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Proposed Rule

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EXPLANATION OF PROPOSALS

Introduction
Amendments to Bylaw 306
Additions to Compliance Rule 2-36
Amendment to Bylaw 1301
Amendment to the Code of Arbitration
New Section 11 to NFA Financial Requirements
New Section 12 to NFA Financial Requirements
New Interpretive Notice
General Comments
Conclusion

Introduction

Current NFA Bylaw 306 creates a forex dealer membership category for Members that derive more than 35% of their gross revenue from financial market transactions by acting as counterparty in forex trades with the retail public. NFA Compliance Rule 2-36 prohibits Forex Dealer Members from engaging in fraud in connection with these transactions. These rules give NFA regulatory authority over the forex business of FCMs primarily engaged in off-exchange forex transactions with retail customers without imposing additional regulatory requirements on Members that are primarily engaged in other regulated activities.

As of May 30, 2003, NFA has fourteen active Forex Dealer Members (including a London firm with only foreign customers), one Forex Dealer Member who is currently suspended because of a Member Responsibility Action, and four Members who have indicated that they intend to become Forex Dealer Members but have not yet commenced business. Six firms pending registration as FCMs have also indicated that they intend to become Forex Dealer Members. In the aggregate, Forex Dealer Members hold approximately $170 million in retail customer funds as of May 23, with the minimum retail account size ranging from $500 to $10,000. This is a 300% increase in customer funds since January 4, 2002.¹⁴

Since January 2002, NFA staff has reviewed approximately one-hundred customer complaints that were filed with these firms or with NFA relating to their forex activities. Hundreds of unregulated entities currently solicit business on behalf of Forex Dealer Members, and NFA has received information that several individuals either disciplined or expelled from the futures industry have been linked to these soliciting firms. Moreover, NFA has taken three MRAs for forex activities during the last two years, including two against Forex Dealer Members.

Although Compliance Rule 2-36's anti-fraud provisions provide a starting point for protecting retail customers of Forex Dealer Members, the Board believes that additional regulatory requirements are needed to protect these customers against unethical business practices and loss of funds due to insolvency or related problems. The Board does not believe, however, that it is necessary to apply all NFA’s futures rules to these off-exchange forex transactions. The proposed rules and interpretive notice are designed to provide adequate customer protection for retail forex without imposing undue burdens on NFA Members. In fact, the proposed regulatory requirements are far fewer and significantly less burdensome than NFA's rules governing exchange-traded futures transactions.

The key elements of the proposal:

Change the definition of Forex Dealer Member from a quantitative to a regulatory test that generally follows the provisions of the CFMA;

Extend the anti-fraud provisions to Associates and to certain Members who introduce retail business to or manage retail customer accounts with Forex Dealer Members;

Require Forex Dealer Members, their Associates, and certain other Members to observe high standards of commercial honor and just and equitable principles of trade in connection with their forex business and to supervise their employees and agents;

Subject Forex Dealer Members to discipline for the activities of unregulated entities soliciting or managing customer accounts;

Require Forex Dealer Members to supervise affiliates that act as counterparties to retail forex customers and subject them to discipline for the activities of those affiliates;

Impose an alternative minimum net capital requirement on Forex Dealer Members based on the notional value of open positions with retail customers;

Require Forex Dealer Members to collect security deposits from retail customers;

Impose annual dues on Forex Dealer Members based on their gross annual revenue from their retail forex business; and

Require Forex Dealer Members and Members doing business with them to submit to arbitration at the request of a retail forex customer.

The following sections describe these requirements in more detail and discuss the comments NFA received¹⁵

Amendments to Bylaw 306

NFA Bylaw 306 currently provides for a separate subcategory of NFA membership that consists of Members that derive more than 35% of their gross revenue from financial market transactions by acting as a counterparty in forex trades with the retail public. The proposal revises the definition to follow the provisions of the CFMA. As a general matter, this means that the revised definition would only apply to Members that are not covered by another regulatory scheme.

The first time NFA solicited comments from its Forex Dealer Members, an attorney for one Forex Dealer Member claimed the proposed rules are anticompetitive because they put Forex Dealer Members at a competitive disadvantage to other NFA Members who engage in the same business but do not generate 35% of their gross revenue from it, and a second attorney made a similar point. These attorneys believe the rules impose higher standards on Forex Dealer Members than they do on other NFA Members conducting retail forex business, and their main quarrel appears to be with the very existence of a separate membership category that applies different rules to Members engaged in the same activities. In fact, one of the attorneys specifically advocated rescinding the category altogether.

As NFA explained in its March 22, 2002 submission letter to the Commission, Bylaw 306 was designed to allow NFA to exercise appropriate regulatory authority over firms that primarily engage in a retail forex business without imposing additional regulation on Members that are otherwise highly regulated and offer forex as a limited portion of their business. Although the 35% test may have some ancillary effects on competition, it was actually created to level the playing field by equalizing the overall regulatory burdens imposed on NFA Members. Nevertheless, the Board believes that the attorneys' argument may have some merit when applied to the existing quantitative test.

As a result, the current proposal redefines Forex Dealer Member in NFA Bylaw 306 to change the definition of Forex Dealer Member from a quantitative to a regulatory test that generally follows the provisions in the CFMA. The proposed definition excludes Members that are otherwise subject to regulatory oversight for their retail forex activities, which means that these Members are not Forex Dealer Members and do not have to comply with Compliance Rule 2-36.¹⁶ The exclusions mostly follow Section 2(c)(2)(B)(ii) of the CEA, although the exclusions for broker-dealers and their affiliates are conditioned on NASD membership. In particular, the following entities would not be Forex Dealer Members: financial institutions (e.g., banks and savings associations), certain insurance companies and their regulated subsidiaries or affiliates, financial holding companies, investment bank holding companies, registered broker-dealers that are members of NASD, and Material Associated Persons of registered broker-dealers that are members of NASD.¹⁷

After making this and several other changes, staff sent the proposals out for a second round of comments. The attorney who had previously objected to any distinction among NFA Members reiterated that objection and continued to argue that the very distinction is anti-competitive. This attorney also argued that our rationale for the revised definition is not valid because Material Associated Persons of broker-dealers are not subject to regulatory oversight for their off-exchange forex transactions with retail customers and because NASD is not proposing similar regulatory requirements. The other commenters either did not address the revised definition or stated that they did not oppose it.

NFA's rationale for the revised definition is well-founded on at least two grounds. First, it appears to be the very same rationale that Congress adopted in authorizing certain entities – including broker-dealers and their Material Associated Persons – to act as counterparties to retail forex customers. Second, broker-dealers are required to maintain certain records regarding their Material Associated Persons and to file consolidated financial statements, so these entities are not entirely outside the regulatory framework.

Whether NASD decides to propose similar rules is also not the issue. The rules of self-regulatory organizations do not have to be similar and, in fact, too much harmonization without a legislative or regulatory directive may itself be subject to attack under the anti-trust laws. Furthermore, NASD's rules already give it authority to take an action against a member for unethical behavior (whether or not it is fraudulent) regarding the member's off-exchange retail forex transactions in that NASD Conduct Rule 2110 requires a member to observe high standards of commercial honor and just and equitable principles of trade in the conduct of its business in general.¹⁸

Changing the definition of Forex Dealer Member as proposed will more closely align it with NFA's regulatory goals while eliminating a quantitative measure that may be more susceptible to attack under the anti-trust laws. The Board recognizes that the proposed rules will still impose a burden on competition. However, the question is not whether the proposed rules will impose a burden on competition but whether they will impose an unnecessary burden on competition. The Board believes the current proposal, including the use of a separate membership category, is the least anticompetitive means of achieving NFA's regulatory objectives.

Additions to Compliance Rule 2-36

As amended, Compliance Rule 2-36(c) requires Forex Dealer Members and their Associates to observe high standards of commercial honor and just and equitable principles of trade in connection with their retail forex business, and Compliance Rule 2-36(e) requires Forex Dealer Members and their Associates with supervisory responsibilities to supervise their employees and agents. Both these requirements are basic regulatory requirements and minimum business practices for any NFA Member, and Rule 2-36 was amended to ensure that Forex Dealer Members follow these practices with respect to their retail forex business.

Section (d) of proposed Compliance Rule 2-36 authorizes NFA to bring enforcement actions against Forex Dealer Members for the activities of unregulated entities that solicit or introduce customers to the Forex Dealer Member or manage customer accounts. Section (f) requires Forex Dealer Members to supervise their unregulated affiliates that engage in forex transactions with retail customers. This section also requires Forex Dealer Members to make their affiliates' books and records available to NFA upon request and authorizes NFA to take enforcement actions against Forex Dealer Members for their affiliates' activities.

Proposed Compliance Rule 2-36(g) extends many of the rule’s requirements to other Members and Associates who solicit retail customers for or manage retail customer accounts with Forex Dealer Members. In particular, these Members are subject to the anti-fraud, just and equitable principles of trade, and supervision provisions of the rule. Otherwise regulated entities are not, however, subject to these requirements.

The commenters either supported or had minor comments on most of the provisions of Compliance Rule 2-36. However, NFA staff received a number of comments on Section (d), which deals with Forex Dealer Members' responsibility for the activities of unregulated third-parties who introduce retail business or manage retail accounts.

As noted above, hundreds of unregistered and unregulated entities are currently soliciting on behalf of Forex Dealer Members. This creates a significant regulatory void in one of the areas most susceptible to fraud. It also creates the opportunity for NFA Members to disavow any responsibility for the actions of these unregulated entities simply by treating them as independent contractors rather than agents. Deterring misleading sales solicitations is a crucial aspect of customer protection, and the Board believes that Forex Dealer Members should not be able to benefit from potentially fraudulent solicitations without also bearing responsibility for those solicitations.

NFA staff initially considered a number of approaches to this problem but found only two that will adequately protect the public. One approach is to adopt a provision similar to NFA Bylaw 1101, which would prohibit Forex Dealer Members from entering into business relationships with other entities unless those entities were either NFA Members or regulated under another scheme – an approach that would essentially force currently unregulated solicitors to either become NFA Members or leave the business. The other approach is to make Forex Dealer Members strictly liable in NFA disciplinary proceedings for the activities of these unregulated entities. NFA asked for and received comments on both of these approaches.

Four Forex Dealer Members preferred the Bylaw 1101 approach, although some of the comments indicate that they really want a legislative fix that would require all third-party solicitors to register. One Forex Dealer Member commented that requiring these entities to become NFA Members in order to introduce business would hold Forex Dealer Members to a higher standard than other FCMs and be harmful to their business. Two attorneys who represent Forex Dealer Members commented that either approach holds Forex Dealer Members to a higher standard than other FCMs engaged in a forex business. Several Forex Dealer Members commented that the strict liability approach would either create an unfair competitive advantage for unscrupulous firms who are willing to take the risk of dealing with unregulated entities or drive those firms offshore. One Forex Dealer Member, NFA’s FCM Advisory Committee, and an FIA subgroup preferred the strict liability approach.

One Forex Dealer Member commented that "strict liability" was not defined and that the strict liability approach would make Forex Dealer Members liable for conduct they would not be liable for in the regulated futures markets. An attorney for a Forex Dealer Member stated that private litigants (e.g., customers) would be able to sue Forex Dealer Members for the activities of unregulated third-parties without even having to prove that the third-party's conduct violates any NFA requirement. Several commenters stated that the rule should not apply to foreign entities doing business with foreign customers since those entities would not be required to register if they were engaged in the same activities in connection with exchange-traded futures, and one attorney stated that the rule would prevent a customer's friend or family member from trading the account based on a power of attorney. Several commenters also asked NFA to clarify what it meant by "strict liability."

Finally, two attorneys commented that the proposal would force unregulated third-parties to register when the law does not require it. One attorney noted that there is no registration category for persons introducing or managing forex accounts and asserted that the proposal would force these entities to arbitrarily register in categories that do not reflect their activities. The other attorney argued that NFA should not be able to do indirectly – i.e., require registration – what it cannot do directly.

After considering the comments from the industry, the Board determined to take the strict liability approach, although it replaced the phrase "strict liability" with "subject to discipline." This approach is less anticompetitive than the Bylaw 1101 approach because it does not require the unregulated entities to become NFA Members, although they may chose to do so. Although this approach makes Forex Dealer Members responsible for conduct they may not be responsible for in the regulated futures markets, they can avoid the additional liability – and put themselves in exactly the same place they would be in the regulated futures markets – by dealing with regulated entities only. The Board also revised the interpretive notice to clarify that NFA will not bring an action if the Forex Dealer Member exercises due diligence and does not otherwise know about the conduct. Furthermore, using the phrase "subject to discipline" rather than "strict liability" clarifies that the rule is not intended to change the standards for recovery in private lawsuits.

Language was added to subsection (d) providing that a Forex Dealer Member is not subject to discipline for the activities of unregulated entities that would be exempt from registration in the futures markets. This change responds to the comments that Forex Dealer Members should not be responsible for the actions of foreign firms that solely introduce or manage accounts for foreign customers or for individuals who manage accounts for family or friends. Since these persons are exempt from registration for transactions on U.S. futures exchanges, Forex Dealer Members will not be subject to discipline for their activities.

Amendment to Bylaw 1301

Bylaw 1301 has been amended to impose annual dues on Forex Dealer Members based on their gross annual revenue from their retail off-exchange forex business. As proposed, Forex Dealer Members with revenue of $100,000 or less will pay normal FCM dues, those with revenue over $100,000 will pay normal FCM dues plus $7,500, and those with revenue over $1,500,000 will pay an additional $5,000. Forex Dealer Members would not, however, pay assessment fees on their forex transactions. If the proposed dues structure were applied to our current Forex Dealer Members, three would pay $15,000, seven would pay $20,000, and the rest would pay the regular FCM dues.

Two Forex Dealer Members agreed with the proposed dues. One of these commenters supported increasing the dues rather than imposing assessment fees, which it felt were inappropriate for market-making activities, and the other simply commented that the amounts were not prohibitive. Another Forex Dealer Member recommended imposing a charge based on the volume of transactions rather than increasing dues and claimed that the proposed dues structure creates a conflict of interest in that NFA would be revenue sharing with the Forex Dealer Members it regulates. One Forex Dealer Member commented that the dues increases would be passed on to the general public, making it harder for them to trade profitably. An attorney for one Forex Dealer Member commented that the proposed dues might be too large considering the industry's small profit margins and suggested using net profits instead of gross revenue. One Forex Dealer Member stated that the dues seem out of line when compared with the dues paid by other FCM Members. Two attorneys who represent Forex Dealer Members commented that the increased dues would put their clients at a competitive disadvantage.

FCM Members pay annual dues and remit per trade assessment fees to NFA. NFA’s assessment fee, however, does not apply to forex transactions, and the annual dues currently paid by Forex Dealer Members will not cover the costs incurred by NFA in regulating these Members. Although the Board recognizes that annual dues are not the same as assessment fees, it was too difficult to determine an appropriate assessment fee for forex transactions given that, among other things, the contract sizes are not standardized and the contracts are often rolled indefinitely. As a result, the Board concluded that it made more sense to increase a Forex Dealer Member’s dues based on its annual revenue from its retail forex business.¹⁹ The Board does not agree that this approach creates a conflict of interest with NFA's regulatory responsibilities.²⁰

Amendment to the Code of Arbitration

The Code of Arbitration has been amended to require Forex Dealer Members, other Members who do business with them, and their Associates and employees to arbitrate forex claims filed by a retail customer. NFA’s arbitration program benefits the retail public, Members, and the industry as a whole. This amendment extends those benefits to disputes involving retail forex transactions where the counterparty is a Forex Dealer Member.

One Forex Dealer Member supported this provision. Another Forex Dealer Member stated that, in its opinion, its "spot FX" transactions are not futures and, therefore, objected to adding these transactions to the definition of futures for arbitration purposes. An attorney argued that NFA does not have the authority to extend its arbitration program to disputes that are not covered by the section of the CEA that requires NFA to provide an arbitration forum.²¹ This same attorney commented that the requirement would put Forex Dealer Members at a competitive disadvantage because "a customer may often be able to pursue an unfounded claim less expensively in NFA arbitration than in a court proceeding" while FCMs who are not Forex Dealer Members would not be subjected to the cost of defending these claims (presumably because customers would find it cost-prohibitive to pursue them). Another commenter also objected to the proposed requirement on the grounds that it is too easy for customers to file frivolous arbitration claims and because NFA's roster of non-Member arbitrators may include individuals who are not familiar with the markets. The FCM Advisory Committee suggested minor wording changes, and the remaining commenters did not address this requirement.

The FCM Advisory Committee's wording changes have been incorporated into the arbitration provision, however no substantive changes were made to the original proposal. While having a low-cost forum may increase the number of frivolous claims, the lack of such a forum makes it cost-prohibitive for customers with small but valid claims to pursue those claims. Therefore, the proposal requires Forex Dealer Members, and Members who introduce customers to or manage accounts for customers of Forex Dealer Members, to arbitrate forex disputes when requested by a retail customer.

New Section 11 to NFA Financial Requirements

NFA’s Financial Requirements have been amended to impose an alternative minimum net capital requirement on Forex Dealer Members based on their forex business. The alternative capital calculation requires adjusted net capital of 1% of the total net aggregate notional value of all open foreign currency futures and options transactions between the Forex Dealer Member and persons who are not eligible contract participants.²² When staff applied this requirement to six of the largest Forex Dealer Members, only two had capital requirements in excess of $250,000, and both of those firms had adequate capital to meet the alternative computation.

Three Forex Dealer Members and one attorney generally supported the proposed capital requirement, although all suggested clarifications or refinements. Of these commenters, one foresaw unintentional, short-term breaches where a customer holds a large open position for a short period; one suggested allowing an offset for customer funds that exceed the required security deposit; and one suggested expanding the definition of net aggregate notional value to include two different currencies whose price movements exhibit a high degree of correlation – a comment that was also made by an attorney that opposed the requirement altogether. Two commenters suggested including proprietary positions in the calculation, and two other commenters recommended allowing the firm to net retail positions against positions with eligible contract participants. One of these commenters stated that failure to allow netting would create an economic disincentive for Forex Dealer Members to hedge their customer risks with substantial financial institutions. One Forex Dealer Member commented that the proposed calculation is too burdensome and would impose "double taxation" on non-internally matched positions, even if they were covered with an institutional counterparty. Three commenters – two Forex Dealer Members and one FCM who is not a Forex Dealer Member – stated that the proposed capital requirement is too low. One of these Forex Dealer Members recommended raising the minimum to $2.5 million, stating that market makers should have a much higher capital requirement than firms dealing on an agency basis. The other two commenters who felt the capital requirement is too low were simply concerned that it would not be sufficient in the event of significant market fluctuations.

NFA’s Financial Requirements include alternative capital requirements based on margin requirements for exchange-traded futures and the amount of segregated funds held by the FCM. There are no corresponding requirements relating to forex trading. Under the existing capital requirements, Forex Dealer Members need only maintain the $250,000 minimum regardless of the size of their retail forex business. This capital requirement puts customer funds at risk in the event of insolvency or related problems. The need for adequate capital is especially critical here since these customer funds do not receive any priority under the bankruptcy laws.

When drafting the alternative capital requirement, staff looked for a risk-related capital computation that is based on those transactions that are of concern to NFA (e.g., off-exchange forex transactions with retail customers) and is simple to calculate. NFA staff also tried to establish a level that protects customers without imposing an unnecessary burden on Forex Dealer Members. Although many of the commenters' suggestions have merit, most are inconsistent with these goals. For example, allowing offsets for currencies whose price movements exhibit a high degree of correlation would make the calculation more complex, and netting retail positions against positions of eligible contract participants reduces the computation's utility for measuring the Forex Dealer Member's exposure to its retail customers. NFA staff also note that, while proprietary positions are not included in the computation, uncovered proprietary positions are still subject to the capital haircuts required by CFTC Regulation 1.17. Therefore, Forex Dealer Members will continue to have an incentive to hedge the risk from their positions as counterparty to retail customers.

Although the proposed calculation is not a perfect measure of risk, it should provide increased protection for customers in the event of insolvency. Obviously, NFA staff will re-evaluate this requirement as staff gains experience with it and will make any changes that appear to be appropriate.

New Section 12 to NFA Financial Requirements

The Financial Requirements are also being amended to add a minimum security deposit requirement for retail forex transactions. Most Forex Dealer Members already require some type of security deposit, and the Board believes it is a sound business practice. The Board also believes that, although Members should have some flexibility in determining the amount they require, there should be a minimum amount. The proposal calls for a requirement equal to 2% of the notional value of transactions in specified currencies (called major currencies in the rest of this discussion) and 4% of the notional value of all other transactions.²³ This proposal is consistent with the margin requirements on the IMM, which average 2% for major currencies and 4% for other currencies.²⁴

The security deposit requirement is very similar to margin requirements for exchange-traded futures contracts. However, the Board chose to call it a security deposit rather than margin because it does not want customers to confuse the requirement with exchange margin requirements. First and foremost, funds deposited to margin exchange positions are required to be segregated and receive a priority under bankruptcy law, and neither is true of these funds. Second, exchange margin requirements change frequently, while we wanted a more fixed requirement to minimize Forex Dealer Members' responsibility to calculate or discover it.

Six Forex Dealer Members supported the concept of a security deposit requirement. Of these commenters, three generally agreed with the 2% level for major currencies and the 4% level for other currencies, while three commenters objected that these levels were too high and recommended using 1%, which some commenters characterized as "industry standard." One commenter suggested allowing Forex Dealer Members to lower their security deposit requirements when exchanges lower their margin requirements for comparable instruments. Three commenters stated that NFA's proposed margin levels would drive business offshore or to entities that are not Members of NFA. Two commenters appeared to oppose the requirement in its entirety.

One of the commenters that proposed a 1% security deposit believes there are several differences between the off-exchange market and the exchange market that justify lower requirements in the off-exchange market. In particular, the commenter mentioned contract size, trading hours, market liquidity, and technology. However, these differences are not universal. For example, Forex Dealer Members are free to set standardized contract sizes that mirror those on the IMM, and many FCMs use automated systems that monitor customer positions on exchanges and margin-to-equity ratios on a real-time basis and prevent orders that exceed pre-set trading parameters.

NFA staff originally proposed limiting the 2% deposit to those currencies that qualify for a 6% haircut under the CFTC's capital requirements, and several commenters recommended expanding the list of 2% currencies to include the Australian and New Zealand dollars and the Scandinavian currencies. After analyzing the IMM margin requirements, the Board adopted that recommendation and added the Austrailian and New Zealand dollars, the Swedish krona, and the Norwegian and Danish krones to the list of 2% currencies.

Like margin, the security deposit is not intended to protect the customer who posts it. Rather, the security deposit is intended to protect the Forex Dealer Member from absorbing the losses of defaulting customers which, if significant enough, could make the Forex Dealer Member insolvent and put the funds of its other customers at risk. NFA believes that requiring Forex Dealer Members to collect security deposits at levels similar to margins for related exchange-traded futures contracts is necessary to protect the funds of non-defaulting retail customers.

New Interpretive Notice

The proposed interpretive notice provides additional guidance on a number of topics. Using an interpretive notice, rather than adopting additional rules or making the proposed rules more detailed, provides Forex Dealer Members with more flexibility to tailor their procedures to their individual situations.

The interpretive notice contains three sections. The first section describes who qualifies as a Forex Dealer Member and explains that firms become Forex Dealer Members automatically when they meet the qualifications. The second section provides additional guidance on the requirements of Compliance Rule 2-36 and addresses disclosure, reporting, supervision, recordkeeping, communications with the public and promotional material, know your customer requirements, responsibility for unregulated third-party solicitors and account managers, and responsibility for affiliates. Most of this guidance is based on practices already employed by a number of the Forex Dealer Members and is also consistent with the practices of other FCMs staff talked to when researching the off-exchange forex markets. Finally, the third section addresses financial issues: dues, capital requirements, and security deposits.

Two attorneys objected to the notice in principle because it imposes requirements on Forex Dealer Members that are not imposed on all FCMs engaging in retail forex transactions. One of these attorneys also objected to the requirement that Forex Dealer Members disclose mark-ups and mark-downs. Another attorney commented that several of the supervisory standards and the use of the term "affiliates" in the interpretive notice were unclear. The Advisory Committees and the FIA subgroup also recommended a number of wording changes.

In response to the comments, the Board clarified the supervisory standards and the definition of "affiliates" and incorporated most of the suggested wording changes. As noted above, the Board also revised the section on responsibility for the acts of unregulated solicitors and account managers. The Board did not, however, eliminate the requirement that Forex Dealer Members disclose mark-ups and mark-downs.²⁵ Certainly Forex Dealer Members expect to make a profit on the transaction, and that profit is the difference between the price at which the Forex Dealer Member can buy or sell the currency and the price it gives to the customer. These contracts are widely traded, and current prices are continuously reported by a number of sources. Therefore, any Forex Dealer Member can pick a reliable source and determine its mark-ups and mark-downs by comparing the prices it gives its customers with the prices reported by that source. The Board believes that it is important for the customer to know how much the Forex Dealer Member is making on the transaction.

General Comments

Two of the attorneys who commented on behalf of Forex Dealer Members argued that NFA is not authorized to adopt some or all of the proposed rules. One attorney noted that the CFTC's authority over retail forex dealers is limited to anti-fraud and anti-manipulation, and another attorney noted that the CFTC has stated that third-party solicitors and account managers are not required to be registered under the Act. Both attorneys contended that NFA's authority is coextensive with the CFTC's, and one of them also argued that NFA cannot prohibit conduct that the CFTC has said is permitted under the Act.

It is true that NFA's proposed rules impose requirements that go beyond the CFTC's jurisdiction over retail forex transactions. However, the CFTC's authority and NFA's authority come from two different sources. The CFTC's authority comes from the CEA, while NFA's authority comes from a contractual relationship between NFA and its Members, which is found in NFA’s Articles of Incorporation and the requirements NFA adopts under those Articles. Among other things, Article III authorizes NFA to "promote the improvement of business conditions and the common business interests of persons engaged in commodity futures or related activity" by regulating its Members. Article III then goes on to authorize NFA to adopt, administer, and enforce requirements as to Members regarding fair practice, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and in general, to protect the public interest. These provisions clearly allow NFA to regulate the forex futures and options activities of its Members.

One of the attorneys also commented that the proposed rules would drive Forex Dealer Members out of NFA. First, the attorney contended that registered FCMs that do only off-exchange forex do not have to be Members of NFA. That argument is based on his interpretation of CFTC Regulation 170.15(a) and the registration requirements in the CEA. Second, the attorney notes that the CEA permits certain FCM affiliates to act as counterparties in off-exchange forex transactions with retail customers without being registered as FCMs (or in any other capacity). Therefore, the attorney argues that registered FCMs will either opt to not belong to NFA or to conduct their retail off-exchange forex business through a non-Member affiliate.

Without commenting on the validity of the attorney's legal arguments, the Board believes that the proposed rules are necessary even if they drive Forex Dealer Members out of NFA. While that result would be unfortunate, the alternative is even worse. The Board feels that NFA Members simply cannot be allowed to engage in unethical practices or put retail customer funds at risk in connection with off-exchange futures and options transactions. If these firms choose not to be NFA Members, they will still be subject to CFTC enforcement actions for fraud and manipulation, which is all our current rules cover. However, if they chose to be NFA Members, they must accept the responsibilities as well as the privileges of that membership.

Several of the comment letters suggested carving foreign entities and customers out of the requirements imposed by the proposed rules. As noted above, the Board has carved foreign solicitors and managers without U.S. customers out of the rule making Forex Dealer Members responsible for the conduct of unregulated entities. The Board has also clarified that – consistent with the provisions of the CEA – the proposed requirements apply to foreign as well as domestic customers.

Finally, several Forex Dealer Members suggested adopting a number of additional requirements. As noted earlier, the proposed requirements are designed to provide adequate customer protection without imposing undue burdens on NFA Members. Many of the suggestions would further enhance customer protection, but some would require a legislative fix and others would place burdens on Forex Dealer Members that are out of proportion to the benefit. While the Board believes in being proactive if there is a significant foreseeable risk, it does not believe in placing undue burdens on Members without a corresponding regulatory benefit.

Conclusion

The proposed rules were crafted to maximize customer protection while minimizing the burden on Members. The proposed rules are necessary to protect retail forex customers against unethical business practices and loss of funds for reasons other than adverse market movements. At the same time, they minimize the burden on NFA Members. They minimize the burden on Forex Dealer Members by providing for "lite" regulation rather than imposing the full array of rules that apply to exchange-traded futures contracts. They also minimize the burden on Members that are already highly regulated and whose retail forex activities are subject to regulatory oversight by other regulators by carving those Members out of the definition of Forex Dealer Member. The Board believes this proposal is the least anticompetitive means of achieving NFA's objectives.

^{14 Six active Forex Dealer Members held approximately $42 million in retail customer funds on January 4, 2002; nine active Forex Dealer Members held approximately $59 million in retail customer funds on July 5, 2002; and eight active Forex Dealer Members held approximately $84 million in retail customer funds on January 3, 2003. Approximately 30% of the May 23, 2003 funds are held by UK and Canadian firms for foreign retail customers – funds that are included in the proposed capital computation discussed later in this letter.
15 NFA staff solicited comments from Forex Dealer Members on two occasions. Staff also discussed the proposals with its FCM and IB Advisory Committees and a subgroup from FIA.
16 Compliance Rule 2-36(d) and (g) exclude these same entities when they introduce customers to or manage accounts for customers of Forex Dealer Members.
17 "Material Associated Persons" are affiliates for which the broker-dealer makes and keeps records under the SEC's risk assessment requirements. See Section 17(h) of the Securities Exchange Act of 1934 and SEC Rule 17h-1T.
18 In contrast, NFA Compliance Rule 2-4 is limited to a Member’s futures business, and the definition of futures in NFA Compliance Rule 1-1(m) excludes most off-exchange transactions.
19 The Board realizes that the increased dues will probably be passed on to customers and that they are higher than dues paid by other FCMs, but the alternative is to charge an assessment fee that would have the same net effect for customers and Forex Dealer Members.
20 Securities self-regulatory organizations have long imposed fees based on their members' gross income, and the SEC tacitly reiterated its approval of that practice earlier this year when it approved changes to NASD's gross income assessment. See 68 Fed. Reg. 819 (Jan. 7, 2003).
21 Under this reasoning, NFA would also not have authority to require Members and Associates to arbitrate their disputes under the Member Rules – rules that were approved by the CFTC and upheld by the 7^th Circuit Court of Appeals. See R.J. O'Brien & Assoc., Inc. v. Pipkin, 64 F.3d 257 (7^th Cir. 1995).
22 Both the capital requirement and the security deposit requirement discussed in the next section must be calculated at a set point during the day while the customer positions are open. One Forex Dealer Member told NFA staff that it ends the day flat because it rolls the positions over by closing them out at the end of the day and opening new positions at the beginning of the next day. Although NFA does not agree with this interpretation, such an interpretation would negate the alternative capital requirement and the security deposit requirement if those requirements were calculated at the end of the day.
23 The currencies that qualify for the 2% security deposit are the British pound, the Swiss franc, the Canadian dollar, the Japanese yen, the Euro, the Australian dollar, the New Zealand dollar, the Swedish krona, the Norwegian krone, and the Danish krone.
24 Section 12 also authorizes the Executive Committee to temporarily increase these requirements in extraordinary market conditions. NFA anticipates that this authority would be rarely exercised.
25 Disclosure of mark-ups and mark-downs has long been mandated in the securities industry. See SEC Rule 10b-10(a)(ii).}

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