Jay D. Franklin

IFA’s Concerns with Currency Speculation and Trading

At the very beginning of his excellent new book, What Investors Really Want, Meir Statman relates the story of how he was accosted at a cocktail party by an engineer who wanted to trade his US dollars for Japanese Yen. The reasons given by the engineer were the same ones that IFA’s advisors constantly hear from prospects: The national debt is unsustainable, so the government will be forced to print more money, leading to hyper-inflation, etc. Professor Statman responded with a brilliant metaphor: Trading in currencies (or really any financial instrument) is not like playing tennis against a wall where you can project where the ball will land thus position yourself accordingly. Rather, it is like playing tennis against an opponent whom you have never met. You simply have no idea where he is going to hit the ball next. The opponent, of course, is the entity taking the other side of the trade, which very likely is someone with a great deal more knowledge of the currency markets.

Based on a recent article in the Wall Street Journal, Statman’s analogy can be taken one step further. Not only are would-be currency speculators playing against a potential Venus Williams, they are playing on a court that is tilted at a 45-degree angle against them. The brokers on whom individuals rely to conduct their trades typically trade against them. Unlike stock trades, there is no requirement of “best execution” on currency trades. Typically, a retail foreign-exchange dealer is usually on the other side of the trade and this same party quotes the price. Although the conflict of interest is disclosed in the contract signed by individual currency traders (who now account for about $315 billion of daily trading volume), the overwhelming majority of them are simply not aware of it. One typical disclosure cited in the article reads as follows:

Your dealer is your trading partner, which is a direct conflict of interest. The dealer may offer any price it wishes, may show different prices to different customers, and the prices shown might not reflect prices available elsewhere.

Such a deal!  How do we sign up for that? Unfortunately, no mention was made of what power microscope is needed to see this disclosure.

Recently, we have pointed out how public pension funds have been hosed in their currency trading by the big banks of Wall Street. Specifically, they gave the pension funds the worst price of the day and pocketed the difference. For example, CALPERS is estimated to have lost $56.6 million to State Street Bank, according to the state attorney general’s office. Since pension funds are counted as among the world’s most sophisticated investors, one may ask how individual retail investors should be expected to fare at this game. To visualize the answer, think about what happens to a rump roast that is tossed into a shark tank.
To summarize, currency trading is just another type of speculation, and as we all know, the expected return of speculation is zero before costs and negative after costs. However, when formulating his Theory of Speculation, Bachelier assumed a fair game in which all participants have equal access to information and can act accordingly. Clearly, these conditions do not exist in the currency markets, so retail currency speculators should expect to do far worse than Bachelier’s  hypothetical speculator. IFA reminds all investors that the expected return of the currency of every country is zero, and anyone who expects to profit from trading currencies should simply ask who will supply the fools that will be parted from their money by taking the other side of his brilliant trades? Perhaps he should consider the possibility that the fool is the man in the mirror.