Proposed Rule

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Section 11 of NFA's Financial Requirements imposes an alternative minimum net capital requirement on Forex Dealer Members equal to 1% of the total net aggregate notional value of all open off-exchange forex futures and options positions in retail customer and non-customer (but not proprietary) accounts. This requirement is easy enough to calculate and apply to futures positions, but it becomes more complicated and may be less relevant to measuring risk when applied to options.

This difficulty was discovered when auditing a Forex Dealer Member that sold only long options or vertical spreads (long and short call or long and short put with different strike prices). The options were deep out-of-the-money, and the firm's capital requirement, as calculated by NFA, was quite high in relation to the risk in the customer positions. Based on this result, the firm asked that NFA re-examine how the capital requirement is applied to options.

NFA is aware of seven Forex Dealer Members that offer retail forex options. As of July 31, 2005, two of these Members had adjusted net capital in excess of $5,000,000; one had adjusted net capital of over $1,000,000; and the remaining four had adjusted net capital of under $1,000,000. All of these firms had sufficient capital to meet their current capital requirements.

The forex capital requirement is based on retail customer positions and is partly designed to provide a cushion against customer defaults. It does not measure the risk in the firm's positions since that risk is already measured by and compensated for through a haircut charge on uncovered positions. This haircut charge indirectly increases the capital requirement by lowering the amount of capital available to meet that requirement.

When drafting the capital requirement, NFA's objectives were to create a 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 also sought to establish a capital level that protects customers without imposing an unnecessary burden on Forex Dealer Members.

NFA's Special Committee to Study Customer Protection Issues considered a number of ways to calculate capital based on options positions while remaining true to the basic capital calculation and NFA's initial objectives. These alternatives ranged from retaining the current calculation, to multiplying the notional value of the underlying currency by the option delta (with or without a minimum delta or floor), to using a modified SPAN-type calculation.

The Special Committee considered these alternative approaches and recommended that the forex capital requirements be amended to adjust the notional value based on the option delta using the larger of the actual delta or a minimum delta of .25.1 A calculation that uses the option's delta produces a capital amount that more reasonably reflects the risk from customers forex option positions. The minimum delta provides a cushion against dramatic price movements triggering multiple exercises, and it is more closely related to risk than a floor.

Using an option's delta to calculate the capital requirement raises one other issue. Although the historical deltas for exchange-traded currency options are available from various sources, many of the options offered by NFA's Forex Dealer Members have different strike prices or expiration dates and, therefore, have different deltas. To ensure that Forex Dealer Members use deltas that are both logical and auditable, the Special Committee recommended requiring these Members to submit the methodology they use to calculate the deltas to NFA prior to use and to maintain records of the actual deltas they use in their capital computations.2

The Board adopted the Special Committee's recommendations.

NFA respectfully requests that the Commission review and approve the proposed amendments to Financial Requirements Section 11 and the Interpretive Notice regarding Forex Transactions with Forex Dealer Members. NFA will announce the effective date once the amendments are approved.

1 A firm would net its customers' option positions against identical options (long and short calls with the same strike price and expiration date and long and short puts with the same strike price and expiration date).

2 During an audit, staff would test the reasonableness of the firm's deltas by checking a sample of the firm's deltas against the deltas that are available from other sources and extrapolating from those third-party deltas.

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