Regulated vs. Unregulated Forex Brokers

One of the first things you will notice once you delve into the world of Forex trading is the huge number of brokers competing for business. The majority of big-name brokerages are regulated in the countries where they provide their services. There are, however, a significant number of brokerages that are based in offshore locations where Forex regulation is either very lax or simply non-existent.

Many industry professional advise traders and investors to stay away from unregulated brokers. Whereas there are obvious advantages of trading with a regulated broker, it's not always why some traders are happy to do business with unregulated brokers.

Why do some brokers forego regulation?

The Forex market is the largest financial market in the world with more than $5 trillion transacted every day. It's therefore hardly surprising that the industry is rife with fraudulent brokers who scam unsuspecting traders out of their money. It's estimated that nearly 26,000 people lost $460 million in Forex swindles between 2001-2007. Broker regulation greatly helps to add to a broker's credibility, and is the main reason why many Forex brokers are quick to point out their regulatory pedigrees in their websites.

Still, some brokers prefer to operate outside any regulation, many times opting to establish their operations in offshore locations.

Legitimate business reasons

While this might seem counterintuitive or even downright malicious, there are some legitimate reasons why some brokers prefer taking this route. One of the biggest is that operating without any regulations allows the broker to significantly lower its operating costs. It's estimated that the cost of maintaining a broker license can run into the millions.

Further, it can allow a broker with limited capital to operate. Capital requirements set out by regulatory frameworks such as MiFID in Europe and SEC in the U.S. can constitute a big barrier to entry. The minimum net capital required by the Securities and Exchange Commission Rule 15c3-1 is $250,000. In such a case, a broker who is unable to raise the minimum capital required might decide to operate as an unregulated entity for a year or two until it's able to meet the capital requirements and face the cost of regulation. Further, SEC prevents any new brokerage to have aggregate indebtedness, including that to clients, that exceeds 15 times its net capital for the past 12 months of operation.

Additionally, many unregulated brokers operating in offshore tax havens are able to enjoy a significantly lighter tax burden than brokers operating in countries where tax rates are high. For instance, a brokerage operating in the U.S. would have to pay 35% corporate tax compared to less than 20% in some regions across the world.

Another big reason why a broker might choose to operate without regulatory oversight is because it allows the broker to offer a different product range than what would otherwise be possible if the broker was regulated. For instance, some brokers might want to offer high leverage levels or interest-paying accounts that are not allowed for regulated brokers. A good example is FXCM Markets, a subsidiary of FXCM, which offers a high leverage of 400:1 and interest-paying accounts for traders. FXCM Markets, however, does not accept traders in the U.S., European Union, Canada, Hong Kong, Japan, and Australia.

Risks when trading with unregulated brokers

Traders should, however, note that not all brokerages choose to operate without regulatory oversight for legitimate business reasons. Some brokerages choose to operate in offshore locations where Forex regulation is lax or lacking so as to take advantage of their clients. Some of these brokers can quickly close shop without any warning, thus leaving their customers counting huge losses with no recourse. Regulated brokers are required to maintain separate company and trader accounts. Unregulated brokers do not have to follow this requirement and can easily jeopardize the trader's capital.

Trading with an unregulated broker can therefore be a nerve wracking affair. In contrast, regulated brokerages are required to maintain a company consumer compensation funds with which to compensate their clients should the company become bankrupt. Additionally, the checks and balances established by the regulator ensure that the broker always acts with the customer's best interest in mind.

It's imperative that you do a proper background check before depositing your money with any broker, whether they are regulated or not. Poring through customer reviews on the Internet can be of help. You should, however, bear in mind that many negative customer reviews are based on experiences when trades go against the trader's expectations and are not caused by the broker's wrongdoing.