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Notice I-05-13

September 26, 2005

Effective Date of Amendments to NFA Forex Requirements

NFA has received notice that the Commodity Futures Trading Commission (CFTC) has approved new Compliance Rule 2-39 and amendments to Compliance Rule 2-36, Financial Requirements Sections 11 and 12, and the Interpretive Notice Regarding Forex Transactions With Forex Dealer Members. A copy of the revised requirements is included at the end of this Notice.

Compliance Rule 2-39 and certain technical amendments to Financial Requirements Section 12 and the Interpretive Notice became effective on September 15, 2005. The remaining changes discussed in this Notice will be effective November 30, 2005.

A. New Compliance Rule 2-39; Soliciting, Introducing, or Managing Off-Exchange Retail Forex Transactions or Accounts

Compliance Rule 2-39 extends certain requirements in Compliance Rule 2-36 to otherwise unregulated Members who introduce retail forex customers to or manage retail forex accounts with any counterparty. In particular, the rule prohibits these Members from engaging in illegal off-exchange transactions, fraud, or conduct inconsistent with just and equitable principles of trade and requires them to supervise their employees and agents.

These requirements previously applied only to Members who were doing business with Forex Dealer Members. They now apply to otherwise unregulated Members doing business with any counterparty, regulated or unregulated. For example, a Member that introduces business to a foreign bank, manages accounts carried by a broker-dealer or its affiliate, or manages forex pools composed of retail customers must comply with Compliance Rule 2-39 unless the Member is subject to another regulatory scheme.

Consistent with NFA's general regulatory scheme for off-exchange retail forex transactions, Compliance Rule 2-39 exempts fully-registered broker-dealers, banks and other financial institutions, insurance companies and their regulated subsidiaries, and most other entities authorized by the Commodity Exchange Act to act as counterparties to retail customers. It does not exempt notice-registered broker-dealers, FCMs that are not subject to a separate regulatory scheme, or their affiliates.

New Compliance Rule 2-39 makes the current subsection (g) of Compliance Rule 2-36 duplicative and unnecessary. Therefore, former Rule 2-36(g) has been repealed.

Compliance Rule 2-39 became effective on September 15, 2005.

B. New Compliance Rule 2-36(g): BASIC Disclosure

The Commodity Exchange Act (CEA) places no restrictions or registration requirements on firms and individuals who solicit retail off-exchange forex transactions or manage retail accounts with authorized counterparties. NFA Compliance Rule 2-36(d) holds Forex Dealer Members responsible for the activities of these unregistered persons, however, and Forex Dealer Members' customers should be aware of NFA's resources for checking the registration status and disciplinary background of introducers and account managers.

New Compliance Rule 2-36(g) replaces the former subsection (g) (which, as discussed above, has been repealed). This new subsection adds a requirement - similar to an existing requirement for security futures products - that Forex Dealer Members provide their retail forex customers with written information regarding NFA's Background Affiliation Status Information Center ("BASIC") system, including the Web site address. The Forex Dealer Member must provide this information when the customer first opens an account and at least once a year thereafter. Forex Dealer Members can deliver the BASIC disclosure electronically as long as they deliver it in a way that brings it to the customers' attention.

One way Forex Dealer Members can meet this requirement is by providing customers with a copy of an NFA brochure entitled "Background Affiliation Status Information Center - An Information Resource for the Investing Public." Hard copies of the brochure are available by calling 1-800-621-3570, or the brochure can be downloaded from NFA's Web site at http://www.nfa.futures.org/investor/basic/basic.pdf. Members have permission to distribute electronic or downloaded copies of the brochure to customers and potential customers if, and only if, they use the entire brochure and do not alter it in any way.

This requirement will be effective November 30, 2005.

C. Amendments to Section 11 and the Interpretive Notice Regarding Transactions With Affiliates and Unregulated Counterparties

Forex Dealer Members must maintain adjusted net capital equal to or in excess of 1% of the total net aggregate notional value of all open forex transactions between the Forex Dealer Member and retail customers and non-customers that are not eligible contract participants ("ECPs"). Forex Dealer Members must also take a capital charge of either 6% or 20% (depending on the underlying currency) on all uncovered proprietary positions.

Under the current rules, a Forex Dealer Member can effectively lower its capital requirement by hedging its net position. NFA's Special Committee to Study Customer Protection Issues was concerned about the Forex Dealer Member's financial position should an affiliate or unregulated counterparty default on its obligations. Therefore, the Special Committee recommended and the Board approved amending Section 11 of NFA's Financial Requirements to remove affiliates from the calculation for the 1% minimum net capital requirement and to impose a concentration charge on material transactions with affiliates and unregulated entities. These amendments are discussed below.

Minimum Capital Requirement - Affiliate Positions

As noted above, Section 11 creates an alternative requirement for Forex Dealer Members based on the net positions of retail customers and non-customers (e.g., employees) that are not ECPs. Proprietary accounts are excluded from this calculation, but because CFTC Regulation 1.17(b)(3) defines a proprietary account as an account owned directly by the firm or its general partners, non-ECP affiliates are non-customers rather than proprietary accounts and have been included in the calculation.

The alternative capital requirement was designed to measure the default risk from non-ECP individuals and entities, and NFA set the requirement at 1% on the assumption that the persons included in the calculation would not have a significant effect on the Forex Dealer Member's ability to meet its obligations. If a Member hedges a significant amount of its exposure with a thinly capitalized non-ECP affiliate, however, the Member may not be able to collect on its "winning" trades with the affiliate to cover its losing trades with regular retail customers. Therefore, including the affiliate's positions in the netting lowers the Member's capital requirement without lowering its exposure.

The Board amended Section 11 to exclude positions of affiliates and principals from the calculation. The amendment also excludes positions of any entity that is created or used by the Forex Dealer Member or any of its principals or affiliates for the purpose of lowering the Forex Dealer Member's capital requirements.

Minimum Capital Requirements - Concentration Charge

CFTC rules require Members to take a capital charge on uncovered positions. Covering those positions with an affiliate effectively decreases the Member's capital requirement by increasing the amount the Forex Dealer Member has available to meet that requirement. As noted above, however, this cover provides little protection if the affiliate is thinly capitalized and unable to meet its obligations to the Forex Dealer Member. Similarly, covering transactions with an unaffiliated, unregulated counterparty provides little protection if the unregulated counterparty is thinly capitalized or has no incentive to make good on its obligations when facing significant losses.

The Board added a new subsection (b) to Section 11 of NFA's Financial Requirements to impose a concentration charge when a Forex Dealer Member hedges a material part of its exposure with an affiliate or an unregulated entity. This concentration charge will apply whenever an unregulated counterparty's net position with a Forex Dealer Member in a particular currency exceeds 10% of the Forex Dealer Member's total long or short position in that currency. The part of the position that exceeds the 10% threshold will be treated as uncovered, and the CFTC's 6% or 20% haircut will apply, depending on the currency. The concentration charge will only affect that part of the excess position that will not otherwise be subject to the haircut, however. If any part of the position above the 10% threshold is uncovered, it will be subject to just one charge. Furthermore, any uncovered amount below the 10% threshold will still be subject to the regular CFTC haircut.

The concentration charge applies to transactions with all affiliates, regardless of their regulatory status. The Forex Dealer Member must calculate the charge as applied to individual affiliates and on a consolidated basis and must take the larger charge.

Since these markets are dealer over-the-counter markets with no clearing corporation to guarantee the trades, counterparty risk is a serious concern. This concern is enhanced when the counterparty does not have a regulator keeping an eye on its financial condition. Therefore, the concentration charge applies to all counterparties that are not regulated in the U.S. or a money center country as defined in CFTC Regulation 1.49 (i.e., Canada, France, Italy, Germany, Japan, and the United Kingdom). NFA staff has the authority to approve additional exemptions from the concentration charge where a counterparty appears to be creditworthy and to have significant reputational or regulatory risk if it walks away from its commitments.

The Interpretive Notice describes the information that NFA will consider when approving a counterparty for the exemption. It also provides examples of how the concentration charge works.

These changes are effective November 30, 2005. They must be reflected in Forex Dealer Members' financial statements filed as of that date.

D. Technical Amendments

Finally, the Board adopted technical amendments to Financial Requirements Section 12 and the Interpretive Notice. The amendments to Section 12 clarify that it does not apply to transactions subject to the rules of a registered futures exchange, and the technical amendments to the Interpretive Notice replace outdated rule references. Those amendments became effective on September 15, 2005. They are not included with this Notice but have been updated on NFA's Web site.

* * *

Questions concerning any of the requirements described above should be directed to Sharon Pendleton, Associate Director, Compliance, at spendleton@nfa.futures.org or (312) 658-6540 or to Elizabeth Kurtz, Associate Director, Compliance, at ekurtz@nfa.futures.org or (212) 513-6014.

COMPLIANCE RULES

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Rule 2-36. REQUIREMENTS FOR FOREIGN CURRENCY FUTURES OR OPTIONS TRANSACTIONS

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(g) BASIC Disclosure

When a customer first opens an account and at least once a year thereafter, each Forex Dealer Member shall provide each customer with written information regarding NFA's Background Affiliation Status Information Center (BASIC), including the Web site address.

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RULE 2-39. SOLICITING, INTRODUCING, OR MANAGING OFF-EXCHANGE RETAIL FOREX TRANSACTIONS OR ACCOUNTS

(a) Unless the Member meets the criteria in Bylaw 306(b), Members and their Associates who solicit customers, introduce customers to a counterparty, or manage accounts on behalf of customers in connection with off-exchange foreign currency futures or options transactions shall comply with subsections (a), (b), (c), and (e) of Compliance Rule 2-36.

(b) Definitions

For purposes of this rule:

    (i) the term "off-exchange" means transactions that are not executed on or subject to the rules of a contract market, a derivatives transaction execution facility, a national securities exchange registered pursuant to Section 6(a) of the Securities Exchange Act of 1934, or a foreign board of trade; and

    (ii) the term "customer" means a person that is not an eligible contract participant as defined in Section 1a(12) of the Act and includes persons who participate in pooled accounts.

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SECTION 11. FOREX DEALER MEMBER FINANCIAL REQUIREMENTS

(a) Each Forex Dealer Member must maintain "Adjusted Net Capital" (as defined in CFTC Regulation 1.17) equal to or in excess of the greatest of:

    (i) $250,000;

    (ii) 1% of the total net aggregate notional value of all open foreign currency futures and options transactions in customer and non-customer accounts that are between the Forex Dealer Member and a person that is not an eligible contract participant as defined in Section 1a(12) of the Act and that are not executed on or subject to the rules of a contract market, a derivatives transaction execution facility, a national securities exchange registered pursuant to Section 6(a) of the Securities Exchange Act of 1934, or a foreign board of trade; or

    (iii) any other amount required by Section 1 of these Financial Requirements.

For purposes of this section, the term non-customer does not include the Forex Dealer Member; any principal of the Forex Dealer Member; any affiliate that controls, is controlled by, or is under common control with the Forex Dealer Member; or any entity that is created or used by the Forex Dealer Member or any of its principals or affiliates for the purpose of lowering the Forex Dealer Member's capital requirements. Transactions carried for these persons may not be netted with customer and non-customer accounts when calculating the requirement under (a)(ii) of this rule.

(b) Each Forex Dealer Member must take a concentration charge on transactions with an unaffiliated, unregulated counterparty if the Forex Dealer Member's net open position with the unregulated counterparty exceeds 10% of the Forex Dealer Member's total long or short position in a particular currency. The amount exceeding 10% will be subject to the CFTC's haircut for uncovered positions regardless of the Forex Dealer Member's overall position.

For purposes of this section, a counterparty is unregulated unless it is:

    (i) a financial institution regulated by a U.S. banking regulator;

    (ii) a broker-dealer registered with the U.S. Securities and Exchange Commission and a member of NASD Inc.;

    (iii) a futures commission merchant registered with the U.S. Commodity Futures Trading Commission and a Member of NFA;

    (iv) an insurance company regulated by any U.S. state;

    (v) an entity regulated as a foreign equivalent of any of the above if regulated in a money center country as defined in CFTC Regulation 1.49; or

    (vi) any other entity approved by NFA.

(c) Each Forex Dealer Member must also take a concentration charge on transactions with affiliates equal to the greater of the following:

    (i) The sum of the amounts by which the Member's net open position with a single affiliate exceeds 10% of the Forex Dealer Member's total long or short position in a particular currency; or

    (ii) The amount by which the Member's net open position with all affiliates combined exceeds 10% of the Forex Dealer Member's total long or short position in a particular currency.

This amount will be subject to the CFTC's haircut for uncovered positions regardless of the Forex Dealer Member's overall position.

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FOREX TRANSACTIONS WITH FOREX DEALER MEMBERS
INTERPRETIVE NOTICE

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9. BASIC Disclosure - Members must provide retail forex customers with information on NFA's BASIC system.

NFA Compliance Rule 2-36(g) requires Forex Dealer Members to provide customers with written information regarding NFA's Background Affiliation Status Information Center (BASIC), including the Web site address.14 This information must be provided when the customer first opens an account and at least once a year thereafter.

Forex Dealer Members may provide the information electronically but must do it in a way that ensures each customer is aware of it. For example, merely having the information on the Member's web site is not adequate, but sending customers an e-mail including a link to that information and explaining what the link is would be sufficient in most circumstances.

C. OTHER REQUIREMENTS

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2. Financial Requirements Section 11(a)

Forex Dealer Members must maintain adjusted net capital equal to or higher than the greatest amount required by Section 11 of NFA's Financial Requirements. For Forex Dealer Members, one of those amounts is 1% of the total net aggregate notional value of all open foreign currency futures and options transactions that are between the Forex Dealer Member and any person that is not an eligible contract participant or a principal or affiliate of the Forex Dealer Member, and it includes transactions with foreign persons.

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3. Financial Requirements Section 11(b)

Section 11(b) imposes a concentration charge on a Forex Dealer Member that has a material position with a single unregulated counterparty (other than an affiliate). An unregulated counterparty is any entity that is not:

    (i) a financial institution regulated by a U.S. banking regulator;

    (ii) a broker-dealer registered with the U.S. Securities and Exchange Commission and a member of NASD Inc.;

    (iii) a futures commission merchant registered with the U.S. Commodity Futures Trading Commission and a Member of NFA;

    (iv) an insurance company regulated by any U.S. state;

    (v) an entity regulated as a foreign equivalent of any of the above if regulated in a money center country as defined in CFTC Regulation 1.49; or

    (vi) any other entity approved by NFA.

Any Forex Dealer Member may ask NFA to approve a counterparty for purposes of making transactions with that counterparty exempt from the concentration charge. In determining whether to approve the counterparty, NFA will consider a number of factors, including:

  • Whether the counterparty is regulated in another jurisdiction and, if so, the type and extent of regulation;
  • The counterparty's capital; and
  • The counterparty's credit rating.

NFA's approval of a particular counterparty exempts all Forex Dealer Members from the concentration charge for transactions with that counterparty. NFA may also approve categories of counterparties (e.g., banks regulated in a particular jurisdiction or with a particular credit rating).

The concentration charge applies whenever an unaffiliated, unregulated counterparty's net position with a Forex Dealer Member in a particular currency exceeds 10% of the Member's total long or short position in that currency. The part of the position that exceeds the 10% threshold is treated as uncovered and is subject to the CFTC's 6% or 20% haircut, depending on the currency. Any uncovered amount above the 10% threshold is subject to only one charge, and any uncovered amount below the 10% threshold is subject to the regular CFTC haircut.

To calculate the concentration charge with unaffiliated, unregulated counterparties, follow these steps:

  • Calculate the total long value for each currency pair using the same formula used to calculate the aggregate long notional value under Section 11(a) but apply the formula to the Member's long positions with all counterparties (including ECPs, affiliates, and principals) rather than to customer and non-customer positions;
  • Multiply the total long value by 10%;
  • Calculate the total short value for each currency pair using the same formula used to calculate the aggregate short notional value under Section 11(a) but apply the formula to the Member's short positions with all counterparties rather than to customer and non-customer positions;
  • Multiply the total short value by 10%;
  • For each unregulated counterparty that is counterparty to more than 10% of the Forex Dealer Member's total long position or total short position in that currency, subtract 10% of the total long value from the Member's net long position with the unregulated counterparty or subtract 10% of the total short value from the Member's net short position with the unregulated counterparty; and
  • Multiply the result by the haircut for uncovered positions in that currency.

For example, assume a Forex Dealer Member is fully hedged. If it hedges its exposure in British Pounds, Euros, and Mexican Pesos with unregulated Counterparty A, the calculation would look like this:

Currency Total Long Value of Member's Open Positions 10% of Long Value Total Short Value of Member's Open Positions 10% of Short Value Value of Net Long Positions with Counterparty A Value of Net Short Positions With Counterparty A Value in Excess of 10%
British Pound $1,257,052 $125,705 $1,257,052 $125,705 $429,606 $303,901
Euro $2,433,256 $243,326 $2,433,256 $243,326 $211,123 $0
Mexican Peso $283,412 $28,341 $283,412 $28,341 $229,404 $201,063

Concentration Charge for British Pounds ($303,901 x 6%) $18,234
Concentration Charge for Euros 0
Concentration Charge for Mexican Pesos ($201,063 x 20%) 40,213
Total Concentration Charge for Positions with Counterparty A = $58,447

4. Financial Requirements Section 11(c)

The concentration charge also applies to a Forex Dealer Member's positions with its affiliates if its net position with any single affiliate exceeds 10% of the Forex Dealer Member's total net long or short position in a particular currency or if its combined position with all affiliates exceeds 10% of the Forex Dealer Member's total long or short position in a particular currency. An affiliate is any entity that controls, is controlled by, or is under common control with the Forex Dealer Member.

To calculate the concentration charge for positions with affiliates, follow these steps:

  • Calculate 10% of the total long and short values for each currency pair using the same steps as for unaffiliated unregulated counterparties under Section 11(b);
  • For each affiliate that is counterparty to more than 10% of the Forex Dealer Member's total long position or total short position in that currency, subtract 10% of the total long value from the Member's net long position with the affiliate or subtract 10% of the total short value from the Member's net short position with the affiliate;
  • Multiply that amount by the haircut for uncovered positions in that currency to calculate the charge for each affiliate;
  • Add the charges for each affiliate to calculate the total charge based on the Forex Dealer Member's positions with single affiliates;
  • Compute the Forex Dealer Member's net position with all affiliates combined and subtract 10% of the total long value from the Member's combined long position or subtract 10% of the total short value from the Member's combined short position;
  • Multiply the result by the haircut for uncovered positions in that currency to calculate the charge based on the Forex Dealer Member's positions with all affiliates combined; and
  • Take the larger charge.

For example, assume the Forex Dealer Member from the previous example has British Pound and Euro positions with three affiliates. The calculation for the affiliate concentration charge on British Pounds would look like this:

Affiliate 10% of Long Value 10% of Short Value Value of Net Long Positions with Affiliate Value of Net Short Positions with Affiliate Value in Excess of 10% Charge (Excess Value X 6% Haircut)
A $125,705 $125,705 $192,554 $ 66,849 $4,011
B $125,705 $125,705 $285,109 $159,404 $9,564
C $125,705 $125,705 $ 99,573 $0 $0

Charge for Affiliate A $ 4,011
Charge for Affiliate B 9,564
Charge for Affiliate C 0
Sum of Charges for Single Affiliates $13,575

Long position, Affiliate B $285,109
Short position, Affiliate A + Affiliate C $292,127
Net position, all affiliates combined ($292,127 - $285,109) $ 7,018
Amount over 10% ($7,018 - $125,705) $0
Charge for Combined Positions ($0 X .06) $0

Affiliate Concentration Charge on British Pounds $13,575

The calculation for the affiliate concentration charge on Euros would look like this:

Affiliate 10% of Long Value 10% of Short Value Value of Net Long Positions with Affiliate Value of Net Short Positions with Affiliate Value in Excess of 10% Charge (Excess Value X 6% Haircut)
A $243,326 $243,326 $304,711 $61,385 $3,683
B $243,326 $243,326 $240,112 $0 $0
C $243,326 $243,326 $228,775 $0 $0

Charge for Affiliate A $3,683
Charge for Affiliate B 0
Charge for Affiliate C 0
Sum of Charges for Single Affiliates $3,683

Long position, Affiliate A + Affiliate B + Affiliate C $773,598
Short position $0
Net position, all affiliates combined ($773,598 - $0) $773,598
Amount over 10% ($773,598 - $243,326) $530,272
Charge for Combined Positions ($530,272 X .06) $ 31,816

Affiliate Concentration Charge on Euros $31,816

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14 Forex Dealer Members can comply with this requirement by providing customers with a copy of NFA's brochure entitled "Background Affiliation Status Information Center (BASIC): An Information Resource for the Investing Public," which is available in print and on NFA's Web site at www.nfa.futures.org.

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