Over the past ten years, investors have willingly expanded their investment horizons, aided by the Internet, sophisticated software order execution platforms, and a creative brokerage community that has expanded, as well, to meet the overflowing demand. Stocks and bonds are no longer the only items favored by today’s modern investor.
Currencies, commodities, overseas offerings, and futures contracts have garnered wide-ranging popularity, but these sectors also have a much higher risk profile. The higher risk in most cases, however, is not confined to the type of investment vehicle alone. These potentially “greener pastures” often involve overseas transactions with unknown counterparties and brokers that would never pass a strict domestic “due diligence” test.
A cross-border investment can also entail country-specific risk, currency risk, geo-political risk, and sovereign risk, to name a few, and the interpretation of foreign financial statements may be more suspect due to different accounting standards. A decade ago, a 5 to 10% standard existed, as the proper exposure of an investment portfolio to cross-border related risks. Today, this outdated benchmark has morphed to 25 to 30% or more. Wise investors need to review their risk exposures on a continuing basis.
One recent example has brought home this point to many investors that harbor a tendency for foreign investments. A multitude of forex traders recently found their account balances frozen, pending a potential seizure by government officials in Cyprus, when the two largest banks in Cyprus ran into financial difficulties that had nothing to do with currency trading activities.
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Over the past nine years, the number of forex brokers calling Cyprus their home has grown to 80 in number. Cyprus joined the European Union in 2004 and converted to the Euro. Tax benefits, flexibility in local laws, and a less-stringent regulatory environment were the obvious reasons so many established firms set up shop on the island on an operational basis. The major firms, however, followed “best practices” in the industry by segregating customer account balances offshore with Tier-1 banks, thereby shielding them from any banking risk that might originate on the island itself.
Back in March, it came to light that the Bank of Cyprus and the Laiki Bank had both invested heavily in Greek bonds and subsequently recorded enormous losses when the bonds were written down in value by Greek bailout agreements. The former bank will be re-structured, and the latter will be shut down. Bank account balances below 100,000 Euros will be safe, but balances above this figure will suffer a severe financial “haircut”, in accordance with new bailout agreement terms.
Local forex brokers that commingled client account balances with operating funds with these two banks will suffer. If they cannot raise additional capital or be acquired in a way that would restore client account balances, then affected forex traders will suffer, as their brokers file for bankruptcy. This entire situation happened quickly. There was little that could be done after the fact.
If you are an investor that is enamored with investing overseas, where many advisors tout the growing opportunities for gain to be, the time to prevent risk scenarios like the one in Cyprus is on the front end, not later down the road. Domestic regulators in the United States can do very little to mitigate fraud or risk from cross-border investment activities. Asserting legal rights in a foreign jurisdiction is fraught with peril.
Investing in domestic mutual or ETF funds that focus on foreign investments is one way to avoid a portion of the risk, but also query your broker as to how he is protecting your account balance from seizure.