Are U.S. foreign exchange trading accounts an adequate way to hedge against U.S. dollar inflation?

Copyright 2012 by John T. Reed

I frequently am asked whether foreign-exchange trading accounts are an adequate way to hedge against U.S. dollar inflation. I recommend opening ordinary savings accounts in foreign currencies in foreign banks in the foreign countries that issued the currencies you are buying. When you can’t do that, I recommend buying the actual cash and putting it into a Canadian safe deposit box. Rule Number 1 of Reed’s Rules of Real Estate Finance (Those rules are in my book Fundamentals of Real Estate Finance.) is

Simple is better than complex.

That particular rule applies to all finance, not just real estate.

I gave one reader some questions to answer. He submitted them to his broker. So I will show you that dialog but the short answer is,

I do not recommend it.

Here is the original email I got and my responses:

Hello Mr. Reed,

First off, I have read quite a few of your books and have enjoyed them immensely. So, thank you for what you do.

I have read about half of Protect from Hyperinflation and Depression, but skipped ahead to the chapter on foreign currency, since that seems to be one of the main things you advocate and something that I want to do ASAP. But, I would like your opinion on an alternate method.

The two options I am considering are opening bank accounts in foreign countries as you did, or using a Forex currency trading account, which is something that, as far as I can tell, you didn't really address in your book. What are your thoughts comparing the two when it comes to liquidity, taxes, and accuracy in exchange rate to truly match the rate of inflation, and fees? Is there a reason that you don't endorse Forex?

Thank you for your time,

Please give me more details on a Forex currency trading account. Who are the counterparties? What exchange trades it? What country regulates it?
Thanks for your kind comments,
Jack Reed

Hello,
I did a live chat with a Forex representative and here are their answers:

You are now chatting with 'Taka'
Taka: Hello, welcome to FOREX.com. May I have your email address to better assist you?
: hello, I am new to this and have some basic questions

Taka: Sure, thank you for your information. How can I assist you today Peter?
when trading with forex, who are the counterparties?
Taka: The rates you are seeing on the platform are a composite feed from the major inter banks. We as the broker are the ones clearing the trades clients place on the platform.
thank you. What exchange trades forex?
Taka: Forex does not have a centralized market.
: What percentage to you take as the broker?
Taka: It is not a percentage, we are compensated on the spread. The spread is the difference between the buy and sell price.
Taka: You are only charged the spread when you enter a position.
: What country regulates Forex?
Taka: For our U.S clients, United States regulates Forex.
what are the taxes on gains in forex? are they taxed at ordinary income levels or as dividends?
Taka: You would need to contact a tax professional regarding that question. We do not report taxes to any agency so it will be the account holders responsibility to do so.
If I wanted to purchase foreign currency to hold as a hedge against inflation in the US, would this be a good tool to do so?
Taka: We do not offer physical exchanges of a currency. You would need to contact a bank for that. We allow clients to speculate in the currency market, so your account balance will always be in USD>
Taka: In your example, you can short the usd if you are speculating that the usd is going to weaken.
And let's say there is hyperinflation, where the dollar could drop to very, very low. Would shorting the US dollar in your example, keep up with that? How is the value established?
Taka: You are trading currency in pairs for example euro against the usd. That is how the value is established.
Taka: So the euro for example can be worth more than the usd if the dollar weakens.
Taka: We do offer practice accounts where you can get a better idea of how this works.
Yes, I have one of those (MetaTrader4) but I need a tutorial of it. What is the website address of a tutorial?
Taka: I would suggest youtube.com and type in metatrader 4 tutorial
Taka: Metatrader 4 is typically meant for traders who use EA's which are trading robots. But you can manually trade on that platform as well.
Is there a different program that would be more appropriate for me?
Taka: We offer our own platform called forextrader pro.
where can I get that?
Taka: http://www.forex.com/forextrader-demo.html
Ok Thank you for your help.
Taka: You're welcome.


I typically don't like to short things due to the infinite amount of risk. So I am a bit leery of that. But what do you think about trading USD for Australian/Canadian/New Zealand currency using this type of platform instead of a physical bank account?

1. Counterparty—The issue is whom can you sue if you do not get what you were promised. The broker says he is an agent for unnamed “major interbanks.” Plus, he uses the word “broker.” That raises the question of what discretion the master (bank) gave the servant (broker).

This reader is going to short the USD. That means he is placing a bet against another party who loses if the dollar falls in value relative to the paired currency in the short. So what guarantee is there that the other party will not renege when they lose?

Generally, you would sue the broker but they may defend saying the master did wrong not them. Then you would have to sue the master but that would require establishing some standing to sue them. My money is in savings accounts in Australia, Canada, and New Zealand. In Canada, for example, my money is in the Bank of Montreal. There is no uncertainty about whom I would sue in the event someone reneged. I do not recommend such tenuous chains of possible defendants when they are unnecessary.

2. Exchange—There is some comfort from an established exchange handling the transactions because they have standards for admission and behavior. However, there is also a history of various misbehaviors by exchanges so it is not dispositive of safety to have an exchange involved. In this case, there is NO exchange, so you are in the Wild West trusting the broker and maybe the unnamed “major interbank.” In my case, I bought foreign currencies from the banks where I have the account. They are in my possession at least in the case of the Australian, Canadian, and New Zealand dollars as entries in my bank statements. Is the case of my Swiss francs, I physically hold them in my Canadian safe deposit box. There is no third party and I hold the actual currencies, not a derivative of them which is the case with what the reader is asking about.

3. Federal regulator—The broker says the U.S. government regulates these accounts. Forget about it. Hyperinflation is almost always accompanied by capital controls. Those prohibit owning or using foreign currency and, historically, gold. Capital controls typically order all financial institutions within their jurisdiction to convert all foreign currency accounts to U.S. dollars immediately and at below market rates. In other words, you will be forced to sell your foreign currency to the U.S. government for less than it is worth. Everbank is the only U.S. bank that lets individuals hold foreign currency accounts there. They warn in their fine print that they may be ordered by the federal government to convert your foreign currencies to U.S. dollars at lousy conversion rates and that they will comply if so ordered. Exactly how the U.S. government would regulate foreign currency derivatives like the reader asks about, I am not sure. But the general idea is the U.S. government does not like Americans owning foreign currency or dissing the U.S. dollar. And after a certain point, like the onset of a run on the dollar, they make it as hard as possible to get out of the dollar and do their best to force those who are already out of the dollar but still within the jurisdiction of the U.S. government back into the U.S. dollar. I would ask the broker what they expect in the nature of capital controls and how they would react to them. I expect they will dodge the question or say they don’t know. Fine. So move your money out of the jurisdiction of the U.S. government. They are the perpetrator of the crime in hyperinflation. It is crazy per se to try to avoid becoming the victim of a criminal by moving your money to a new asset but one which is just as under U.S. government jurisdiction as the old asset.

4. Account denominated in U.S. dollars—In theory, an account denominated in U.S. dollar would be okay if it adjusted by the minute. But a general principle of governments who deliberately cause hyperinflation is to prevent any way of avoiding the pain. For example, FDR outlawed owning gold to prevent people from converting U.S. dollars to gold which reduced the amount banks had to lend or just avoid failure due to runs on the bank. So if forex derivatives help you avoid the pain of government-induced inflation, the government will likely outlaw it and if the account is in U.S. dollars and under U.S. jurisdiction, the U.S. government will eliminate it.

Why are we bothering with all this? Just open savings accounts in countries that are less likely to hyperinflate. You only take on more complexity when there is no choice or the benefits are worth the complexity risks.

My sense is the only attraction of brokerage types of assets is they offer a sort of easy wide catalog that appear to serve every possible need. But the fact is they get higher fees than banks in savings accounts even if things go well, plus they inject all sorts of complexity and additional risks and there seems to be no countervailing benefits. They just make it so seductively easy but I have not found any benefits at all to offset all the risks. And am I the only one who sense a bit of evasiveness on the broker’s part in this exchange?

Here is another reader email and my response:

Hello John,

Your recommendation to stick to either a savings account in a foreign country, or foreign currency in a safe deposit box in a foreign country, is 100% correct.

First, forex is the modern-day equivalent of the early 20th century "bucket shops" described in "Reminiscences of a Stock Operator". You're quite right about the lack of regulation and counterparty risk. In short, in addition to being a profitable trader or investor, you must be shrewd enough to spot fraud and cheating (and I see your [not me, it was the reader who sent me the email who had the chat] chat with that broker was setting off your alarm bells). If you want the real lowdown on it, a good (and short) book on the subject is "Beat the Forex Dealer" by Augustin Silvani.

Regarding brokerages, the two that I consistently see recommended by professionals are Interactive Brokers and Tradestation. I've used both and never had a problem with either. However, people who aren't professional traders should stay away from these too, because they present a more insidious problem: namely, the very convenience they offer merely gives free rein to your greed and fear.

Once you have an account open at a brokerage, it's easy to find yourself watching the prices flashing on the screen and start feeling an urge to "do something" (greed). You might have opened the account just to buy Aussie dollars, for example, but then you might hear that it's a good idea to short the Japanese Yen, because they're debasing their currency and their current account has gone into a deficit. You may think, why not try it? Pretty soon you're drawn away from holding a long-term position into short-term trading, which destroys your account. It takes a lot of self-discipline to just shut the thing off and keep it off. By contrast, a pile of foreign currency sitting in a safe deposit box won't tempt you to do anything.

I check the WSJ currency listings for my four currencies—AUD, CAD, CHF, NZD—Tuesday through Saturday. Essentially, my currencies have been unchanged since I bought them in the last year or so. I never do anything with the accounts except add to them. There is no leverage in a savings account.

On the other hand, say you're long Aussie dollars and then one day their price (in US dollars) takes a dive. Maybe there was a poor employment report in Australia or something. Now you'll be tempted to liquidate your position (which you can do with one mouse click) "just until the price recovers" (fear). That of course leads to buying high and selling low.

The problem is magnified by leverage. If you're trading a currency futures contract that involves leverage, the swings in your account balance will be larger and it will be harder to keep your emotional balance. (Forex allows insane leverage - 100,000 to 1 or more!) I've never been able to sleep well when I had a leveraged position on - it felt like trying to sleep while operating a chain saw.

In short, when I've paid for an investment (e.g. mutual funds, precious metals, savings accounts, or foreign currencies) in cash with no leverage and simply stashed it somewhere, I've found it easy to sit tight for years at a time and make money (or at least not lose it). Whenever I've fooled around with a brokerage account I've had my head handed to me in short order for the reasons outlined above.

Best regards,
Jason Wells

Good warning. I would never do that sort of craziness and forgot others do. It is in teh interests of brokers to engender that trading mindset. They get paid for your trades, not your profit.