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(additions are underscored and deletions are
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(ii) 1% of the total net aggregate notional value of all open foreign currency futures and options transactions in customer and non-customer (but not proprietary) 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 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.
SECTION 12. SECURITY DEPOSITS FOR FOREX TRANSACTIONS WITH FOREX DEALER MEMBERS.
(a) Except as provided in (b) below, each Forex Dealer Member shall collect and maintain the following minimum security deposit for each foreign currency futures and options transaction 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 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:
(ii) 4% of the notional value of other transactions;
(iii) for short options, the above amount plus the premium received; and
(iv) for long options, the entire premium.
(b) A Forex Dealer Member that consistently maintains adjusted net capital of at least twice the greater of the amount required by Section 11(i) or (ii) of these Financial Requirements is exempt from (a) above.
(c) The Executive Committee may temporarily increase these requirements under extraordinary market conditions.
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FOREX TRANSACTIONS WITH FOREX DEALER MEMBERS INTERPRETIVE NOTICE
The Commodity Futures Modernization Act of 2000 (CFMA), which was signed into law on December 21, 2000, amended the Commodity Exchange Act (CEA) to provide that only certain regulated entities may offer off-exchange foreign currency futures and options contracts (forex) to retail customers.1 Under the CFMA, registered futures commission merchants (FCMs) and their affiliates are among the entities that may offer forex contracts to retail customers.2 As described below, NFA Bylaw 306 creates a Forex Dealer Member category for certain NFA Members who act as counterparties to forex transactions with retail customers.3 This category allows NFA to exercise appropriate regulatory jurisdiction over the retail forex activities of these Members without imposing unnecessary, and potentially duplicative, regulatory burdens on Members that are otherwise subject to regulatory oversight for their activities.
Given the differences between off-exchange forex transactions and traditional exchange-traded futures and options, the Board of Directors does not believe that it is appropriate to apply the full array of NFA's futures rules to off-exchange forex transactions. Therefore, rather than simply incorporating off-exchange forex transactions into the definition of "futures," NFA adopted NFA Compliance Rule 2-36 to govern these transactions.
Bylaw 306 and Compliance Rule 2-36 define forex transactions as off-exchange foreign currency futures and options transactions that are offered to or entered into with persons that are not eligible contract participants as defined in Section 1a(12) of the CEA and are limited to those transactions where an NFA Forex Dealer Member is the counterparty or the person offering to be the counterparty. For these purposes, "forex" does not include transactions executed on a contract market, a designated 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, which continue to be covered by other regulatory schemes.
Consistent with the provisions of Section 2(c) of the CEA, Bylaw 306 and Compliance Rule 2-36 apply only to transactions with retail customers. In developing its forex requirements, NFA's primary concern was to ensure that they provide adequate protection for retail customers without imposing undue burdens on NFA Members. NFA also believes that its requirements should, where consistent with customer protection, promote innovation and competition. In order to provide Members with as much flexibility as possible, NFA has chosen to deal with a number of issues by providing guidance under NFA Compliance Rule 2-36 instead of by adopting additional rules.
NFA Compliance Rule 2-36 sets out the general standards that apply to Forex Dealer Members and their Associates in connection with forex transactions with retail customers. Subsection (b) prohibits Forex Dealer Members and their Associates from engaging in fraudulent activities, subsection (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 forex business, and subsection (e) requires Forex Dealer Members and their Associates with supervisory duties to supervise their employees and agents. Other subsections address a Forex Dealer Member's responsibility for its unregulated affiliates and third-party solicitors, make Forex Dealer Members subject to discipline for the conduct of certain non-Members with which they do business, and extend certain of the rule's requirements to other Members and Associates who do business with Forex Dealer Members.
This notice has three sections. The first section explains who qualifies as a Forex Dealer Member under NFA Bylaw 306, the second section provides additional guidance about the requirements in Compliance Rule 2-36, and the third section covers other miscellaneous requirements.
A. BYLAW 306
In general, Forex Dealer Members are NFA Members who act as counterparties to retail, off-exchange forex futures and options transactions. This is a self-executing requirement, which means that any Member who qualifies is automatically a Forex Dealer Member. There is no application form and no approval requirement.
Members who do not act as counterparties are not Forex Dealer Members, even if they introduce or manage retail forex accounts. Under NFA Compliance Rule 2-36(g), however, most Members who introduce retail forex accounts to Forex Dealer Members or manage retail forex accounts for customers of Forex Dealer Members are required to comply with subsections (a), (b), (c), and (e) of that rule.
Bylaw 306(b) 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 2-36.4 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 are not Forex Dealer Members:
B. COMPLIANCE RULE 2-36
As noted above, this section provides additional guidance on what Compliance Rule 2-36 requires. Certain sections specifically refer to Forex Dealer Members. Except for Members that meet the criteria in Bylaw 306(b), all other provisions of this notice also apply to Members and their Associates who solicit retail forex transactions on behalf of a Forex Dealer Member, introduce retail customers to a Forex Dealer Member, or manage accounts for retail customers that enter into forex transactions with a Forex Dealer Member. This notice does not apply to transactions with counterparties listed in Bylaw 306(b) or to transactions between Forex Dealer Members and eligible contract participants.
1. Disclosure - Forex Dealer Members must provide retail forex customers with understandable and timely disclosure on essential features of forex trading.
At or before the time a retail customer first engages in a forex transaction, a Forex Dealer Member and its Associates should provide the customer sufficient information concerning the characteristics and particular risks of entering into forex transactions.
Forex Dealer Members should update any material information that has changed prior to entering into new transactions with current retail customers if failing to update the information would make it misleading.
2. Reporting - Forex Dealer Members must provide retail forex customers with timely and accurate notice of the status of their accounts.
Forex Dealer Members should provide written confirmations within one business day after any activity in the retail customer's account, including offsetting transactions, rollovers, and deliveries. The confirmation should include the details of the transaction as well as any mark-ups and mark-downs, if applicable, and all commissions, costs, fees and other charges incurred in connection with the transaction.
Forex Dealer Members should provide regular monthly summaries of all forex transactions and other account activity to retail customers for all accounts that have open positions at the end of the month or changes in the account balance since the prior statement. Forex Dealer Members should provide summaries at least quarterly for all other open accounts.
With the customer's consent, confirmations and monthly summaries may be transmitted by electronic means.
3. Supervision - Members and their Associates having supervisory responsibilities must diligently supervise the Member's forex business, including the activities of the Member's Associates and agents. Members must establish, maintain, and enforce written supervisory procedures.
NFA has provided Members with guidance on minimum standards of supervision through interpretive notices issued under NFA Compliance Rule 2-9.7 In these interpretive notices NFA recognized that, given the differences in the size of and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes "diligent supervision" for each firm. This principle also applies to the supervision of a Member's forex business.
Although Members have the flexibility to design procedures that are tailored to their own situation, an adequate program for supervision would include procedures for performing day-to-day monitoring. These procedures would include:
Finally, a Member's supervisory responsibilities include the obligation to ensure that its employees are properly trained to perform their duties. The formality of a training program will depend on the size of the firm and the nature of its business. Procedures should be in place to ensure that supervisory personnel know and understand the firm's supervisory procedures and that employees receive adequate training to abide by NFA requirements and to properly handle retail customer accounts.
4. Recordkeeping - Members must keep books and records relating to their forex operations for a period of five years from the date thereof and shall keep them readily accessible during the first 2 years of the 5-year period. All such books and records shall be open to inspection by NFA.
Members should adopt and enforce reasonable procedures to create current and accurate books and records and to keep them from being altered or destroyed. The Member should be able to promptly produce its records in a format that NFA can read and reproduce.
5. Communications with the Public and Promotional Material - No Member or Associate shall make any communication with potential or current retail customers that operates as a fraud or deceit; uses a high-pressure approach; or implies that forex transactions are appropriate for all persons. Promotional material used by the Member or Associate shall not deceive the public; contain any material misstatement of fact; mention the possibility of profit unless accompanied by an equally prominent statement of the risk of loss; or include any reference to actual past trading profits without mentioning that past results are not necessarily indicative of future results.
No Member or Associate may represent that forex funds deposited with a Forex Dealer Member are given special protection under the bankruptcy laws.
Members and Associates may not solicit customers based on the leverage available unless they balance any discussion regarding the advantages of leverage with an equally prominent contemporaneous disclosure that increasing leverage increases risk.
Every Member should adopt and enforce written procedures to supervise communications with potential and current retail customers and promotional material. A supervisory employee should review and approve all promotional material.
All promotional material should be maintained by each Member and be available for examination for the periods specified in the recordkeeping section of this notice, measured from the date of last use.
6. Know Your Customer - Members and Associates have a duty to acquaint themselves sufficiently with the personal and financial circumstances of each retail forex customer to determine what further facts, explanations and disclosures are needed in order for the customer to make an informed decision on whether to enter into forex transactions.
Every Member should determine what information it will obtain from a prospective retail forex customer. At a minimum, the Member soliciting the retail customer to engage in forex transactions with a Forex Dealer Member should obtain the customer's name, address, principal occupation or business, current estimated annual income and net worth, approximate age, and an indication of the customer's previous investment and trading experience. Members and their Associates need to ensure that each retail customer they solicit has received adequate information concerning the risks of forex transactions so that the customer can make an informed decision as to whether forex transactions are appropriate for the customer. These obligations fall on the Forex Dealer Member when a non-Member solicits the customer.
7. Doing Business with Non-Members - Forex Dealer Members are subject to discipline for the activities of most non-Members who solicit or introduce retail forex customers to the Forex Dealer Member or manage accounts for those customers.
If a customer is solicited or introduced by a non-Member of NFA, or if the customer's account is managed by a non-Member, the Forex Dealer Member is subject to discipline for the non-Member's conduct if that conduct would violate NFA requirements when engaged in by an NFA Member. In other words, a Forex Dealer Member is subject to an NFA disciplinary action for the non-Member's activities when soliciting, introducing, or managing accounts for the Forex Dealer Member's retail customers even if the non-Member was not the Forex Dealer Member's agent.
The rule allows NFA to bring a disciplinary action even if the Forex Dealer Member acts diligently and has no knowledge of the third-party's conduct. As a practical matter, however, NFA will not take disciplinary action unless the Forex Dealer Member knew or should have known of the third-party's conduct or failed to exercise due diligence when establishing and maintaining the relationship with the third party.
The Forex Dealer Member is not subject to discipline for the actions of non-Members who are described in NFA Bylaw 306(b). It is also not subject to discipline for the actions of non-Members who would be exempt from Commission registration if they were acting in the same capacity in connection with exchange-traded futures contracts, such as foreign persons that solicit, introduce, or manage accounts for foreign customers only.10 The Forex Dealer Member does, of course, have certain basic duties to its customers, including a duty to supervise its own activities in a way designed to ensure that it treats its customers fairly. Specifically, the Forex Dealer Member would violate this duty if it has actual or constructive notice that one of these entities engaged in fraudulent conduct and fails to take appropriate action.
8. Affiliates - Forex Dealer Members must supervise and are subject to discipline for the activities of affiliates that are authorized to engage in forex transactions solely by virtue of their affiliation with a Forex Dealer Member.
The CEA authorizes affiliates of FCMs to act as counterparties to forex transactions with retail customers if the affiliate directly or indirectly controls, is controlled by, or is under common control with the FCM and the FCM makes and keeps records regarding the financial activities of the affiliate for purposes of the Commission's risk assessment requirements.11 If a Forex Dealer Member has one or more affiliates that act as counterparty to retail forex customers solely on the basis of that affiliation, the Forex Dealer Member must supervise the affiliate's retail forex activities and is subject to discipline for that affiliate's activities.12 The Forex Dealer Member must also make these affiliates' books and records available to NFA upon request.
C. OTHER REQUIREMENTS
This section of the notice provides guidance on dues, capital requirements, and security deposits. These requirements apply only to Forex Dealer Members.
1. Bylaw 1301
Forex Dealer Members are not required to pay assessment fees on retail off-exchange forex transactions. Instead, NFA Bylaw 1301(e) imposes annual dues that are graduated according to the firm's gross annual revenue from customers (e.g., commissions, mark-ups, mark-downs) for these activities. Profits and losses from proprietary trades are not to be included. To calculate dues:
For example, a Forex Dealer Member with annual revenue in excess of $1,500,000 for which NFA is the designated self-regulatory organization would pay annual dues of
The dues will be assessed on the firm's membership renewal date and will be based on the Forex Dealer Member's latest certified financial statement.
2. Financial Requirements Section 11
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, including foreign persons. To calculate this capital requirement, follow these steps:
3. Financial Requirements Section 12
Forex Dealer Members must collect security deposits from retail customers equal to 1
For short options, the Forex Dealer Member must collect this amount plus the premium the customer received. For long options, the Forex Dealer Member must simply collect the entire premium from the customer.
This requirement does not apply to any Forex Dealer Member that consistently maintains adjusted net capital equal to or in excess of two times the greater of the amount required by Section 11(i) or (ii) of the Financial Requirements. A Forex Dealer Member claiming the exemption must file advance written notice with NFA. If a firm that claims the exemption falls below double its capital requirement under Section 11(i) and (ii), it must immediately notify NFA. If the firm does not come back into compliance within 48 hours, it must collect the required security deposits on all customer positions and may not claim the exemption for six months. A firm that claims the exemption but falls below the required capital amount three times within 90 days may not claim the exemption for six months.13
1 For purposes of this notice, the term "retail customer" refers to any counterparty - domestic or foreign - that is not an eligible contract participant as defined in Section 1a(12) of the CEA.
2 Other NFA Members may offer these contracts if they are also registered in one of the other categories listed in Section 2(c)(2)(B)(ii) of the CEA.
3 The Board of Directors has determined that the retail, off-exchange forex transactions entered into by these firms should be subject to NFA's regulatory jurisdiction and are a proper subject of NFA regulation and oversight under Article XVIII(k) of NFA's Articles of Incorporation.
4 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.
5 Bylaw 306(b)(ii) excludes broker-dealers that are members of any fully-registered national securities association and FCMs that are members of another registered futures association. At this time, however, NASD is the only fully-registered national securities association and NFA is the only registered futures association.
6 These are affiliates of broker-dealers for which the broker-dealer makes and keeps records under the Securities and Exchange Commission's risk assessment requirements. See Section 17(h) of the Securities Exchange Act of 1934 and SEC Rule 17h-1T.
7 See, for example, Compliance Rule 2-9: Supervision of Branch Offices and Guaranteed IBs, NFA Manual paragraph 9019; Compliance Rule 2-9: Supervisory Procedures for E-Mail and the Use of Web Sites, NFA Manual paragraph 9037; Compliance Rule 2-9: Supervision of the Use of Automated Order-Routing Systems, NFA Manual paragraph 9046. These interpretive notices do not apply to off-exchange retail forex activities, but they may provide helpful guidance to Members in connection with those activities.
8 The Commodity Futures Trading Commission has stated that all employees of an FCM who solicit or accept orders for forex transactions from retail customers must be registered with the Commission as an associated person of the FCM. See Division of Trading and Markets Advisory Concerning Foreign Currency Trading by Retail Customers (March 2002).
9 The screening process should include 1) checking BASIC and any other readily available sources and 2) asking the third-party to represent that neither it nor any of its principals is subject to a statutory disqualification or to identify and explain any statutory disqualifications.
10 For this purpose, foreign persons and foreign customers are 1) natural persons who are not residents of the United States or 2) legal entities that are organized under the laws of a country other than the United States, do not have their principal place of business in the United States, and do not conduct their retail forex activities from a location in the United States. "United States" includes U.S. territories and possessions.
11 See Sections 2(c)(2)(B)(ii)(III) and 4f(c) of the CEA and CFTC Regulations 1.14 and 1.15.
12 Obviously, the Forex Dealer Member must also ensure that no entity with common ownership engages in the retail forex business unless it is authorized to do so.
13 For this purpose, underages within the same U.S. calendar day are one occurrence.