Proposed Rule
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At its November 2004 meeting, NFA's Board appointed a Special Committee to Study Customer Protection Issues ("Special Committee”), including retail forex. The Special Committee is a blue-ribbon committee composed of a cross-section of the industry, including NFA Board members and representatives of firms that offer retail forex products. The Special Committee developed, and the Board approved, the following proposals designed to increase customer protection involving retail forex.
A. Explanation of Amendments to NFA Compliance Rule 2-36 and a new Compliance Rule 2-39 Regarding Forex Sales Practice Issues
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1. Members Who Solicit for Non-Forex Dealer Members
- Recently, a situation arose where a CTA Member managed forex accounts - and only forex accounts - carried by a U.K. based forex dealer that was not an NFA Member. NFA staff had significant concerns about the promotional material the CTA used to solicit retail forex accounts, but none of NFA's rules prohibited the CTA from using that promotional material.1
- In another case, a South Florida IB that conducted no exchange-traded futures business was soliciting and introducing retail forex accounts to an affiliate of an FCM shell, which is not a Forex Dealer Member. When NFA began an examination of this IB, over forty individuals - who were not registered - simply vacated the premises, and the firm shut down operations shortly afterwards. Staff auditors recognized one of these individuals as a former AP who NFA suspended for sales practice fraud. Additionally, three other individuals on the premises were previously registered with Member firms closed for sales practice fraud.
- Lastly, some entities are registering as IBs or CTAs and becoming NFA Members because a non-member foreign bank is requiring registration before it will do business with those entities.
NFA's forex rules do not apply to Members and Associates who introduce forex business to or manage forex accounts carried by entities that are not Forex Dealer Members. Since most of NFA's rules apply only to exchange-traded products, we are unable to prosecute Members for using misleading promotional material when they do business with counterparties who are not Forex Dealer Members. For example:
The Special Committee recommended extending this provision to cover transactions with all forex dealers, not just Forex Dealer Members. Since Compliance Rule 2-36 only applies to transactions with Forex Dealer Members, the Special Committee proposed and the Board approved a separate rule to make it clear that the requirement covers retail forex transactions with non-Forex Dealer Members as well as with Forex Dealer Members. This proposal also eliminates current subsection (g) of Compliance Rule 2-36 - since the new rule would make it duplicative and unnecessary - and makes corresponding technical amendments to the forex interpretive notice.
When reviewing the Special Committee's proposal, FIA representatives suggested a minor, non-substantive change to the definition of an off-exchange transaction. Since the definition of an off-exchange transaction in proposed Compliance Rule 2-39 mirrors the definition in Bylaw 306, Compliance Rule 2-36, and Sections 11 and 12 of the Financial Requirements, the Board approved changing those definitions as well.
2. BASIC Disclosure
The CEA places no restrictions or registration requirements on firms and individuals who solicit retail off-exchange forex transactions or manage retail accounts as long as the transactions are done with authorized counterparties. NFA Compliance Rule 2-36(d) holds Forex Dealer Members responsible for the activities of the unregistered solicitors and account managers.
Forex Dealer Members' retail customers should be aware of NFA's existence so they can check the disciplinary background of firms and individuals and file complaints with NFA. Therefore, the Special Committee proposed and the Board approved adopting 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, when the customer first opens an account and at least once a year thereafter. Forex Dealer Members could meet this requirement by simply forwarding customers a copy of an NFA brochure entitled "Background Affiliation Status Information Center — An Information Resource for the Investing Public.”
The proposed amendment to the interpretive notice clarifies that 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.
Section 2(c) of the CEA authorizes unregulated affiliates of FCMs to act as counterparties if the FCM makes and keeps records of the affiliate under the risk-assessment provisions of the Act. NFA's Forex Dealer Members are required to supervise the retail forex activities of their 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 counterparty is an affiliate of an FCM that does not itself act as a counterparty. In the situations described below, the FCMs are not Forex Dealer Members and, therefore, NFA's forex dealer rules do not reach the forex activities of their affiliates.
- At least six firms that are registered only as FCMs offer exchange-traded products through the FCM and offer OTC forex to retail customers through an unregulated affiliate.2 NFA recently expelled one of these FCMs from NFA membership based, in part, upon its failure to supervise its guaranteed introducing brokers, and the CFTC recently filed an enforcement action against the forex affiliate of this same FCM alleging anti-fraud violations in the sale of retail forex.
- There are three FCMs that have no customers and appear to be shell firms registered for one purpose only: to qualify their affiliates to offer retail forex. One of these shell firms has a principal who was employed at firms with prior disciplinary problems. Another of these registered FCMs is a subsidiary of a former Forex Dealer Member that formed the subsidiary and withdrew its own FCM registration in order to avoid NFA's forex rules. Since the new FCM does not conduct retail forex business, it is not a Forex Dealer Member and neither its activities nor those of its parent company - the former Forex Dealer Member - are subject to NFA's forex requirements.
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 recommended and the Board approved amending NFA's Financial Requirements to impose a $5,000,000 capital requirement on 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.3 The proposed capital requirement ensures that firms are willing to invest significant resources in order to engage in a retail forex business, and the amount is consistent with the capital requirement contained in CFTC Regulation 1.14.4 Capital requirements are no substitute for regulation, however. A greater benefit of a $5,000,000 capital requirement is that it may encourage FCMs to conduct their retail forex business directly through the FCM since the capital requirement for most Forex Dealer Members is significantly less than $5,000,000.
Increasing the capital requirement for FCMs with forex affiliates could, however, 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 affiliates' forex customer funds. While the FCM's DSRO resolved that particular situation, it may not be resolved as easily the next time. Therefore, the Special Committee also recommended and the Board approved restricting an FCM's ability to use an affiliate's customer funds to increase the FCM's capital.
C. Explanation of 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% on all uncovered proprietary positions depending on the underlying currency.
At least one Forex Dealer Member has created an affiliate for the express purpose of lowering its capital requirement. The Forex Dealer Member "hedges” its net position by entering into an opposite transaction with the affiliate. This allows the Member to significantly lower its minimum capital requirement by netting the affiliate's positions against retail customer positions before calculating the 1% requirement.
Using an affiliate for this purpose also decreases (or even eliminates) the Member's haircut charges for uncovered proprietary positions, effectively lowering its capital requirement. This is not just an affiliate issue, however. Several Forex Dealer Members cover their positions with unregulated entities - often located in foreign jurisdictions - that could be thinly capitalized or simply have no incentive to make good on their obligations if they are facing significant losses.
The Special Committee 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 are included in the calculation. This can make a significant difference in a firm's net capital requirement. For example, netting allowed the Forex Dealer Member mentioned above to lower its minimum capital requirement by $3.8 million dollars - from $5.0 million dollars without including the affiliate's positions to $1.2 million dollars when they were included - on a particular day.
The alternative capital requirement was designed to measure the default risk from non-ECP individuals and entities, and NFA set it at 1% because we assumed they would have relatively small positions that, in most circumstances, would not have a significant effect on the Forex Dealer Member's ability to meet its obligations. In this case, however, the affiliate carries very large positions. If the affiliate is thinly capitalized, the Member will 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 Special Committee proposed and the Board approved amending Section 11 to exclude positions of affiliates and principals from the calculation. Because the Special Committee recognizes how creative some Members can be, the proposed language 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
Using an affiliate to hedge its positions affects the Forex Dealer Member's capital requirement in another way. 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 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 Special Committee recommended and the Board approved imposing a concentration charge when a Forex Dealer Member hedges a material part of its exposure with an affiliate or an unregulated entity. This would be accomplished by adding a new subsection (b) to Section 11 of NFA's Financial Requirements.
The concentration charge proposed by the Special Committee and approved by the Board would 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 would be treated as uncovered, and we would apply the CFTC's 6% or 20% haircut, depending on the currency. The concentration charge would only affect that part of the excess position that would not otherwise be subject to the haircut, however. If any part of the position above the 10% threshold is uncovered, it would be subject to just one charge. Furthermore, any uncovered amount below the 10% threshold would still be subject to the regular CFTC haircut.
The Special Committee considered which types of entities may pose serious counterparty risk and, therefore, should be subject to the concentration charge. The Special Committee recommended and the Board approved that the concentration charge be applied to transactions with all affiliates (regardless of regulatory status) and to all other 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). The Special Committee also recommended and the Board approved that NFA staff have 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 regarding forex is amended to describe the information that NFA will consider when approving a counterparty for the exemption as well as provide an example of how the concentration charge works.
The concentration charge would also apply to transactions with all affiliates, whether regulated or unregulated. The Forex Dealer Member would calculate the charge as applied to individual affiliates and on a consolidated basis. The Forex Dealer Member would then be required to 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. Imposing a concentration charge on affiliates and unregulated counterparties will create a better financial cushion against a counterparty default.5
Other U.S. regulatory schemes impose concentration limits to protect against significant financial loss due to the failure of any single entity. For example, banks are not allowed to loan more than 10% of their capital to any one person, and investment companies are subject to similar limitations on the amount they can invest in certain entities. The concentration charge proposed by the Special Committee is less onerous than these outright prohibitions but should accomplish the same purpose.
NFA respectfully requests that the Commission review and approve the proposed adoption of Compliance Rule 2-39 and proposed amendments to Compliance Rule 2-36, Financial Requirements Sections 1, 11 and 12 and the Interpretive Notice regarding Forex Transactions with Forex Dealer Members.
1 Fortunately, we were able to prosecute this particular CTA for lying to NFA, and the CTA settled the case by agreeing to permanently withdraw from NFA membership. Other situations may not be as easy to deal with, however.
2 This number may be too low. NFA does not monitor FCMs that belong to an exchange and for which the exchange is the designated self-regulatory organization ("DSRO”). Therefore, we may not be aware of every FCM that has an affiliate engaging in retail forex.
3 This requirement would not apply to Forex Dealer Members who conduct some of their retail forex activities through an affiliate since Forex Dealer Members are required to ensure that those affiliates comply with NFA's forex rules and are subject to discipline for rule violations by their affiliates.
4 As you know, the CFTC has taken the position in a pending enforcement case that an FCM affiliate is not an authorized counterparty for retail forex transactions unless the affiliate is a "material affiliated person” ("MAP”) under the CFTC's rules. Under those rules, an affiliate cannot be a MAP unless the FCM maintains $5,000,000 in adjusted net capital (or holds $6,250,000 in segregated funds). If the CFTC's interpretation prevails, the $5,000,000 capital requirement could help ensure that only affiliates of FCMs with substantial financial resources could act as counterparties in retail forex transactions. The CFTC's position could significantly deter the use of shell FCMs and keep thinly capitalized FCMs that sell exchange-traded products from offering OTC forex through affiliates. The CFTC's enforcement case may take months - if not years - to reach a final disposition, however.
5 Several members of the FCM Advisory Committee felt that the concentration charge should be applied to transactions with all counterparties, including regulated counterparties. On the other hand, one Forex Dealer Member felt that regulated affiliates should be excluded.