Avoiding Fraud in Currency Trading

Most consumers are familiar with the Latin phrase caveat emptor – translating as “buyer beware” – which encourages a thorough inspection of a product or service before it is purchased. Few intelligent people would entertain the notion of parting with their hard-earned money before scrutinizing the credentials of an investment counselor. Yet, financial fraud is a large and growing international problem. Even before the dawn of the Internet age and the “nameless, faceless” global bazaar it helped to create, financial improprieties turned many a trusting soul into a helpless victim. Investors in today’s foreign exchange marketplace need to fully understand the potential for various types of fraud, and must make every attempt to minimize the perils associated with them.

Buyer and seller beware

With no global regulatory body in place to oversee international trading activity on the foreign exchange markets, the potential exists for participants to engage in illegal activity and questionable business practices. Traders are bound largely by the laws and conventions in their own country of residence. Some types of transactions involving foreign currency can be quite complex, and as such, individual investors must have the utmost confidence in the individuals and firms with whom they choose to do business. By the time the various parties with interests in a suspicious transaction have put the puzzle pieces back together, considerable financial damage can be wrought, and the available avenues for legal recourse are often limited – or worse – nonexistent.

The underlying mechanics of foreign exchange are necessarily complicated. For the markets to function in an orderly manner, a great deal of cooperation and communication must occur between all interested parties. While actual transactions are usually executed by means of a quick telephone conversation or a simple click of a computer mouse, individual investors need to fully comprehend the risks borne by dealing with a faceless business partner or by engaging the services of intermediaries to execute their trades.

Who’s Minding The Store?

Under the terms of domestic legal conventions such as the Uniform Commercial Code, it is presumed that all parties to a business transaction are acting in good faith. In principle, the foreign exchange marketplace is no different, even though no set of legal codes exists to enforce compliance with commonly accepted international business practices. Unfortunately, traders in foreign exchange cannot rely on a Geneva Convention-type treaty that demands fair treatment for all market participants, or a Warsaw Convention-type policy that limits participants’ liability should things suddenly go awry.

Harkening back to the very definition of the medium, currency is exchanged between two parties because they mutually believe that currency has a common value. But recent history clearly shows that in spite of the trust and faith placed in individuals and institutions, sometimes, all is not as it seems to be. And occasionally, whether due to malfeasance or outright criminal activity, the impacts of fraud can cascade across the world like a tsunami.

The “other” irrational exuberance

Anyone who has ever been captivated by the Las Vegas-style slot machine known as a “one-arm bandit” can tell you that the heart and the mind don’t always cooperate with each other. Drawn like a moth to the flame, an adrenaline-fueled speculator will often continue to feed a highly irrational investment scheme to the point where he or she is utterly oblivious to the eventual outcome. Trading in the foreign exchange markets requires a mindset that will allow continual comparisons between the rational and the irrational. The business of foreign exchange also requires a system of internal checks and balances to ensure that solvency is maintained at all times.

Unstable pyramids

While confidence games come in all shapes and sizes, one of the most common types of fraud in the financial services industry is a criminal enterprise known as the “Ponzi scheme.” Originally named after Charles Ponzi, a dubious New Englander who bilked investors out of millions of dollars in the 1920s through a sham involving international mail coupons, Ponzi schemes – or “pyramid” schemes – continue to operate illegally in every country today. In a typical Ponzi scheme, an individual or company attempts to hide its mounting investment losses by luring in new customer money and paying old investors with new deposits. When losses hit catastrophic levels and customers are unable to withdraw their money as promised, the entire “house of cards” topples over.

In a classic example of a Ponzi scheme, a Princeton, New Jersey trader by the name of Charles Kohli induced his clientele to fund bad currency trading investments through a series of small companies, culminating with the loss of more than $40 million of private investors’ money in 1995. Kohli was subsequently convicted and sent to prison.

The wrath of the rogues

Even within large, seemingly stable financial institutions, certain personality types can lead to undesirable behavior patterns which skirt established policies and procedures put in place to minimize an institution’s risk of exposure to bad deals. Often classified as “rogue” traders, these individuals can shake entire organizations to their very foundations.

The Barings Bank of England collapse in February of 1995 has become a classic case study on risk management and “rogue” trading. Barings, a well-known and respected British investment house, was decimated to the tune of almost £850 million by the activities of a single person. Nick Leeson, a trader based in the firm’s Singapore office, engaged in a series of risky transactions, all while carefully concealing his mounting losses through faulty internal accounting procedures and funding new investments via new lines of credit without management’s authorization. While the scandal didn’t arise directly from interbank foreign exchange trading, it did involve certain futures contracts and over-the-counter (OTC) deals that were not listed on any official exchanges. The incident led to the enactment of new regulations regarding the reserves that are required to be held by international banks engaged in making commercial loans. Today, Barings is no more, and Leeson sits in a prison cell serving a lengthy sentence after being extradited back to his native >Britain .

Five years after the Barings collapse, another “rogue” trader at a U.S. division of Ireland’s Allied Irish Bank accrued $690 million in losses involving Japanese yen/U.S. dollar transactions made over the span of several months in the year 2000. Again, poor internal controls and a lack of management oversight were primarily to blame.

Where are the currency police?

It strikes some investors as odd that there is no single entity that regulates the foreign exchange marketplace. At various points throughout history, individual nations – including the U.S. – have attempted to exert control over the markets, but have failed to succeed. Most traders agree that this is a good thing – ensuring that no one nation can unduly influence the financial affairs of another, or unfairly restrict international trade. In the case of foreign exchange futures, U.S.-based investors have some limited protections afforded to them under the watchdog activities of the Commodity Futures Trading Commission (CFTC). However, the CFTC doesn’t regulate the foreign exchange industry per se – it only monitors compliance with domestic statutes involving the trading of currency-based futures.

Watchful eyes of government

Over the years, numerous U.S. law enforcement and governmental agencies have investigated domestic and international criminal activity involving the foreign exchange markets. Because financial crimes often involve interstate activity, the bulk of enforcement efforts often fall under the jurisdiction of the federal government. The Securities and Exchange Commission (SEC), the Department of the Treasury, the Federal Bureau of Investigation (FBI), and the United States Postal Service’s Postmaster General (USPS) have all played key roles in uncovering fraudulent practices. Additionally, attorneys general offices in many U.S. states have developed highly-trained task forces which are devoted exclusively to the pursuit and prosecution of financial crimes.

Self defense tactics

Individual investors should always be wary of institutional foreign currency traders who promise huge profits with little or no risk. Additionally, any foreign exchange trader who urgently pressures a client to authorize a trade must be viewed with some degree of suspicion. Unlike securities brokers who must be licensed by the National Association of Securities Dealers (NASD) in order to legally conduct business, there is no universal accreditation in the world of foreign exchange. Thus, the onus falls on the individual investor to vet the authenticity of any trader with whom he or she chooses to do business. While foreign currency traders may or may not also be licensed to sell securities, investors can easily check with the NASD to see if there is any history of violations or enforcement actions against registered individuals.

When investors deal with large institutions, there is often a presumption that the risk for being victimized through fraudulent activity is generally low. In reality, this is not always the case. Investors in the foreign exchange markets must learn how to read and interpret the statements that they receive from any trading firm. Oftentimes, questionable entries on a paper statement are the first tip-off that a customer’s account has been used for unauthorized activity. Investors also have the right within reason to ask for an explanation of a firm’s internal accounting controls, and should feel free to inquire about the educational and business backgrounds of any individuals who might be assigned to servicing their accounts. Investors can also access the SEC’s various databases and query various states’ attorney general offices to check for violations and enforcement actions against U.S.-based financial firms.