Description

Short FXCM

Share price        $2.30
Shares outstanding    80 million
Market cap        $184 million
Borrow rate        15%

I am short FXCM common and call options.

FXCM is an FX broker that offered significant leverage to clients (50:1 in the US and 100:1 outside the US). Normally, this amount of leverage can be managed by closing out positions as soon as client equity hits zero, but it’s extremely dangerous in the case of big price gaps. After the SNB de-pegged the CHF, many of FXCM’s clients who were long EUR/CHF found themselves with deep negative balances. FXCM is on the hook for $225 million in losses as it had indicated in its marketing that such negative balances would be non-recourse, although it is now attempting to recover a portion of those balances. Regardless of the recovery prospects, FXCM had a more immediate problem of a regulatory capital deficit. As a result, it borrowed $300 million from Leucadia under extremely onerous terms. (The credit agreement is filed here: http://www.sec.gov/Archives/edgar/data/1499912/000090951815000025/0000909518-15-000025-index.htm). The key term in the agreement is that the lenders have a right to force a sale of the company, and that a portion of the proceeds shall be paid to the lenders as follows:

50% of the first $350 million
90% of the next $500 to $680 million (depending on the outstanding credit balance at 4/16/15)
60% of the remaining amount

When we also take into account the $300 million of debt, the following sale prices would result in the following values for FXCM common:

The peak market cap of FXCM prior to the blowup was $1.36 billion. However, the fair value of the company has decreased significantly since then, for the following reasons:

• Reputational damage. Retail FX trading is full of sketchy brokers, and retail clients are likely to view FXCM with greater caution after this event. Furthermore, FXCM’s attempt to clawback some negative balances, contrary to its marketing, will be a huge negative. The manner in which margin requirements were increased, with little notice, was also poorly received.
• Reduction in leverage. 100:1 leverage was both a selling point for the service as well as a booster of volumes. FXCM has now reduced leverage to 25:1 for some customers. When US leverage was reduced from 400:1 to 50:1 in 2009-2011, FXCM US revenues dropped by over half. A similar impact can be expected today.
• Reduction in customer equity. Customer equity stood at $1 billion on January 22, vs. $1.33 billion at September 30, 2014. We cannot tell how much of the reduction stems from trading losses vs. withdrawals, but this is clearly a negative. This brings customer equity back to 2011 levels.
• Regulatory risk. There is likely to be increased scrutiny on leveraged FX brokers.
• Increased market perception of risk. Had the market been aware of the blowup risk tied to its leverage, it’s likely that the market value of FXCM would have been lower even absent the SNB event. I would argue that this discount should have been extremely significant, 50% or greater.

FXCM shares also received a temporary boost when the company announced that it would attempt to clawback SNB losses. FXCM is very unlikely to succeed in this, as it has advertised non-recourse leverage prominently throughout its marketing. Clients will successfully argue that they relied on these statements. As a point of reference, IBKR does not market non-recourse leverage and has a strong legal case to recover losses, yet after the SNB event, CEO Thomas Peterffy stated that recoveries were likely to be minimal. So I think it is appropriate to discount zero to minimal recoveries here. We can give them credit for tax losses on the $225 million.

A fair sale price for FXCM today would likely be $1 billion or less, rendering zero value for the common equity. Therefore, the equity should trade at its option value.

Catalyst

FXCM has become a day trader’s toy following the SNB decision, leading to wild volatility and overvaluation of the stock. Many of the traders currently moving the stock are the same speculative traders who gamble on FX. As this speculative interest fades, FXCM should settle closer to its fair value well below $1.