Forex, or the foreign exchange market where investors and institutions trade currencies, is the biggest financial market in the world. Around $6.5 trillion trades each day on the forex markets, according to the 2019 Triennial Central Bank Survey.
While forex trading is legal, the industry is rife with scams and bad actors. Investors need to do their due diligence before venturing into what can be a Wild West version of global financial markets.[Read: What Are Mutual Funds? The Ultimate Guide.]
How Forex Trading Works
Forex, also known as FX, trading takes advantage of the fluctuations in currency exchange rates. “The FX market does not set a currency’s absolute value but rather determines the value of one currency relative to another,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “You can take a position in virtually any major currency against another major currency in the FX market.”
For instance, you might bet on the U.S. dollar versus the Japanese yen. Or the yen versus the Mexican peso.
While most of the activity in forex markets is done by multinational corporations to hedge natural positions, individual investors sometimes speculate on currency movements.
“Investing in currencies, whether traditional currencies or cryptocurrencies, is fundamentally different than investing in stocks, bonds or real estate,” Johnson says. “Over the long term, investing in the stock market is a positive-sum game” because the value of stocks rises over the long term.
“On the other hand, over both the short and long term, investing in currencies is a zero-sum game,” Johnson says. “When the U.S. dollar strengthens versus the yen, those holding U.S. dollar positions win and those holding yen positions lose an equal and opposite amount.”
For this reason, he says that those wanting to build wealth long term should stick to the stock market.
If you do venture into the world of forex, however, you need a forex brokerage account. The trouble is, not all forex brokers have your best interest at heart.[Sign up for stock news with our Invested newsletter.]
Are Forex Brokers a Scam?
While on its face forex is legal, “there are many potential bad actors in the space, and it is a prime atmosphere for spoofing, ghosting and/or front-running,” says Braden Perry, a regulatory and government investigations attorney with Kennyhertz Perry LLC, based near Kansas City, Missouri.
Spoofing and ghosting are when a trader manipulates the market by placing a large order the trader doesn’t plan to execute in order to create the impression of interest in the position. Front-running occurs when a broker, knowing a client is going to be placing a big order, places an order for the broker’s own account ahead of the client’s.
The rise of internet-based trading platforms has only exacerbated the risks, creating more opportunities for fraudulent promotional schemes, overstatement of returns and the failure to pay out for wins, Perry says. “Furthermore, some actors are using manipulative software to rig the system.”
The main issue with forex trading is a lack of transparency and unclear regulatory structures with insufficient oversight. However, there are forex products listed on exchanges that have regulatory oversight. Likewise, there are legitimate brokers making a business in the market as well.[READ 2020’s Dividend Aristocrats List: All 66 Stocks]
How to Choose a Forex Broker
“Forex trading is safe if you properly select a brokerage account and firm,” says Sergey Savastiouk, CEO of Tickeron, a market intelligence platform that assist users with portfolio and trading decisions on stocks, exchange-traded funds, mutual funds, forex and cryptocurrencies.
Savastiouk tells investors to test brokers by putting money in and taking it out to gauge how accessible it is. He also says it’s a legitimate concern if you cannot call your broker and speak to a representative.
Second, consider the country affiliation and where the firm is located. “The more developed countries have better regulations,” Savastiouk says. “It is much better to select a brokerage firm from the United States, Canada, Europe or some select countries in Asia. Everywhere else you should be concerned with.”
He also recommends making sure any company is registered with the Securities and Exchange Commission. “If the company is SEC-registered, they typically work in a wide, compliant and transparent territory that investors can trust.”
Registration is key. Perry says the easiest way to protect yourself is to do your due diligence and ensure you’re trading on a regulated U.S. exchange. “This way, you can verify (the broker’s) registration and view job and disciplinary history through BrokerCheck, (the Financial Industry Regulatory Authority’s) registration database, or Background Affiliation Status Information Center,” the National Futures Association’s registration database.
He also recommends asking forex brokers about their policies and procedures for placing trades. The most reputable brokers use third parties to audit their trading and ensure they and you are getting fair rates on trades.
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