Proposed Rule

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NFA's forex rules and interpretive notice became effective on December 1, 2003. Our experience since then indicates that the rules and the interpretive notice can be fine-tuned to better fit the off-exchange retail forex market and to lessen the burden on Forex Dealer Members without lessening customer protection. While we are still studying certain issues, the Board adopted changes to the security deposit requirement since that requirement is the subject of no-action relief scheduled to expire on June 1, 2004. It also adopted several technical amendments at this time. The proposed amendments are discussed below.

Security Deposits

Section 12 of NFA's Financial Requirements requires Forex Dealer Members to collect and maintain a minimum security deposit for retail forex transactions. The Section 12 requirement is 2% for certain specified currencies (called major currencies in the rest of this discussion) and 4% for all other currencies. When we adopted this requirement, we noted that most Forex Dealer Members already required some type of security deposit, and we felt that it was a sound business practice. We set the level for the security deposit to be consistent with the margin requirements on the IMM, which average 2% for major currencies and 3.9% for other 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 that, if significant enough, could make the Forex Dealer Member insolvent and put the funds of its other customers at risk. When adopting this requirement NFA believed that requiring Forex Dealer Members to collect security deposits at levels similar to margins for related exchange-traded futures contracts was necessary to protect the funds of non-defaulting retail customers.

On October 30, 2003 staff met with a number of Forex Dealer Members to discuss the new requirements. One of the topics covered during the meeting was the security deposit requirement, which the Forex Dealer Members felt put them at a competitive disadvantage and was not the most efficient way to achieve NFA's goal. The people present at the meeting suggested several alternatives that they believe would accomplish the same objective while imposing fewer burdens on Forex Dealer Members.

In light of those discussions, staff decided to study alternative approaches and re-examine the security deposit requirement. Staff also issued an interim no-action letter allowing Forex Dealer Members to charge a 1% security deposit on transactions in the major currencies but leaving the 4% requirement unchanged. That no-action relief is scheduled to expire on June 1, 2004 unless extended.

Our review indicates that a security deposit requirement may not be the most effective way to achieve our goal and the CME margin requirements may not be the appropriate yardstick. Futures margin requirements protect the FCM and the clearing corporation from the risk of customer defaults. This is particularly important in agency markets because both the FCM and the clearing corporation have obligations to third parties. The FCM is obligated to make margin payments to the clearing corporation because the clearing corporation is obligated to pay profits to the person on the winning side of the trade. Customer margin payments ensure that the FCM will have the money to pay its obligations to the clearing corporation, and the variation margin paid by the FCM to the clearing corporation ensures that the clearing organization will have the money to pay its obligations to the persons on the winning side of the trade.

Dealer markets work differently. In a dealer market, there is no clearing corporation and the person on the other side of the trade is the dealer itself. Therefore, the dealer does not have to pass the money through to a third party, and a default should have less effect than a default in an agency market. Obviously, the dealer has to pay profits to its winning customers, and the money it should have been able to collect from a defaulting customer will not be available to pay those profits. If the dealer is fully hedged, the dealer also owes money on its hedge position which, again, it will not be able to pay from the profits it should have collected from a defaulting customer. However, the dealer's ability to make good on its obligations is not directly related to the customer's default.

A number of Forex Dealer Members suggested that increasing the firm's capital requirement is a more efficient and effective way to protect customers from defaults by other customers in these dealer markets and we agree. We were concerned about raising the capital requirement across the board, however, because we do not want to create barriers to entry based on capital where other protections are adequate. Therefore, we are retaining the security deposit requirement but proposing an exemption for firms that maintain twice the capital required by the greater of Section 11(i) or Section 11(ii) of the Financial Requirements, which equates to the greater of $500,000 or 2% of the net notional value of retail positions.15 In reviewing the capital positions of our Forex Dealer Members, we noted that most firms would qualify for this exemption.

The additional capital that Forex Dealer Members must maintain to meet the double capital requirement is not a one-for-one replacement for the gross security deposit that Forex Dealer Members are currently required to collect. Nor do we believe a one-for-one replacement is necessary. Unlike capital, security deposits belong to the customers, not the firm, and security deposits posted by non-defaulting customers are not available to meet the firm's obligations. Furthermore, since NFA's rules only apply to retail customers, who tend to have relatively small positions, defaults by those customers are unlikely to have a significant effect on the firm's capital absent a catastrophic event that results in widespread defaults.

Forex Dealer Members should not be allowed to toggle back and forth between the exemption and the security deposit requirement based on their capital position. Therefore, the proposed amendments to the interpretive notice require Forex Dealer Members to notify NFA in writing before using the exemption. The interpretive notice also provides that a Forex Dealer Member that does not consistently maintain the required capital may not claim the exemption for six months.

We also recommend amending Section 12 to reduce the security deposit for the major currencies to 1%. Since we provided the no-action relief on December 1, 2003, we have not seen any evidence that this level is too low.

Since customers at firms that maintain double their capital requirement are allowed to use higher leverage, we added language to the interpretive notice emphasizing that firms may not discuss the advantages of leverage without telling the customer that increasing leverage increases risk.

Technical Amendments

The Board also adopted three technical amendments. The first simply eliminates an unnecessary subsection reference in Section 11 of the Financial Requirements. At one point in the drafting process we had a subsection (a) and a subsection (b). We eliminated subsection (b) before the rule was approved but inadvertently retained the (a) before the text of the rule.

Second, we recommend eliminating footnote 13 in the interpretive notice. Footnote 13 indicates that Forex Dealer Members must apply haircuts for uncovered proprietary positions based on the currency pair rather than the individual currencies. This is inconsistent with the way these haircuts have been treated in the past, and we have been advising our Forex Dealer Members to continue calculating the haircuts the traditional way.

Finally, dues for Forex Dealer Members start with the relevant FCM dues and then add a dues surcharge that is a substitute for charging an assessment fee on these products. The interpretive notice includes an example of how the dues are calculated. The Board approved a reduction in FCM dues, which is the subject of a separate submission letter. Therefore, the example was amended to reflect the new base amount.

15 Of course, a Forex Dealer Member subject to Section 11(iii) must still meet the greater amount required by Section 1 of the Financial Requirements.

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