices come from a real

exchange source; intermediaries stream prices from a stock exchange and present such to

investors in order to speculate with the price movements. There is no need for an

intermediary to obtain a trading access to the exchange but only to “mirror” the stock

prices in that exchange; thus, the structure can be as simple as Market-maker – trader.

Although, this example is the simplest one, more participants can also be part of the

trading chain.

Figure 2

24 Securities Lending Transactions: market development and implications – Bank for International Settlements

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Participants

There has been previously mentioned some of the main participants within the retail forex

exchange structure, such as banks, brokers, dealers, market makers and investors, but there

are other important figures to consider when trying to understand the trading process of

this market.

Between intermediaries who give direct market access to investors and the interbank

structure, there are two key figures that can be found to be part of the trading process.

These are Clearing Houses and Prime Brokers.

Clearing HouseA central location or central processing mechanism through which financial institutions

agree to exchange payment instructions or other financial obligations. The institutions

settle for items exchanged at a designated time based on the rules and procedures of the

clearing house. In some cases, the clearing house may assume significant counterparty,

financial or risk management responsibilities for the clearing system25. When

intermediaries such as brokers, dealers and market-makers receive trading orders from

their customers, they can extern such order to a third party; in this case, a clearing house

can become the counterparty to the trader instead of the intermediary, in this case, the

intermediary only acts as a broker.

Prime BrokerPrime brokerage refers to financial, administrative and operational services offered by

large banks to hedge funds, asset managers, smaller banks and other clients providing

services that may include clearing, margin lending, financing and execution, among

others.26

25 Implications for central banks of the development of electronic money – Bank for International Settlements26 A user’s guide to the triennial central bank survey of foreign exchange market activity – Bank for International Settlements

14

In foreign exchange markets, prime brokers facilitate trades for their clients by either

transacting directly with them at attractive prices or providing them with access to

electronic platforms that are only available to dealers, such as EBS and Thomson Reuters

Matching. In effect, prime brokerage allows clients to trade with other dealers using the

prime broker’s pre-screened credit and in the name of the prime broker. The client trade is

“given up” to the prime broker, who is interposed between the dealer and the client and

becomes the counterparty to both legs of the foreign exchange trade as principal.27

The main difference between a Clearing House and a Prime Broker is that the main activity

of the Clearing House is to become the counterparty to the trades executed by the broker’s

client. On the other hand, the Prime Broker is the “broker’s broker” which has the option

to become counterparty to the ordered trade or to find other dealers where to accommodate

such trade.

Another way for brokers, dealers and market-makers to make money is by the associated

work of Introducing Brokers and Money Managers. These figures are a link between the

final customer and the intermediary.

Introducing Brokers and Money ManagersIntroducing brokers are independent agents that invite potential customers to trade under

the broker’s platform without being involved in the operations made by the investor, but

acting merely as a sales agent for the broker without being part of the firm. Introducing

brokers usually receive a fee for every trade the investor has made, although this fee is set

by the broker, and not between the investor and the introducing broker, the cost of it is

already included in the spread given in the platform to the investor. This fee is called

“rebate”.

Since the introducing broker is not involved in the trading, his only commission is by the

rebate for every trade the investor makes and he can try to incentive the investor to make

27 A user’s guide to the triennial central bank survey of foreign exchange market activity – Bank for International Settlements

15

more trades by offering services like market analysis, trading strategies, trading signals,

trading chats and courses on technical and fundamental analysis so the investor can trade

more and the IB can obtain his commissions. Brokers may use different schemes to reward

the introducing broker, such as increasing the rebate based on the amount of trades

investors make during a period of time – usually a month - or by the amount of capital

invested by either each client or the whole portfolio.

Money Managers trade on behalf of the firm’s customers under the purpose to find them

profitable positions when analyzing the market through technical and fundamental tools.

Money Managers receive fees for their services, both from the firm and customers, which

could turn into a conflict of interests.

First of all, the Money Managers are associated with the firm when a customer submits a

Power of Attorney form allowing the Money Manager to have access to the customer’s

account to trade on his behalf, this access could be through direct usage of the customer’s

trading platform or a special account for the Money Manager where all his customers can

be traded individually or as a pool through an account called a “Master Account” where he

can execute orders on behalf of all his customers at the same time, or same click.

Money Managers when being granted a Master Account, usually receive a rebate per trade

from the firm, motivating him to get compensation when trading, regardless to the final

result of the trade made.

There are other ways a Money Manager gets remunerated when trading:

16

Fixed Monthly FeeA Money Manager can set – under an agreement with his client - a Fixed Monthly Fee to

trade a customer’s account regardless the profit and loss results of the trades made during a

period of time, this alternative could be considered to allow the Money Manager focus on

his real activity without thinking about extra commissions per trade. Although, this

practice would seem fair, it might be discouraging to Money Managers if the fee might

seem high or low in proportion to the managed account, for example charging $200 USD

as management fee when the account is $5,000 USD or less, leaves the Money Manager

under pressure to achieve a minimum profit of $200 or 4% during a month in order to

cover his fees without giving any profit to the customer; or on the other hand charging the

same amount of $200 for a $100,000 USD account, if achieving a 4% of return within a

month, his fee might be quite small compared to what he is giving his customer, this fee is

negotiated between the Money Manager and the customer through a document submitted

to the broker in order to execute the proper measures. Rebate fees given by the broker

additional to the fixed monthly fee may apply here in order to motivate the Money

Manager to trade more.

Performance FeeA Money Manager can set a percentage fee from the profit performance he can make to his

customer during a period of time, usually under a monthly measure, this way the Money

Manager shows a win-win situation, if he is able to give a profit during a month he earns

the right to charge a commission for his services. Some brokers allow this practice under a

“water mark” policy which means that the Money Manager will have to profit over the

previous amount achieved in order to charge his fee again, avoiding the Money Manager to

profit without giving a benefit to the customer. This performance fee ranges between 5%

and 60% of the profit earned and it is negotiated between the Money Manager and the

customer through a document submitted to the broker in order to execute the proper

measures. Rebate fees given by the broker additional to the performance fee may apply

here in order to motivate the Money Manager to trade more.

17

Fixed Fee per Round LotThis fee is set as a mark-up upon the spread to every round lot trade made by the Money

Manager; a round lot trade is equal to a position that enters and exits through the platform

regardless if the broker handles it in house or routes out. The Money Manager charges

every trade made regardless to the outcome of the trade and the net balance of the account

at the end of the month. This Fixed Fee per Round Turn is negotiated between the Money

Manager and the customer through a form submitted to the broker in order to execute the

proper measures. The fee can vary from fractions of pip up to 20+ pips. Rebate fees given

by the broker additional to the performance fee may apply here in order to motivate the

Money Manager to trade more, although, some brokers keep the right to give this rebate if

the Money Manager is charging under this scheme since the Money Manager is already

getting remuneration by trades made. This practice could lead to an overtrading or

“churning” leaving a fair trading activity out.

Other alternatives could also apply under the broker’s discretion, it might be possible to

combine characteristics of the alternatives mentioned above in order to seek an honest and

fair practice from a MM towards his customer such as a fixed fee per round lot only to

those trade being profitable, although this might push the MM to keep trading as much as

he wants in order to obtain profitable trades that will earn him commissions, or earn the

right to charge those fixed fees per round lot under the condition of achieving a profit for

the customer that is equal or higher than the total commission earned by the trader.

Money Manager ProfilingMoney Managers can be very lucrative to brokers, they are the ones that bring customers

and trade under an expertise façade leaving the broker without the responsibility of the

outcome of the customer’s account. In order to become a Money Manager with a broker a

kit of requirements are set, such as trading experience and potential portfolio to trade, to

mention some. Some brokers also require a trading history from a certain amount of time

in order to analyze and identify the Money Manager’s capabilities and evaluate the proper

configuration of execution towards trades made by that Money Manager. If the Money

18

Manager is considered to be profitable to the customer, the trades made by the Money

Manager will be sent to a third party in order to avoid potential losses to the broker and

leave the risk out the firm. If the Money Manager is considered to be incompetent, his

trades will be taken in house in order to capitalize from all those orders made. At the end

of the day, nobody likes to lose money on the trade and if the broker can manage the risk in

an efficient way, it can assure profits.

In my experience, Money Managers can do more damage than Bucket Shops.

19

PART II

MECHANICS OF THE TRADE

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Mechanics of the Trade

When trading in the retail forex market, such activity can give the impression to be a task

as easy as to click the computer’s mouse, but there are many factors surrounding the trade

that most of the time traders can’t appreciate the mechanics involved in this activity. Such

mechanics and factors can be placed into 3 categories:

Before Trade Execution

Open Position

Trade Liquidation

It is important for the trader to understand some of the concepts related to the activity such

as currency pair, pip, buy and sell, stop loss, take profit, standard and mini lots, quotes

delivery and leverage.

Important concepts

Currency PairAs mentioned before, currencies are trade in this market; therefore, a currency is

exchanged for another. Currency trades are always expressed in pairs, with a top term

called “base currency” and a bottom term called “quote currency”. If dealing with

EUR/USD the base currency is the Euro and the quote currency is the US Dollar, which

expresses the amount of US Dollars worth for every Euro. When looking at a price chart, if

the price goes up, it is said that there is a “bullish movement”, the Euro is obtaining

“appreciation” and the US Dollar obtains a “depreciation”, that means that it is needed a

bigger amount of US Dollars to buy 1 Euro; if price goes down, it is said that there is a

“bearish movement”, the Euro is decreasing its value while the US Dollar is increasing it,

that means that it is needed a smaller amount of US Dollars to buy 1 Euro. 28

28 A beginners guide to forex

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PipCurrencies are expressed in 4 decimal places, for example 1.000; Pip is an acronym for

Price Interest Point and it is the minimal price movement a currency can have, a 1 pip

movement will set the previous price of 1.000 to 1.00129, although, there are some

practices among brokers nowadays to provide with fractions of a pip in the quotes

displayed on their trading platforms.

Buy and SellThese are the type of trading orders given to the broker to enter a position in the market,

this are attached to the base currency; when entering a buy order, the base currency is

bought at a certain price, and in order to obtain a benefit, price has to go up, if price goes

down will result in a loss if trade is exited with a price under the entry price; when entering

a sell order, the base currency is sold at a certain price, and in order to obtain a benefit,

price has to go down, if price goes up will result in a loss if trade is exited with a price

above the entry price.

Stop LossThe Stop Loss is a very useful tool that allows the trader to pre-set an exit point at a certain

price in order to exit the market and avoid larger losses when the price has gone to the

opposite direction as the trading position the trader has. Brokers’ platforms usually have

this tool available and there is a minimum of pips of distance between the current chart

price and this pre-set level, this minimum can vary from broker to broker. Not only is used

to avoid a loss but also to ensure a profit if price is considerably ahead of the trade’s entry

point, the trader may set this level to exit the market when the current price touches the

level.

29 A beginners guide to forex

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Take ProfitThis tool could be considered as opposite as the Stop Loss, where an exit level is pre-set

ahead of entry price in order to ensure a profit when touched by the current price. It can

also be used when trying to minimize the loss.

Standard and Mini LotsWhen trading through a broker, the investor will enter the position in standard contracts of

100,000 units denominated a Standard Lot. This gives the pip its value; a standard lot will

make a pip worth $10 USD; that means that when entering the market with a standard lot,

every time the price changes 1 pip, a gain or loss of $10 USD is obtained, although, to

capitalize it, trade must be exited.

The Standard Lot is the base of trading contracts but there are also alternatives created to

investors with lower amount of capital by letting the lot to be fractioned in 10 equal parts,

denominated Mini Lot, where the trader is entering into the market with contracts of

10,000 units instead of 100,000. Thus, the value of the pip is $1 USD.

Quotes deliveryNowadays, information about market prices are relatively easy to obtain, there are many

private services that will help getting quotes to know the market situation in any given

moment. Many websites give real time quotations on currency and stock prices, although

when being a free service, quotes on stock prices usually have a delay of 15 to 20 minutes

to the current price.

The set of prices are due to the supply and demand of a particular financial product at a

given time, when trading in stock exchanges, an official price is set since all the trading is

done inside that exchange place, making easy to obtain information upon the trades made

and the prices resulting to that activity. CFD’s can obtain a stream of price directly from a

stock exchange through private quotation services such as Bloomberg or Reuters, to name

some, and connect their platforms to the stream provided in order to give the investor real

time prices to execute trades.

23

For the currencies exchange, is a bit more complex since there is no physical place where

to trade all positions, making it a global market where purchases can be made anywhere in

the world at any given time. Prices are provided by an amount of players, usually large

banks, offering currencies at different prices and allowing the buyers and sellers

alternatives on volume and prices to trade. Since no official price is set in this market, a

broker can obtain quotations from several of those big banks and try to average the price

obtained and provide the retail investor with a generic price which will be the base of his

trade, or simple connect its platform to a streaming provider, like Currenex, which already

averages prices obtained in the prime market.

Prices between brokers may defer according to how many and which large banks provide

them with prices, therefore, differences between prices offered by brokers can be seen

when comparing platforms or trading with more than one broker at a time. Sometimes

brokers will provide different prices throughout its trading platforms, if a broker gives the

investor the possibility to use a Demo platform where virtual money is given to the

investor to trade and try the tools given by the broker to trade on a “real account”, that

platform may show a slightly different price than the one given through the trading on a

real account. This difference in price may be result of the usage of a dealing desk where

trades are evaluated and routed according to the broker’s policies.

In algorithmic trading, investors connect their computers directly with trading systems

known as electronic communication networks (ECN). Examples of ECNs in FX markets

are Electronic Broking systems (EBS and Thomson Reuters Matching), multi-bank trading

system (Currenex, FXall and Hotspot FX) and single-bank trading systems30 (trades

executed electronically via a single-bank proprietary platform).31 A computer algorithm

then monitors price quotes collected from different ECNs and places orders without human

intervention.32 These systems allow different market-makers to quote prices in competition

with one another.33

30 The $4 trillion question what explains FX growth since the 2007 survey – Bank for International Settlements31 A user’s guide to the Triennial Central Bank Survey of foreign exchange market activity – Bank for International Settlements32 Rise of the Machines33 Methods in foreign exchange markets – Bank for International Settlements

24

Some investors might see this difference in price provided by the same broker as unfair,

but when analyzing prices during a reasonable time, it can be used upon the investor’s

advantage. When analyzing the market through the prices given by different brokers and

the prices provided by their platforms, in some moment it is possible to determinate the

market sentiment, either bullish or bearish by the delay of the price on a real account

platform compared to the demo account platform, at a specific time helping to look up for

possible trading opportunities.

Example

When a bullish sentiment is set in the market, the price of the real account platform could

show a delay on price by 1 or 2 pips, when compared to the demo account price and an

opposite delay during a bearish sentiment. Although, this might be possible to identify,

during horizontal trends this advantage would disappear.

LeverageBrokers can offer leverage to the capital invested by the trader; this leverage could range

from 2:1 up to 700:1 according to the broker’s policies, giving the trader a higher purchase

power than the used with his original capital.

When trading under non-leverage conditions (1:1), the trader has the possibility to change

his money for another currency and capitalize profits or loses according to the price

change; if the trader is buying €1,000 at the price of 1.4123 USD that means that he will

have to pay $1,412.30 USD to obtain those Euros, if the price of the EUR/USD changes to

1.4223 the next day and switches back his position, he will get paid $1,423.30 USD for the

Euros he has sold, that way he has made a profit of $10 USD on this move. On the other

hand, if the price have had dropped from 1.4123 to 1.4023 instead, he would have had

experienced a loss of $10 USD. When trying to profit from speculation on the currencies

market, this profit obtained seems to be very small, unless using a large amount of capital.

That need upon large amount of capital is provided by the broker as leverage when trading

the retail forex market. According to trading policies settled by the broker, an investor may

trade large amounts of capital with a minimal usage of capital provided by the investor.

25

When trading through a broker, the investor will enter the position in standard contracts of

$100,000 USD, but the investor doesn’t need to have $100,000 USD in order to trade such

contract. If in the leverage policies from the broker are to provide a 100:1 leverage, the

investor only needs $1000 USD of his capital to be able to use that contract for trading but

the reflected outcome of the trade will be based upon trading $100,000 USD.

Returning to the exampled used above, where a trader enters the market to purchase a

contract of $100,000 on the EUR/USD on 1.4123, he will only need to use $1000 USD and

the rest will be provided by the broker on a “virtual credit”, under 100:1 policy, to allow

the trader to operate with a larger amount of money and that way seek a larger profit.

Although this might be a much higher potential profit, it could also turn into much higher

potential loses. Since the contract is 100 times larger than the used capital, the profit and

loss from the difference in prices obtained will also be 100 times larger.

Once entering a long position in the market with a price of 1.4123 and exiting at 1.4223 the

investor would obtain a $1000 USD profit, a number quite considerable if we compare it

with the trade made on a non-leveraged position. The same way, if the trade had given an

exit price of 1.4023 from a 1.4123 entrance price, it would become a $1000 USD loss for

the trader.

The larger the leverage provided by the broker, the lesser amount of capital is required

from the investor to put down upon the trade and lock the position.

Under normal circumstances, a broker would require a minimum margin in the traders

account in order to avoid larger loses than those the trader can afford.

If the investor is trading mini lot contracts and enters a long position on 1.4123, he will

require using $100 USD of his capital in order to execute such trade, and again, if the exit

price is 1.4223 that would turn into a $100 USD profit for the trader, on the other hand, if

the price falls and he exits the market on 1.4023 that will turn into a $100 USD loss.

The advantages of leverage is the availability of fast cash on small movements of the

market and it is possible thanks to a low percentage of price change on a daily basis; if we

26

look upon price changes on the stock market, we can see that some shares move 15% or

more on a single day, this is hardly possible on currencies on normal circumstances.

Before Trade ExecutionThe trader usually has a trading platform provided by the broker with an online access to

place buying and selling orders; this platform has tools for the trader to use such as price

charts where different technical indicators can be displayed in order to give the trader

information about trends, ranges and volatility that can be part of the trading decision

process.

Platforms also give currencies and other instruments’ quotes that can vary due to volatility

the market has at any given moment, during economic news releases prices are usually

more sensible to change when such economic indicator impacts the balance between offer

and demand.

At this point, the only threat a trader can have is his effective connectivity to the broker

which can make the difference between an order executed or not.

Brokers usually use two different price streams when feeding demo and real trading

accounts, when comparing price quotes in both platforms it can be seen small differences

in prices, this is due to the execution of trades. A broker will not use important resources

such as a dealing desk or an order router algorithm for “fake” orders placed under a demo

account and will not let those fake orders to interfere by creating tickets and resulting into

“noise” upon the real account deals, since this can also bring a delay on the execution flow

for the real customers. The usage of both streams can be useful to the trader’s advantage.

The trader has the option to use a market order which is to enter the market at the current

price with a buy or sell order; this order will take the base currency as the traded one, but

risks of volatility and slippage can take a different price giving the trader an unfavorable

position upon the trade.

Other options to use to enter the market are the stop-limit orders which are placed in a

price level in advance waiting for the price to touch such level and enter the market. A

27

buy-stop order is placed at a level under the current price; brokers will usually allow

setting this order at a minimum of 5 pips of distance from the current price. This order is

used when considered the price to fall for a moment and buy at a lower price before rising

again. A buy-limit order is placed at a level over the current price; brokers will also allow

setting this order at a minimum of 5 pips from the current price. This order is used when

considered the price to break up from a range where it has been for a period of time and

take advantage of the price’s momentum. For sell orders under this kind of tool, the

contrary should be considered, a sell-stop order is placed above the current price expecting

to sell at a higher price before the price falls and the sell-limit order is set under the current

price expecting to enter and keep the falling flow.

Open PositionThe process begins with the execution of the trade, once a trade is executed; the next step

is to ensure that the counterparties to the trade agree on the terms of the transactions –

instrument involved, price, amount to be exchanged, settlement date and counterparty. This

step is referred as trade matching. Trade matching and confirmation set the stage for trade

clearance – since there is no delivery upon the retail forex market, book-entry is occurs34.

There are some risks when positions are executed, such as a legitimate price change, the

rejection of a clearing center to take certain position, costs regarding holding positions for

long periods and margin impact on the balance when the position is open.

SlippageSlippage is the difference between the asset price when the trading decision is taken, and

the price actually realized by a broker or an algorithmic execution system35, varies with

factors reflecting market conditions, floor broker motivations and type of order placed36,

that can be measured in several ways like ticks, points, dollars, etc.37

34 Delivery versus payment in securities settlement systems – Bank for International Settlements35 The slippage paradox36 Slippage and the Choice of Market or Limit Orders in Futures Trading37 Measuring and avoiding slippage

28

The slippage can appear in the forex order executions due to the lack of the possibility to

benchmark the currency price within the broker’s information and the different prices

offered by other brokers, since there is no official price at any given time.

Even though, it is possible for financial institutions to invest in trading platform

development and execution time optimization, the opportunity for the Bucket Shop to save

money in every trade made by the investor can become an important factor to the broker’s

capital and a significant cost to the investor.

The same way it is possible for a broker to determine the investor’s profitability when

trading, profiling the risk involved in the operations and decide where to channel the trades

made, the Bucket Shop can also determine the use of a slippage algorithm that can be

activated both in and out the market through their dealing desk. As mentioned above, the

slippage is the difference between the “clicked” price and the realized price from the

broker,

If active when entering the market, the price will jump, when order executed, in favor of

the order’s direction and instantly jump back to the initial clicked price, making the order

to enter in a less favorable price since it needs more points to start being profitable due to a

“virtually increased spread” due to a price manipulation.

Entering a market order:

When placing a buy market order, it is expected to obtain a profit by raising of the price, if

slippage algorithm is active, executed price will be over the planned entry price, making

the order to have more points to cover in order to obtain a profit while keeping the fixed

spread.

Example

An EUR/USD spread is 2 pips and a buying market order is planned to enter at 1.4120/22,

where the position will take the 1.4120 price and a 2 pips raise movement to 1.4122 is

needed to break even, from 1.4123 and above, the position will show a profit.

29

If 1 pip slippage algorithm is active, when order is to be executed, price will instantly raise

1 pip to enter the position at 1.4121 and return immediatelly to the “real” provided price at

1.4120, in this case, the price needed to reach in order to have a break even and start

obtaining profit is 1.4123 instead of the previously mentioned above.

Although, one pip may seem a minimal deviation, it still represents an advantageous tool

towards the firm, either to save (in the event of a profitable trade to the trader)or capitalize

more money (in the event of a losing trade).

The same principle would apply in the opposite direction when entering with a sell market

order.

If active when exiting the market, the price will jump, when order executed, against the

order’s direction when being profitable and inactive when losing.

Exiting a market order:

Taking the example used above, when placing a sell market order to close our initial

position (buy) there are two possible scenarios if slippage algorithm is active, obtaining a

less favorable exit price when the trade shows profit or loss, and obtaining a less favorable

exit price only when trade shows profit but not when loss.

Example

An EUR/USD buy order that entered at a 1.4122 and current price shows a 10 pip profit,

when exiting the market at a planned price of 1.4132 using a market order, if a 1 pip

slippage algorithm is active, the price will instantly execute the exit order to a 1.4131 price

making a profit of 9 pips instead of the 10 pips profit.

If the same example, a EUR/USD buy order entered at 1.4122 shows a current price where

a 10 pip loss will be capitalized, an active 1 pip slippage algorithm will instantly execute

the exit market order at a 1.4111 price with a loss of 11 pips instead of 10.

The same principle would apply in the opposite direction when entering with a sell market

order.

30

There are ways to avoid this situation, only to the trader’s eyes, by using trading tools like

stop-limit orders that pre-establish a fixed price where to enter and exit if price hits such

level. Stop-limit orders do not guarantee un-manipulated prices, in any given moment; the

Bucket Shop can fall into making modifications to the provided platform’s price to the

investor.

It is important to notice that these activities or practices are not always the reasons behind

slippages and do not constitute something all brokers do. High price volatility will clearly

affect the magnitude of slippage.38

When trading in other financial markets where the activity is centralized in one place like

CBOT or NYSE, it is easier to detect unfavorable situations when slippage on the trade and

fix them. (Brown, Koch and Powers – Slippage and the Choice of Market or Limit Orders

in Futures Trading39) asses the frequency and magnitude of slippage with a unique sample

of over 7,000 CBOT futures tickets for 70 retail brokers with detailed information upon

size of order, time at which the order was placed and price which the order was

subsequently executed, using CBOT time and sales data they were able to estimate the

time at which the order actually cleared and which price the order cleared. Their evidence

indicates that on average, slippage on market orders is not significant different from zero

and limit orders slippage bounded from below at zero due to market regulations that

require broker to cover the cost of adverse fills. The lament of retail traders that “the

system” is biased against them is not supported by the data, either for market orders or for

limit orders.

In the example above, I would consider a very important factor, the centralization of the

activity and execution of operations; when having a centralized exchange market where

there is an “official” price, is easier to identify when and under which price the trade was

executed, something that cannot be controlled at the Forex market operations due to its

decentralized nature where no single entity registers every single forex trade40 and where

no official price is set at any given time but rather the available offered by the broker. The

prices market-makers quote are the prices at which they are willing to sell or buy that 38 Slippage and the Choice of Market or Limit Orders in Futures Trading39 Slippage and the Choice of Market or Limit Orders in Futures Trading40 Where brokers get e-forex quotes

31

particular pair.41 Discrepancies can and do exist, a firm might use a feed that is an

algorithm of rates from different sources, filtering out the highest bid and the lowest

offer.42

RolloversThe rollovers, are charges as interest carry cost for keeping an open forex position held

overnight.43 When trading order clearing is sent to a third party, firms are charged interest

that is prorated. The brokerage firm will pass that charge to traders, calculated from the

close of the London sesion. If the base currency has a higher interest rate than the paired

currency, the trader will be charged interest. Although the amount charged each day is very

small, it can add up over time.44

Due to the expectation of a potential large profit or loss when trading in the forex market,

this speculative activity was indirectly designed to involve short term trades or intraday

operations, but since there are many different kind of traders, those who hold their

positions for “over a day” will experience the rollover if positions are held overnight.

The holding of a currency in a given position will generate an interest to be paid or be

charged according to the difference of current interbank interest rates of a currency. This

difference could be in favor or against the position held by the trader. If trading the

EUR/USD on a long position and current interbank interest rates are higher in Europe, the

trader may receive a rollover fee, if holding a short position under the same conditions, the

investor may pay a rollover fee for his position. The amount of rollover fees are usually set

by the broker and may vary among brokers, but usually follows the current interbank rates

market conditions at a given time.

In theory, if holding a long and a short position with the same amount of lots in the same

currency pair, a term known as hedge position, the fees should settle themselves and make

no impact on the account’s balance when during the time both positions are held; in

41 Where brokers get e-forex quotes42 Where brokers get e-forex quotes43 Innovations in managing currency risk44 A beginners guide to forex

32

practice, the fees will usually be in favor of the broker when being under this kind of

trading option.

Holding a hedge for a long time could bring important consequences to the investor’s

balance. During 2005 I saw a trader went short on GBP/USD at around 1.7400 with a 10

Standard Lots position expecting the cable to go down to its next support level at around

1.7100, when price started rising he hedged the position with a 10 Standard Lots long

order, stopping the loss for a time until market allowed him to see an opportunity when to

open that hedge and potentially reduce the loss or even obtain a net profit from scaled

positions; that opportunity did not present for him for a long time, when checking the

outcome of such hedge strategy, the client’s account suffered a loss of $10,000 USD on

rollover fees for holding that large amount of money for such long time.

To hedge a position is basically just to open a trade opposite to the initial position in the

same currency pair using the same amount of lots of the initial trade.

33

BalanceThe account’s balance is an important factor to consider, since the margin requirements

can make a winning or losing position to take the trader out of the market.

When a position is open, the amount of lots is “locked” and the balance will show the

impact of the price movement while the trade is still in the market.

Example

If a trader has a $10,000 USD on his account and enters the market on a long position on

the EUR/USD at a 1.4123 price with only one standard lot. As mentioned above, a

standard lot gives the trader 100,000 units with this position under 100:1 leverage, this

means that for every $1 USD the trader uses for his trade, 100 units of Euro are acquired

independently from the current price, this results in a purchase of 100,000 units of Euros

using only $1,000 USD.

These units are locked and every difference in the price when trade is active will be

reflected on the balance; that is, if the trade is executed at that price, the trader will have a

long EUR/USD position with a balance of $10,000 USD; if the EUR/USD price moves to

1.4124 the balance will show an increase to $10,010 USD but such profit it will not be

capitalized until the order is liquidated or closed. The same scenario happens when the

price of such position falls to 1.4122, such change will reflect a $9,990 USD balance on

the account but such loss will not be capitalized until the order is liquidated or closed.

If executing a sell order on EUR/USD the broker “lends” 100,000 units of Euro to the

trader for him to sell, therefore incurring into a rollover charge if holding the position

overnight as explained above; the same process for a long position will apply but in a

contrary direction.

Trade LiquidationEvery trade must be reversed through the broker, even if the broker is using different prime

brokers or clearing houses on each of the executions and avoiding arbitrage situations. As

mentioned above, one of the risks a trader can face is the slippage which can make a small

34

impact upon the result of his position but if repeated several times during a period of time

may result in a significant damage to his balance.

In this moment, another important risk factor is the rejection, from the broker, of the trade.

It is important to know the different policies involving confirmation of trade execution

since the trader has no other information where to rely on the veracity of the trade other

than what the broker reports to him. Brokers do not disclose clearance process and routing

information with the traders and this part of the process can be also an important issue the

trader could face any given time.

35

PART III

OPERATIONAL MODELS

36

Operational Models

It is important to notice that retail forex trade execution is not necessarily instantaneous,

especially in a fast moving market or times with high price volatility such as economic

indicators release; brokers may have direct connection on the market to a counterpart

somewhere else in the world with the exact amount of money ready to exchange at the

exact price, although, when acting as a market-maker or a Bucket Shop, trading should

have different time execution characteristics. In the stock exchange market, price quotes

are only for a specific number of shares and investors may not always receive the price

they saw on their screen (at a certain time) or the price their broker quoted and the broker

has to evaluate such orders and assesses who offers the best terms of execution45, but when

trading in a market place where investors and brokers are the only players, execution

should be easier. Market-makers and Bucket Shops use a dealing desk to decide what to do

with the orders received by traders; they can also use algorithms to automatically hedge

risk in their inventories or to clear positions in an efficient manner.46

Key steps in clearance and settlementThe process of clearing and settling includes a number of key steps, including the matching

of terms of the trade, calculation of the obligations of the counterparties as a consequence

of matched trades (clearance), discharge of those obligations (settlement) through the final

transfer of instrument (delivery) and the final transfer of funds (payment). 47

When an order is executed, the intermediary has different options on how to carry such

trade:

45 http://www.sec.gov/investor/pubs/tradexec.htm46 The $4 trillion question what explains FX growth since the 2007. Bank for International Settlement47 Delivery versus payment in securities settlement systems – Bank for International Settlements

37

Broker Model1. The broker may route the order out the firm to a) an Electronic Communications

Network (ECN) that automatically matches buy and sell orders at specified prices48,

this counterparts could be players dealing through other brokers or b) a liquidity

provider that will take every order routed by the broker. If using a liquidity

provider, the broker can, and probably will, use the investor’s available capital to

mirror the order executed by the trader, if trading policies conditions are met to that

specific moment (we will discuss this later).

This alternative can be considered an example of a Vertical Trading Chain, where

different institutions provide the adequate services to the proper execution of the

trade49. This also has a settlement risk failure50.

If an investor takes a long position in EUR/USD let’s say 1.4123, the broker may

send the order to an ECN that will automatically match another investor outside the

firm or institution that is willing to sell Euros and take US Dollars at that price, or

the broker will execute an order that mirrors that purchase of EUR/USD at 1.4123

with its liquidity provider and reverse the position when the investor exchanges

those bought Euros into US Dollars again.

48 http://www.sec.gov/investor/pubs/tradexec.htm49 Clearing, settlement and depository issues – Bank for International Settlements50 Delivery versus payment in securities settlement systems – Bank for International Settlements

38

Figure 3

Market-Maker Model

2. The broker may decide to internalize the order by finding a counterpart within their

universe of customers trading at the same time or waiting for an order to become

counterpart from a previous open order. Execution time through this activity

depends on the amount of customers the firm has and who are willing to trade at a

specific time, when having a large amount of customers buying and selling it

39

should be faster to match buyers and sellers of a currency than leaving pending

orders to be executed when playing in a small pool of traders. Under this model, the

broker is acting more like a mini exchange market.

This alternative can be considered an example of a Horizontal Trading Chain,

where the same institution provides the matching service among its clientele

universe, to the proper execution of the trade51.

If an investor takes a long position in EUR/USD let’s say at 1.4123, the broker will

look in its customers inventory to match the order with another customer selling

Euros for US Dollars at that time at 1.4123. Under a non-delivery policy, the holder

of such Euros has to keep the position until desired price is reached and wait for a

counterpart within the firm’s customers willing to buy those Euros in exchange for

US Dollars.

Figure 4

51 Clearing, settlement and depository issues – Bank for International Settlements

40

Central Counterparty Model3. The broker may decide to become the counterpart of the order at all times executing

the trades made by investors where execution should be instant at all times since

there is no match to find either in or out the firm, and stands ready to buy and sell

the solicited currencies or CFDs on a regular and continuous basis at a publicly

quoted price52. This should be the most effective model to follow since the investor

does not need to wait for another player who is willing to exchange a currency at a

specific price, nor to wait to reverse the position taken. This option might be

considered to be the closest to resemble the Bucket Shop business model.

This alternative can be considered an example of a Central Counterparty, where the

intermediary should maintain an adequate capital base and strong risk management

tools to mitigate its own risks and deal with adverse situations. These tools may

include, but are not limited to; margin call procedures, settlement of margin calls in

central bank money, exposure limits, and guarantee funds, among others. Traders

can effectively mitigate the exposure and risk through a careful selection and due

diligence of their counterparties53.

A central counterparty can reduce liquidity risks by broadening the scope of

payment netting.54

If an investor takes a long position in EUR/USD let’s say at 1.4123, the broker will

sell those Euros in exchange for US Dollars and reverse the position when the

trader decides not to hold Euros anymore and exchange them to US Dollars again at

the price provided by the broker.

52 http://www.sec.gov/investor/pubs/tradexec.htm53 Clearing, settlement and depository issues – Bank for International Settlements54 New developments in clearing and settlement arrangements for OTC derivatives – Bank for International Settlements

41

Figure 5

The three alternatives described above consider all examples to have the same size in

traded capital volume, when investors look to exchange a currency at a given price and no

spread between buying and selling prices, it should also be considered that not always the

same amount of capital will match between buyers and sellers, therefore it is considered

that the third alternative should be the most effective when trying to keep a reasonable

flow of execution for the customer. Even though a broker may choose to follow one of

such alternatives, it is possible to combine the three of them at the broker’s discretion.

Although these three alternatives may apply to the trading execution techniques a broker

may choose to follow in the retail forex market, it is important to note that when trading

(CFDs) only the third one will apply since real possession of shares is not possible in this

product model, therefore exchange is not made outside the firm or between customers,

leaving the opportunity to instant executions open since market conditions such as traded

capital volume and counterpart risk.

42

How do brokers, market makers and bucket shops make money?As mentioned before, the execution alternatives that intermediaries have when executing

orders from the traders have different impact on the way such intermediaries can make a

profit out of the trading activity.

The first alternative model (Broker) presents an execution outside the firm where the

broker tries to find a counterpart through an ECN or a liquidity provider charging a fixed

fee per round traded order added as a mark-up in the spread between the bid and ask price

obtained for the customer.

If an investor is buying EUR/USD at 1.4123 and the broker routes the order through an

ECN or a liquidity provider, the broker will charge for instance 1 point when obtaining the

counterpart, that way, the real execution price for the trader will be 1.4124, buying it at a

higher price that includes the fixed fee for the broker, when reversing the position, the

broker will charge another fixed fee from the selling price, leaving the investor with a

lower selling price than the one really obtained, the firm will have no benefit from the

spread between the prices other than the fee. This practice is common and illustrates the

way intermediaries obtain their profit independently than the results achieved by the

orders. This fee can be included, in the spread or execution price given, as a shown

commission for the broker or simply hidden; since the customer does not see the real price

given he may also not see the fee obtained by the broker.

Some intermediaries keep the trading in its purest brokerage form by using a Straight-

Through Process alternative leaving all the trading execution by routing electronically

every order made without involving a dealing desk to re-quote or any manual

intervention55.

The second alternative model (Market-maker) presents an execution inside the firm where

the broker tries to find a counterpart by matching the orders within its customers, charging

a fixed fee per round traded order added as a mark-up in the spread between the bid and

ask price obtained between the customers.

55 Clearing, settlement and depository issues – Bank for International Settlements

43

If investor A is buying EUR/USD at 1.4123 and the firm has another customer, investor B

that is willing to sell EUR/USD in that moment at a given price of 1.4121, leaving a spread

of 2 points between buying and selling prices, the broker will match the orders by buying

the Euros from investor B at 1.4121 and selling those Euros to Investor A at 1.4123

leaving a net profit for the broker of 2 points. If the broker also charges a 1 point fee as

mentioned on the example above, then investor B will get paid for his Euros a price of

1.4120 and investor A will pay for his Euros a price of 1.4124, leaving the broker with a 4

points profit independently than the results achieved by the orders.

The third alternative model (Central Counterparty) presents an execution where the firm is

always the counterpart of all trades made by the investors regardless to the volume and

price traded, giving an instant execution since there is no other counterpart to match the

order with and executing the reverse order, this model represents a higher risk of loses but

big potential profits as well, since the trade is against the firm, the trader is sure to always

have available execution. Initial profit to the firm is through the spread given to the

investor, it may also include a fixed fee per round traded added as a mark-up in the spread,

the big difference between this model and the other two is that the results of the executed

order will affect directly the firm. If the trade once is reversed results into a profit for the

investor that will become a loss for the firm less spread, if the trade has once reversed

results into a loss for the investor that will become a profit for the firm plus spread. The

risk of high loses can be overwhelmed by potential high profits.

If an investor is buying EUR/USD at 1.4123/21 and the firm is the counterpart, the investor

should have instant execution of the order. If the price rises to 1.4135/33 and closes his

position at such price, the net profit would be 10 points since he is buying at 1.4123 and

selling at 1.4133. The spread would be in favor of the firm but the difference between

prices would benefit the investor making the firm lose 10 points. If the investor is buying

EUR/USD at 1.4123/21 but the price falls to 1.4113/11 and closes his position, then the

investor is losing 12 points that will now be the firms benefit, 10 points from the price

difference plus the spread.

44

At first instance this seems to be the most risky position a broker can incur but it is also the

one where it can obtain large capital when trading against investors.

Why is this model so followed and profitable?As mentioned before, brokers have the options to choose between models by not keeping

only one but a mix of them. When having a group of market analysts and a dealing desk

behind doors, brokers can potentially minimize the loss risk and maximize the profits by

the sending the orders that will cause a profit to a third party and keeping the profitable

ones. When analyzing the market, either through technical or fundamental tools and

models, the group of analysts will give suggestions to the dealing desk on what orders

should be kept in house and which ones throw them to the market.

When technical analysts spot a trend or an important price movement, either on intraday or

middle and long term charts every position received from traders to the dealing desk in

favor of the trend would be sent to a third party and every received order that goes against

the trend will be kept in house. If analysts see it is clear that the EUR/USD price will rise

from 1.4123 to 1.4223 that means that every bullish position will result into a profit for the

trader but a loss for the firm, in that instance, every buying order executed would be sent to

an ECN to find a counterpart that is willing to take the risk or to a liquidity provider to

keep that customer happy with his order but not costing to the firm, when doing this, the

firm has a potential profit of only the mark-up charged to the position but a potential loss

of cero since the firm is not the counterpart of the position. Now, every bearish position

executed will be taken expecting the market to go up, that way when an investor sells his

Euros at that price and buys them again at a higher price that would result into a loss for

the trader but a profit for the firm, as long as the market conditions follow what analysts

see, every short position is taken by the firm until reaching the targeted price and look for a

new strategy, if for any reason the price does not behave as expected then the firm would

reflect a loss while the trader obtains a profit from such position. The dealing desk controls

the flow of the orders according to the analysts as in where should they be sent to. On the

other hand, analysts can also get mistaken and market could flip against its expectations, in

case this situation occurs, usually the orders sent to a third party would not be touched and

45

wait for the investor to close it since the firm is not having any loss from it, but when the

broker is trading in house it has the option to route out a mirrored position to a liquidity

provider in order to maintain a fixed profit until the investor closes his position.

Many brokers have a non scalping policy, where trades are made either for very little

points or for a very little time, giving the dealing desk no time to evaluate the position and

where to route it, this applies specially during high volatility moments during economic

news releases.

When economic indicators are released, it is usually a very volatile moment for the market,

especially if such indicators could bring a high impact on the price and could make it move

fast, it is hard for the dealing desk to keep control of orders when many orders come at the

same time and price moves towards an unexpected side, if the firm sends every order to a

third party, execution could take long time and maybe incur into a slippage of price, either

accidental or intentional, if the firm is executing them in house there is a high risk to result

into big loses. When the firm falls into this uncomfortable situations, it is easy to delete

the orders where traders have obtained a profit under the excuse of “the market did not take

the order due to volatility and was not properly executed, therefore every profit incurred in

such trade would be eliminated from the balance”, although, orders that show loss for the

traders, well, those have no need to be deleted since the firm is making a profit out of.

One way for the firm to low the risk is to evaluate the impact that the economic indicator

could bring to the market under the published outcome of the indicator, for example, if

market conditions show that an increase on the CPI (Consumers Price Index) will bring a

benefit to the USD and the expected Index is to be 0.2%, any increase over the expected

value will bring an appreciation of the USD making the chart price of the EUR/USD fall

and route every short position to a third party after the news release while keeping all the

long positions, and any increase under the expected value or a contraction of the index will

bring a depreciation of the USD making the chart price of the EUR/USD up and letting the

firm to route all long positions and keeping all the short ones, although it may take some

seconds to adjust the dealing desk to the outcome situation, the risk of high loses is

reduced avoiding then a big impact in the firm’s capital.

46

Everything is reduced to a risk management the firm is willing to maintain; with a very

high capital behind to either route or directly counterpart orders, a team of analysts and a

fast dealing desk, the advantage that a market maker has over the limited resources a retail

investor has, is considerable.

Comparing the ModelsInvestor A has an account balance of $10,000 USD and trades only 10% of his account per

position and has traded 2 orders today on EUR/USD, each one of 1 Standard Lot, one long

position of 10 pips profitable and one short position giving a 10 pips loss, resulting in no-

gain at the end of the day.

Routed Execution to an ECN or a Liquidity Provider – Broker Model

The broker, acting as a true router, sends both positions outside the firm to an ECN or a

liquidity provider leaving the outcome risk to a third party and charging 1 pip on each way

on each order giving the broker a net profit of 4 pips at a $10 USD value per pip.

Currency Position Quote Price Lots Pips Won/Lost Profit/Loss Broker Fee Total Broker Fee Broker Profit

Investor A EUR/USD Open Buy1.4123/21 1.4123 1 0 0 1 10 10

Investor A EUR/USD Close Buy1.4135/33 1.4133 1 10 100 1 10 10

Investor A EUR/USD Open Sell1.4145/43 1.4143 1 0 0 1 10 10

Investor A EUR/USD Close Sell1.4153/51 1.4153 1 -10 -100 1 10 10

Total 0 0 4 40 40

47

Market Making Model

The broker, acting as a true market maker, matches the positions against another investor,

leaving the outcome risk to both participants but taking a 2 pips profit on both spreads on

all positions when settling the trades giving the market maker a net profit of 8 pips at a $10

USD value per pip.

48

Currency Position Quote Price Lots Pips Won/Lost Profit/Loss Broker Fee Total Broker Fee Broker Profit

Investor A EUR/USD Open Buy 1.4123/21 1.4123 1 0 0

Investor B EUR/USD Sell 1.4123/21 1.4121 1 0 0

Difference in prices paid and charged on spread between both participants 2 20 20

Investor A EUR/USD Close Buy 1.4135/33 1.4133 1 10 100 0 0

Investor C EUR/USD Buy 1.4135/33 1.4135 1 0 0

Difference in prices paid and charged on spread between both participants 2 20 20

Investor A EUR/USD Open Sell 1.4145/43 1.4143 1 0 0

Investor D EUR/USD Buy 1.4145/43 1.4145 1 0 0

Difference in prices paid and charged on spread between both participants 2 20 20

Investor A EUR/USD Close Sell 1.4153/51 1.4153 1 -10 -100 0 0

Investor E EUR/USD Sell 1.4153/51 1.4151 1 0 0

Difference in prices paid and charged on spread between both participants 2 20 20

Total 0 0 8 80 80

Central Counterparty Model

The broker, acting as the counterpart, takes all the positions against the investor, leaving

the outcome risk to the firm with a profit and a loss as well as the trader but with a spread

profit giving the firm a net profit of 4 pips at $10 USD value per pip.

Currency Position Quote PriceLots Pips Won/Lost Profit/Loss Broker Fee Total Broker Fee Broker Profit

Investor A EUR/USD Open Buy 1.4123/21 1.4123 1 0 0

Broker EUR/USD Sell 1.4123 1 0 0

Investor A EUR/USD Close Buy 1.4135/33 1.4133 1 10 100 0 0

Broker EUR/USD Buy 1.4133 1 -10 -100 0 0

Spread charged to Investor A 2 20 20

Investor A EUR/USD Open Sell 1.4145/43 1.4143 1 0 0

Broker EUR/USD Buy 1.4143 1 0 0

Investor A EUR/USD Close Sell 1.4153/51 1.4153 1 -10 -100 0 0

Broker EUR/USD Sell 1.4153 1 10 100 0 0

Spread charged to Investor A 2 20 20

Total 0 0 4 40 40

Under the quick view of the comparison of these models the most effective one is the

market making model giving the firm the biggest profit when matching the trades between

its own customers than routing them to a third party or liquidity provider and also when the

firm becomes the counterpart of all trades made by the investor.

As mentioned before, the firm can mix the different execution models to its benefit.

49

Under the impression that the EUR/USD price will raise, analysts will recommend the

dealing desk to keep in house all short positions while routing all long positions to a third

party or match them to another customers within the firm that are waiting to be the

counterpart of such trades. This is how it would illustrate under such circumstances.

Currency Position Quote Price Lots Pips Won/Lost Profit/Loss Broker Fee Total Broker Fee Broker Profit

Investor A EUR/USD Open Buy1.4123/21 1.4123 1 0 0 1 10 10

Investor A EUR/USD Close Buy1.4135/33 1.4133 1 10 100 1 10 10

Mark-up charged to Investor A 2 20 20

Investor A EUR/USD Open Sell1.4145/43 1.4143 1 0 0

Broker EUR/USD Buy 1.4143 1 0 0

Investor A EUR/USD Close Sell1.4153/51 1.4153 1 -10 -100 0 0

Broker EUR/USD Sell 1.4153 1 10 100 0 0 100

Spread charged to Investor A 2 20 20

Total 0 0 4 40 140

There are many kind of players trading, scalpers, swing traders, news traders, intraday

traders, technical and fundamental traders, and the amount of trades they make vary from

several a day to once a week or month.

Hypothetically, if a broker has 1000 customers worldwide with a $10,000 USD account

and trade 2 times a day with 1 standard lot per trade and under the suppose that they don’t

lose nor win, the firm could have potential profits of 1000 times the ones shown in the last

example or $140,000 USD per day versus the $40,000 USD made if the intermediary acts

only as a broker.

50

Additional to that, if the broker has 100 money managers that have 10 customers of

$10,000 USD each also trade 2 times a day with 1 standard lot per trade and under the

same conditions that they don’t lose nor win, the firm could have potential profits of 1000

times the ones shown in the last example or $140,000 USD per day versus the $40,000

USD made if the intermediary acts only as a broker.

It is impossible to be sure of the future and guarantee the market to move towards we see,

or want, and to effectively evaluate and direct all trades made by customers to the most

profitable alternative the broker could take, but if the broker is able to capitalize correctly

half of this trades, it can assure a good chunk of profit.

Customers can be profiled to be routed to an effective risk management of their positions, a

profitable customer will get his trades routed out to a third party so the firm can avoid a

counterpart risk with this specific trader, a losing customer will be handled in house the

firm in order to capitalize from most of the trades made.

51

PART IV

REGULATION IN DENMARK

52

Institutions in DenmarkThe Danish Financial Supervisory Authority (Finanstilsynet) is the main supervisory body

of financial markets in Denmark, such as insurance and pension markets, as well as

financial institutions, mortgage lenders and stock brokers. In the area of the stock market

acts as the secretariat for the Securities Council (Fondsradet).56

The supervision of financial securities issuers is the responsibility of the Securities

Council, an independent public body regulated by Section 25 of the Securities Trading Act.

The Securities Council has powers to issue regulations for the whole financial market in

the form of Executive Orders that have the force of law and should be complied by the

participants in the financial markets.57

The Financial Business Council (Finansiele Virksomhedsrad) is the public authority

appointed under the Danish Financial Business Act (Lov om Finansiel Virksomhed) which

contains common rules for the financial services industry. The Financial Business Act is

therefore the basic regulation and it supplements the special laws that apply to specific

sectors of the industry. The Financial Business Council advises the Financial Supervisory

Authority in connection with the regulations it issues and its dissemination of information.

Furthermore, the Council is empowered to take decision on supervisory questions which

either concerns matters of principle or which have important consequences for the financial

services industry.58

Investment companies are regulated by the Investment Associations Act

(fondmaeglerselskabsloven) and are subject to the supervision of the Financial Supervisory

Authority. Investment companies are the only companies entitled to offer securities trading

services to the public, apart from credit institutions or mortgage lending institutions. They

must be licensed by the Financial Supervisory Authority.59

56 Nordic Financial Market Law – Chapter 457 Nordic Financial Market Law – Chapter 458 Nordic Financial Market Law – Chapter 459 Nordic Financial Market Law – Chapter 4

53

Financial Business ActThe Financial Business Act is the main law regarding to financial activities undertakings

can do, it sets a general view of the different kind of activities and rules areas upon

licensing such activities and its main focus is to the markets’ participants that give access

to the final customer. Financial undertakings must obtain the appropriate license when

pursuing a specific activity and can also be licensed to carry one or more financial

activities upon licenses obtained under the Danish Financial Supervisory Authority. This

Act applies to undertakings such as banks, investment associations and investment

management companies60 61 whom activity consist on carrying out investment services62,

among others, such as retail foreign exchange and contracts for difference63 64.

Undertakings that carry out activities comprising receiving from the public deposits or

other funds to be repaid as well as activities granting loans at their own expense but not on

the basis of issuing mortgage-credit bonds shall be licensed as banks65. As mentioned

before, banks can also obtain other licenses, upon meeting the appropriate requirements;

banks may be licensed66 to carry out activities mentioned in Annex 4, schedule A of the

Financial Business Act as securities dealers, as well as those undertakings which are not

licensed as banks but carry out the same activities mentioned in Annex 4 schedule A, shall

be licensed only as securities dealers. Securities dealers may carry out one or more of the

activities mentioned in Annex 4 schedule B of the Financial Business Act67.

Securities dealers without license as bank, mortgage-credit institution or investment

management activities covered in Annex 6 of the Financial Business Act are investment

companies and may only carry out activities as mentioned in Annex 4 of the Financial

Business Act like execution of orders of instruments like retail forex or CFDs68. Securities

dealers shall have exclusive right to administer and carry out foreign-exchange spot

60 Financial Business Act, I, Part 1, 1(1)61 Financial Business Act, I, Part 1, 5(1)62 Financial Business Act, I, Part 1, 5(1)(3)63 Financial Business Act, Annex 4, Schedule A on Investment Services64 Financial Business Act, Annex 5 on Instruments65 Financial Business Act, II, Part 3, 7(1)66 Financial Business Act, II, Part 3, 7(2)67 Financial Business Act, II, Part 3, 9(1)68 Financial Business Act, II, Part 3, 9(2)

54

transactions for investment purposes with a view to earning a profit for investors from

changes in the exchange rate on a commercial basis for third parties69.

Financial undertakings and financial holding companies shall be operated in accordance

with honest business principles and good practice within the field of activity70, more

specific regulation in this matter is disclosed in the Executive Order on Investor Protection

in connection with Securities Trading. It is important to notice that conflict of interests

between the financial undertaking and its clients may exist, therefore, a financial

undertaking licensed to operate as a securities dealer shall have appropriate rules and

procedures for transactions with the instruments mentioned in Annex 571, be able to

identify conflicts of interest which could damage the interest of clients and restrict these

conflicts of interest as much as possible and, if there is a risk that the interest of clients

could be damaged, inform the client of the general content of the conflict of interest before

entering into an agreement72.

As mentioned before, the intermediary institutions are covered in this Act upon the legal

constitution of them and the activities they are allowed to do, including but not limiting to

retail foreign exchange and contracts for difference. As for the operative where trading and

relation between intermediary and customer takes part, the Securities Trading Act sets the

rules.

Securities Trading ActThis act regulates the activity regarding to the securities trading73 as purchase and sale of

securities for own and third party’s account74, transmission of purchase and sale of

securities75, professional advice with respect to securities76 and portfolio management77.

This act also applies to the operation of clearing activities, book-entry activities and

69 Financial Business Act, II, Part 3, 9(3)70 Financial Business Act, III, Part 6, 43(1)71 Financial Business Act, IV, Part 8, 72(2)(1)72 Financial Business Act, IV, Part 8, 72(2)(2)73 Securities Trading, etc, Act, I, Part 1, 1(1)74 Securities Trading, etc, Act, I, Part 1, 1(2)(2)75 Securities Trading, etc, Act, I, Part 1, 1(2)(3)76 Securities Trading, etc, Act, I, Part 1, 1(2)(4)77 Securities Trading, etc, Act, I, Part 1, 1(2)(5)

55

registered payment systems78. The financial security instruments applied under this Act

include, among others, the Forex79 and CFDs80 instruments.

The Securities Trading Act describes securities dealers as financial undertakings licensed

as banks, to the extent that such undertakings are licensed under section 9(1) of the

Financial Business Act, and financial undertakings licensed as investment companies81. An

“operator” is described as a limited company operating on a regulated market82, a “clearing

center” means a limited company carrying out securities clearing activities83 and “central

securities depository” means a limited company carrying out book-entry activities84. The

same way a financial undertaking can do different activities licensed under the Financial

Business Act, securities dealers can also be licensed to perform activities as a clearing

center and central securities depository.

Under this Act, a company that operates an alternative market place shall mean a company

that operates a multilateral trading facility as an alternative market place85. The activities

covered by section 7(1) of this Act may not be commenced until the Danish FSA has

granted a license hereof86.

A “regulated market” shall mean the multilateral system where within the system and in

accordance with the absolute regulations hereof, a plurality of third parties interest in the

purchase and sale of securities are brought together and carried, in such a manner that

agreement on trading in securities admitted to trading in accordance with the regulations or

systems of the market, shall be made87.

An operator of a regulated market may carry out ancillary activities in addition to operating

a regulated market, for instance as a clearing center, central securities depository and

operation of multilateral trading facilities. The Danish FSA may decide that the ancillary

78 Securities Trading, etc, Act, I, Part 1, 1(3)79 Securities Trading, etc, Act, I, Part 1, 2(1)(4)80 Securities Trading, etc, Act, I, Part 1, 2(1)(9)81 Securities Trading, etc, Act, I, Part 2, 4(1)(1)82 Securities Trading, etc, Act, I, Part 3, 7(1)(1)83 Securities Trading, etc, Act, I, Part 3, 7(1)(2)84 Securities Trading, etc, Act, I, Part 3, 7(1)(3)85 Securities Trading, etc, Act, I, Part 3, 7a(2)86 Securities Trading, etc, Act, I, Part 3, 8(1)87 Securities Trading, etc, Act, II, Part 4, 16(1)

56

activities are to be carried out by another company. If the operator of a regulated market is

operating a multilateral trading facility as an ancillary activity, the multilateral trading

facility may however always be operated by the same company as the regulated market88.

If an operator of a regulated market carries out activities as a clearing centre, a central

securities depository or a multilateral trading facility as an ancillary activity, cf. subsection

(1), the requirements of this Act for a license and operation of this type of undertaking

shall apply. With respect to ancillary operation of a multilateral trading facility the

requirements of the Financial Business Act for a license and operation of this type of

undertakings shall also apply89.

An operator of a regulated market shall be responsible for the market being conducted in

an adequate and appropriate manner90.

The operator shall be obliged to identify and deal with any conflicts of interest between the

operator and the operator’s group, and the sound function of the regulated market91, to

ensure sound management of the technical function of the market’s systems, including the

establishment of effective emergency systems92, to have regulations ensuring honest and

correct trading, and list objective criteria for effective execution of orders93, to ensure

effective and timely execution of transactions carried out in the systems of the market94, to

have at its disposal sufficient financial resources to ensure the well-functioning functions

of the market, taking into account the transactions carried out on the market and the risks

to which the market is exposed95, to register the transactions that are carried out by

members of the market by use of the market’s systems, with a view to identifying

violations of the market’s regulations, trading conditions in violation of the regulations for

the regulated market or behavior that may involve violation of Part 1096.

88 Securities Trading, etc, Act, II, Part 4, 17(1)89 Securities Trading, etc, Act, II, Part 4, 17(2)90 Securities Trading, etc, Act, II, Part 4, 18(1)91 Securities Trading, etc, Act, II, Part 4, 18(2)(1)92 Securities Trading, etc, Act, II, Part 4, 18(2)(3)93 Securities Trading, etc, Act, II, Part 4, 18(2)(4)94 Securities Trading, etc, Act, II, Part 4, 18(2)(5)95 Securities Trading, etc, Act, II, Part 4, 18(2)(6)96 Securities Trading, etc, Act, II, Part 4, 18(2)(8)

57

An operator of a regulated market shall publish the current prices and the market depth of

these prices of shares admitted to trading on the regulated market, and which are offered in

the system of the regulated market. This information shall, within the normal operating

hours of the regulated market, regularly be made available to the public on reasonable and

commercial terms97.

An operator of a regulated market may lay down regulations regarding postponement of

publication on the basis of the size or type of the transactions98. Sometimes forex and

CFDs customers trade large amounts of capital per trade; sometimes it can bring problems

when trying to clear the trade, the intermediary may set rules on how to deal with when

those situations are presented.

One of the most important rules this Act applies is “price manipulation” which covers,

among others, transactions or orders to trade which employ fictitious devices or any other

form of deception or contrivance99. The Securities Trading Act doesn’t go deep into this

concept but more important guidance can be found on the Executive Order on notice,

notification and public disclosure of managers’ transactions, list of insiders, notification of

suspicious transactions, signals of market manipulation and accepted market practices

(Executive Order on market abuse)100 although, such rules are more relevant to “less

complicated” securities such as shares and bonds where big orders can affect market’s

price, in the case of retail foreign exchange, it is unlikely that orders where the

intermediary acts as counterparty will make an impact into the market’s price.

Under the Securities Trading Act, “Clearing” means the calculation of obligations and

rights pertaining to an agreed exchange of financial instruments, including cash101,

“settlement” shall mean any exchange of services for the purpose of fulfilling the

obligations of the parties102. A clearing centre may keep cash accounts for clearing

participants and arrange for the lending and borrowing of money and securities in

97 Securities Trading, etc, Act, II, Part 4, 18a(1)98 Securities Trading, etc, Act, II, Part 4, 18b(3)99 Securities Trading, etc, Act, II, Part 10, 38(1)(3)100 Executive Order on market abuse101 Securities Trading, etc, Act, III, Part 15, 50(1)102 Securities Trading, etc, Act, III, Part 15, 50(2)

58

connection with clearing, settlement, or clearing and settlement of securities

transactions103.

Book-entry and registryBook-entry for securities issued and transferred electronically104 which are negotiable and

dematerialized105, such as forex and CFDs, are registered through a central securities

depository and entry of rights to such securities106. Apart from the central securities

depository concerned, financial undertakings licensed as banks or investment companies

and clearing centers shall have the right to report transactions for book entry with a central

securities depository on its behalf107 108 109 . An account-holding institution shall be obliged

to report, without delay, received applications for book-entry in a central securities

depository110.

Notification of the book-entry shall be given to the party or parties entitled according to the

book-entry register as well as to the applicant. Notifications of any impediments for the

book-entry shall be given.111.

103 Securities Trading, etc, Act, III, Part 15, 53(1)104 Securities Trading, etc, Act, IV, Part 19, 59(1)105 Securities Trading, etc, Act, IV, Part 19, 59(2)106 Securities Trading, etc, Act, IV, Part 19, 59(3)107 Securities Trading, etc, Act, IV, Part 21, 62 (1)108 Securities Trading, etc, Act, IV, Part 21, 62 (1)(1)109 Securities Trading, etc, Act, IV, Part 21, 62 (1)(6)110 Securities Trading, etc, Act, IV, Part 22, 66 (4)111 Securities Trading, etc, Act, IV, Part 22, 66 (1)

59

Executive OrdersExecutive orders are supplementary rules that detail in a more specific context some of the

activities and concepts under the Financial Business and the Securities Trading Acts. The

most important executive orders that fit into the retail foreign exchange and CFDs markets

are”

Executive Order on Risk-Labeling of Investment ProductsThis executive order categorizes the risk of losing the amount invested or more into green,

yellow and red labels, where forex and contracts for differences are placed into the red

label, where there is a risk of losing more than the amount invested or the product type is

different to understand112 113.

Executive Order on Investor Protection in connection with Securities TradingThis executive order applies to Danish securities dealers’ activities upon securities

trading114 of financial instruments115 in Denmark116, but void when the customers of such

securities dealer are eligible counterparties117, it also provides categories of customers

which a securities dealer shall divide into professional customer118, eligible

counterparties119 and retail customers which are neither professional customers nor eligible

counterparties120.

This executive order requests that a securities dealer shall act honestly and

professionally121.

112 Executive Order on Risk-Labeling of Investment Products 4(1)113 Executive Order on Risk-Labeling of Investment Products 4(4)114 Executive Order on Investor Protection in connection with Securities Trading, Part 1, 2(1)115 Executive Order on Investor Protection in connection with Securities Trading, Part 1, 2(3)116 Executive Order on Investor Protection in connection with Securities Trading, Part 1, 1(1)!1)117 Executive Order on Investor Protection in connection with Securities Trading, Part 1, 1(5)118 Executive Order on Investor Protection in connection with Securities Trading, Part 2, 4(1)(1)119 Executive Order on Investor Protection in connection with Securities Trading, Part 2, 4(1)((2)120 Executive Order on Investor Protection in connection with Securities Trading, Part 2, 4(1)((3)121 Executive Order on Investor Protection in connection with Securities Trading, Part 3, 5

60

When a securities dealer provides or administers orders for a retail customer without

providing investment advice or portfolio management, the securities dealer shall obtain

information for the customer about his knowledge and experience in the investment field

relevant to the specific type of product or service being offered or requested. The securities

dealer shall assess whether the product or service under consideration is appropriate for the

customer122. If, on the basis of the information received, the securities dealer considers that

the product or service is not appropriated for the customer, the customer shall be made

expressly aware of this123.

When a securities dealer has executed an order on behalf of a customer, the securities

dealer shall, provide the customer with important information about the execution. If the

order is executed for a retail customer, the securities dealer shall send the customer a

settlement note no later than the first weekday after execution or, if the securities dealer

receives confirmation from a third party, no later than the first weekday after receipt of the

confirmation124.

A securities dealer shall implement procedures to ensure, that an order is executed on

behalf of a customer, registered and allocated expeditiously and precisely125, that

comparable customer orders are executed consecutively and expeditiously unless the

nature of the order or the appropriate market conditions make this impossible126 and

immediately he becomes aware of this, the securities dealer informs a retail customer of

any significant problems with the execution order127.

122 Executive Order on Investor Protection in connection with Securities Trading, Part 6, 17(1)123 Executive Order on Investor Protection in connection with Securities Trading, Part 6, 17(2)124 Executive Order on Investor Protection in connection with Securities Trading, Part 7, 21(1)125 Executive Order on Investor Protection in connection with Securities Trading, Part 9, 27(1)(1)126 Executive Order on Investor Protection in connection with Securities Trading, Part 9, 27(1)(2)127 Executive Order on Investor Protection in connection with Securities Trading, Part 9, 27(1)(3)

61

PART V

OPPORTUNITY AREAS

62

The retail foreign exchange and contracts for difference markets are some of the most

interesting markets to trade, high liquidity and fast execution make this instruments very

attractive to every kind of participant, even those who have never seen a price chart before

can fall into the charms of a leveraged instrument that may return high quantities of profits

while trading at home. Volatility in the currencies can give a dynamic environment where

emotions take an important role in the traders’ decisions.

The nature of the retail foreign exchange, under its decentralized scheme may leave

regulation loop-holes where intermediaries can virtually vanish the traders’ accounts.

There is this though that since forex doesn’t have a physical place to be traded it cannot be

regulated, but there are tools that allow controlling unfair practices in this kind of market.

When speaking about financial markets, specially trading them, there is a common

assumption that those kinds of instruments are to be used for only suitable and

sophisticated clients that have large amount of money or knowledge and can go on with

their lives even when incurring in some financial loses. In the case of retail forex is not like

that at all, there are brokers that allow investors to open an account with as low as $1 USD

and trade it. This kind of instrument is open to every kind of investor who is willing to

speculate with part or their whole money through out a financial intermediary.

As a personal note, during my experience as advisor for some companies in this field, I

have seen cases of fraud, theft, lies and unfair practices in all kind of intermediaries such as

broker, introducing brokers, money managers, clearing centers, regulated or not, that made

me wonder about the quality of the laws behind this activity.

Before starting this paper, skepticism regarding effectiveness of the Danish laws within

these markets helped me to decide the writing of this paper. Although, I expected to find

larger deviations between the activity’s current regulations and my perspective upon the

intermediaries’ practices, I must admit that in the case of the Danish regulations, simplicity

and centralized regulation, as it currently is, are the keys to maintain an effective control of

brokers, dealers and market-makers.

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While the Danish Financial Supervisory Authority is the main body behind financial

regulation in Denmark, it is internally divided into different kind of divisions dedicated

exclusively to the areas appointed by the DFSA, therefore keeping a central place where

effective communication can be provided in matters of regulation information flow

between the divisions while being under the same regulation umbrella. My perspective

before this research, questioned the need of the creation of an independent regulatory body

focused exclusively into these markets or industries while separating areas of mortgage-

credit institutions, insurance companies and financial intermediaries totally from each

other in an institutional level the same way is seen in the USA where the Securities

Exchange Commission, the Commodities and Futures Trade Commission, the National

Futures Associations and the Financial Industry Regulatory Authority, either acting as a

government institution or a self-regulated authority, regulates different markets,

intermediaries and execution processes.

I believe that a separation of institutional bodies in Denmark will not be the answer to a

more effective regulation; the Danish financial legislation does not need a self-regulated

authority to mix information, create new laws that might contradict current legislation nor

confuse the customer. I believe one of the most important issues regarding regulations in

Denmark is the lack of effectiveness communication between institutions regarding such

laws. Legislation in Denmark changes rapidly and in my experience, the delegation of

authority can lead to uncomfortable and sometimes unfair situations where not everybody

is treated the same, when speaking of financial instruments and legislations this can lead to

important consequences that can be avoided by keeping the current institutional structure.

Although, in my opinion, the current Danish legislation deals with many of the general

aspects of corporate and activities regulation through the licensing of these activities, I

believe there are areas of opportunity where investors can be more protected in these

markets.

The Financial Business Act, in my opinion, maintains a clear path upon regulation of

financial undertakings with a simple structure, focuses on the legal aspects of the

constitution of undertakings, the requirements to be licensed and delegates the securities

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trading area to the Securities Trading Act to avoid confusion on these kind of activities

with the credit and insurance undertakings.

The Securities Trading Act is clear upon the trading activity, although most of its structure

is very attached to the stock markets rather than financial derivates, perhaps a division of

activities in this act where financial derivatives can be explained and regulated more

specifically and separately from the stock markets, may give a more protection sense to

financial derivatives’ investors.

In my opinion, even thou, the retail foreign exchange and contracts for difference markets

seem to be a very specific area where maybe a reformation of the current Danish

regulations is not needed, but a change in some of the soft law can be very efficient to

boost investor’s confidence that activity is completely regulated.

Some of the Executive Orders in the current Danish financial legislation deal specifically

on topics like classification of customers, book-entry processes, good practices, etc, I

believe that it is possible to contribute positively if there is a Guidance upon retail forex

and CFDs markets where an official public institution recognizes some of the concepts and

practices described in this paper and sets rules on the investors’ protection field.

One of the changes I propose is, based upon the instruments classification mentioned in the

Executive Order on Risk-Labeling of Financial Products, is the classification of

intermediaries, not necessarily to use colors as the executive order just mentioned, but to

categorize brokers, dealers and market-makers. I think the DFSA could be a pioneer in this

concept by developing a regulation where setting new parameters on financial socially

responsible behavior from intermediaries by creating a scale where the trader could be

aware of what kind of intermediary he is choosing to trade with.

In this case, I think a classification upon the amount of trades kept “in house” vs. routed to

the market. Above is shown the different order execution models brokers choose to work,

it would be important for the customer to know what kind of models the broker is using to

execute orders, and the % of orders traded on each of the models, that way a trader knows

what to expect from a broker that becomes the counterpart 75%, of the trades and sends

25% of the trades to a third party, or other customers inside the firm, etc., with this kind of

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parameters, I believe, transparency will become an important issue to consider when

choosing a broker comes in the picture. This kind of classification may also bring positive

critics upon foreign investment opportunities in Denmark and a better control impression

from the DFSA.

With this proposed classification will be easier to obtain information on the effectiveness

of the trading, in the Executive Order on Investor Protection in connection with Securities

Trading mentioned above, a confirmation of the settlement has to be handled to the client

no later than the first weekday after trade has been executed, in my opinion, even thou it is

to be confirmed the next day at the latest, I believe that unfair practices can be presented in

this situations where profitable trades can be reversed. Nowadays automated trading is

quite used among traders and situations where scalping is met and several profitable trades

can be made in one day, a reversed settlement 24 hours after an executed trade may bring

unfair practices. I believe in this matter, the DFSA may adopt one of the NFA’s rulings on

trade confirmation at a maximum of 15 minutes after the order is executed, either to enter

or exit the market, that way 2 confirmations are sent in order to maintain a more equal

opportunity of profit to the trader.

Price manipulation is an area that can be extended, as mentioned above, the use of

algorithms can become an important factor when routing the trade, with a proper

classification of the amount of routed trades and kept in house it is possible to obtain more

specific information about any price manipulation situations. If trades are kept in house, a

slippage, generally, should not be presented and trade confirmation of settlement should be

instant. If trades routed to a third party, information about executed prices should be

presented and differences between prices will be easier to find.

In my opinion, there should be a restriction upon the brokerage and dealing activity when

trading CFDs. Since CFDs providers have information of the current positions taken from

their customers, CFDs providers should not have access to buy actual shares they provide

over CFDs mirrors, since such purchases can influence the positions its traders have. A

front running situation is highly unlikely to happen but at the end of the day, using

information from its customers, if a broker or dealer, by knowing its clients trading

positions, buys or sells instruments where such transaction will be reflected into a price

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movement and indirectly to the traders balance, therefore, in the most strict perspective

that is considered as price manipulation.

Different quoted price can be presented to the clients at a given time, I don’t think this is a

matter to be regulated since like any other street market, different prices can be given

according to different kind of customers, although, I believe that a better trading

conditions, like a tighter spread, should be rewarded upon trade volume, either in capital or

executed trades, this kind of alternative may influence the introducing broker and money

managers to fall into practices where the interests of the customer are not respected in any

matter.

In the Introducing Brokers and Money Managers field, I think the DFSA and the current

regulation is in a disadvantage against such figures since the regulation’s scope includes

undertakings only located in Denmark, the EU or those countries non members of the EU

where financial agreements have been made. This leaves the IBs and MMs in a good

position to melt down customer’s accounts without being bothered by the authority

supervising financial undertakings in Denmark.

I propose that under the payment agreements brokers and dealers located in Denmark only

the water mark scheme is applied to reward the agents involved in the trading activity. The

same way, I believe that, even though the DFSA has no jurisdiction upon IBs and MMs

outside the regulation’s scope, a minimum set of requirements should be met by the broker

or dealer in order to provide agents the access to the market and therefore reward them

with commissions; such requirements could include appropriate certifications that

demonstrate agents capabilities and skills upon managing or giving advice to investors and

effectiveness on the trade with parameters such as winning rate, market exposure per trade

and amount of trades per period, this way a customer is fully informed of the alternatives

and can choose whether such alternatives meet his trading expectations and such

alternatives are backed by a regulated intermediary and the DFSA.

I believe there is much more work to do regarding the trading in this markets, I don’t think

the deregulation of this activities will be the answer to a better equilibrium between

participants, but finding such equilibrium will take time and many complaints from

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investors before an effective set of rules can be implemented. I think the DFSA can be

innovator in this market and lead global changes, in this kind of markets in a more socially

responsible activity.

Regarding to the execution models used by intermediaries, I don’t think it is necessary to

interfere about using one kind or another, I think the most important part is to keep close

supervision upon the correct functioning of it and keep at all times the investors’ interest in

front of the intermediaries’.

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PART VI

CONCLUSIONS

69

The retail foreign exchange and contracts for difference are indeed complicated markets

that need a particular supervision of trading process. Although, the concept of a bucket

shop used one hundred years ago keep some activities on the eye of regulations, the global

markets development bring different opportunities nowadays. The same way financial

undertakings and products have changed; it is possible to adapt some of the bucket shop

characteristics to current trading opportunities making markets and trading execution more

efficient where independent undertakings can offer fair conditions to retail investors while

staying within the proper regulation frame.

The structure of the markets can offer different alternatives to investors where while trade

complex instruments can choose through a variety of intermediaries and conditions and are

not attached to only one investment possibility or standard trading limitations. A global

trading structure like the foreign exchange and contracts for difference markets promotes

competition among the access providers such as brokers, dealers and market-makers with

faster execution methods, tighter spreads and the possibility to offer through a platform

that can be download to the investors computer the same opportunities that sophisticated

investors had exclusive access many years ago.

The brokers, dealers and market-makers are not the only intermediaries in this trading

game, and even thou they can become the most important link between traders and the

market, other figures take part of it regarding tasks on clearing and settlement, as well as

the agents that connect investors to brokers, which can be a useful tool to many investors

whom only purpose is to get their accounts trader rather than trade it themselves. In my

experience, these agents can damage more than other intermediaries and special attention

should be kept in place regarding their activities.

There are different business models brokers, dealers and market-makers can use in order to

achieve a more efficient execution methods; while such methods can be kept private since

is the core of the business, it is important for the trader to have the proper rights regarding

execution transparency in order to obtain an execution balance where unfair practices are

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avoided and all the participants in the trading structure can obtain their maximum benefit

from such markets.

The Danish Financial Supervisory Authority has done a good job regarding to regulation of

financial undertakings under the Financial Business Act and the trading activity under the

Securities Trading Act. These Acts are the core legislation over the foreign exchange and

contracts for difference activities and even thou some changes may provide a better trading

environment in these particular activities, drastic changes upon both Acts are not necessary

and improvement can be made through out soft laws such as Executive Orders protecting

the investor on areas such as execution methods, price manipulation, commissions paid to

agents and fair practices regarding the participants. Special guidance can also be developed

to inform the investors the proper rights and obligations each of the participants have in

order to maintain a clean and transparent environment within the trading industry.

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