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Proposed Rule

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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 At its November 2005 meeting, the Board rescinded the February 2005 amendments and approved a new proposal to increase the requirement to $7,500,000 and make several technical changes.

Certain FCM affiliates as described in section 2(c)(2)(B)(ii)(III) of the Commodity Exchange Act ("ACT") may act as counterparties to retail forex transactions. NFA's Forex Dealer Members are required to supervise the retail forex activities of these 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 a counterparty is an affiliate of an FCM that does not itself act as a counterparty. Specifically, if an FCM itself does not act as a counterparty, the FCM is not a Forex Dealer Member and, therefore, NFA's forex dealer rules do not reach the forex activities of its affiliate.

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 pursuant to section 2(c)(2)(B)(ii)(III) 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.

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.

Capital requirements are no substitute for regulation. Several non-exchange members have capital below this threshold, but they are either shell FCMs or Forex Dealer Members that may be encouraged to transfer the affiliate's business to 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 re-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 CEA 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.

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