Proposed Rule

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EXPLANATION OF PROPOSED AMENDMENTS

At its February 2005 meeting, the Board approved amendments to Financial Requirements Section 1 to adopt a $5,000,000 alternative capital requirement for FCMs with forex affiliates. At its November 2005 meeting, the Board rescinded the February 2005 amendments and approved a new proposal to increase the requirement to $7,500,000 and make several technical changes.

Section 2(c) of the CEA authorizes unregulated affiliates of FCMs to act as counterparties to retail forex transactions if the FCM makes and keeps records of the affiliate under the risk-assessment provisions of the Act. NFA's Forex Dealer Members are required to supervise the retail forex activities of their unregulated affiliates and are subject to discipline if their affiliates' acts and omissions violate NFA standards. This rule only applies to Forex Dealer Members, however, so it does not apply to any Member that conducts all of its retail forex business through an affiliate.

This structure creates potential problems for NFA when the firm acting as counterparty is an affiliate of an FCM that does not itself act as a counterparty. In the situations described below, the FCMs are not Forex Dealer Members and, therefore, NFA's forex dealer rules do not reach the forex activities of their affiliates.

  • At least eight firms that are registered only as FCMs offer exchange-traded products through the FCM and offer OTC forex to retail customers through an unregulated affiliate.1 Another firm that offered exchange-traded products was recently expelled from NFA membership based, in part, upon its failure to supervise its guaranteed introducing brokers, and the CFTC has separate enforcement actions pending against the FCM and its forex affiliate alleging anti-fraud violations in the sale of retail forex.

  • There are three FCMs that have no customers and appear to be shell firms registered for one purpose only: to qualify their affiliates to offer retail forex. One of these shell firms is currently pending withdrawal because the CFTC froze its assets and charged it with retail forex fraud. A principal of this firm, who was also charged, had a disciplinary history with previous firms. Another of these shell FCMs is a subsidiary of a former Forex Dealer Member that formed the subsidiary and withdrew its own FCM registration in order to avoid NFA's forex rules. Since the new FCM does not conduct retail forex business, it is not a Forex Dealer Member and neither its activities nor those of its parent company - the former Forex Dealer Member - are subject to NFA's forex requirements.

Most sophisticated entities understand counterparty credit risk and will not deal with a counterparty - regulated or unregulated - that does not have the financial ability to meet its obligations. Retail customers, on the other hand, may not understand the credit risk of dealing with a particular counterparty or have the knowledge to ensure that they deal only with firms that have substantial financial resources. This raises customer protection concerns when a thinly capitalized or shell FCM conducts a retail forex business out of an unregulated affiliate that is authorized to act as a counterparty solely because of its affiliation with the FCM.

Capital requirements can ensure that an entity has a significant financial stake in the operation of its business, which may give the firm an incentive to operate ethically in order to protect its financial investment. Therefore, the Special Committee for Customer Protection Issues recommended and the Board approved a $5,000,000 capital requirement for FCMs that offer retail forex out of an affiliate that is authorized to act as a counterparty to retail transactions solely by virtue of its affiliation with the FCM. This capital requirement was designed to ensure that firms are willing to invest significant resources in order to engage in a retail forex business, and the amount was consistent with the CFTC's capital threshold for "material affiliated persons" (MAPs) under its risk-assessment rules.

A $5,000,000 capital requirement may be too low, however. In January 2002, NFA had 7 active Forex Dealer Members with liabilities to customers of approximately $42 million, for a per firm average of $6 million. By early September 2005, NFA was the DSRO for 31 active Forex Dealer Members with liabilities to customers of approximately $795 million, for an average of $25.6 million. In 31/2 years the number of Forex Dealer Members has increased almost 450%, their aggregate liabilities to customers have increased almost 1900%, and the per firm liability to customers has increased 425%. Assuming forex affiliates have had similar growth, raising the FCM's minimum capital requirement to $7,500,000 - or 50% more than the requirement in effect since December of 2000 - is a conservative increase.

Retail customers' forex funds are not required to be segregated, and they may not receive a priority in bankruptcy even if they were. Also, since retail forex affiliates tend to be unregulated, customer funds are at greater risk at an affiliate than at a Forex Dealer Member. Based on these considerations, at its November meeting the Board raised the proposed capital requirement for FCMs doing retail forex business out of an affiliate to $7,500,000.

All but one of the exchange member FCMs doing business out of a forex affiliate have capital well in excess of $7,500,000, and the other firm would not even meet a $5,000,000 requirement. Several non-exchange members also have capital below either threshold, but they are either shell FCMs or are Forex Dealer Members that could transfer the affiliate's business to the FCM.

Capital requirements are no substitute for regulation. A greater benefit of a $7,500,000 capital requirement is that it may encourage FCMs to conduct their retail forex business directly through the FCM since the capital requirement for most Forex Dealer Members is significantly less than $7,500,000.

The Board also recognized that increasing the capital requirement for FCMs with forex affiliates could have an unintended result. NFA is aware of at least one situation where an NFA Member that was not a Forex Dealer Member attempted to shore up its capital with an unregulated affiliate's forex customer funds. While the FCM's DSRO resolved that particular situation, it may not be resolved as easily the next time. Therefore, the Board approved an amendment in February that restricts an FCM's ability to use an affiliate's customer funds to increase the FCM's capital. In November, the Board approved this amendment as originally proposed.

Finally, the Board made several technical changes to the proposed capital requirement and the Interpretive Notice regarding Forex Transactions with Forex Dealer Members. These changes clarify that only FCM affiliates as described in section 2(c)(2)(B)(ii)(III) of the Commodity Exchange Act can offer retail forex.

NFA respectfully requests that the Commission review and approve the proposed amendments to the Financial Requirements Section 1 and the Interpretive Notice regarding Forex Transactions with Forex Dealer Members.


1 This number includes FCMs that belong to an exchange and for which the exchange is the designated self-regulatory organization ("DSRO").

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