Proposed Rule

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At its July 2005 meeting, NFA's Special Committee for Customer Protection Issues ("Special Committee") voted to recommend a $5,000,000 minimum capital requirement for FCM Members who act as principals to retail forex options transactions. The Board approved this requirement at its November 2005 meeting.

Options dealers face special risks. Options are harder to price than outright transactions, and deltas are less transparent for OTC options that do not mirror exchange-traded options. Firms may also be less likely to appreciate the potential risk in an options portfolio, where the risk profiles of long and short positions vary significantly and the strategy variations are limited only by the number of available strike prices. Some firms may also be lulled into complacency by the deep-out-of-the-money status of their short options positions. Risk management is more complicated for options than for futures positions, and OTC customers have no clearinghouse to protect them if the dealer is unable to cover the customers' gains when they attempt to exercise winning options positions. A $5,000,000 capital requirement would help ensure that the dealer could meet its obligations to these customers.

These risks can exist for all forex options dealers, regardless of whether they are Forex Dealer Members. Therefore, the new requirement would apply to all FCMs that act as principals to retail forex options transactions.

Historically, the Commission has recognized that dealer products create higher risks for a registrant than exchange-traded products. CFTC Regulation 32.12(a)(1) - which was adopted in 1978 - imposes a $5,000,000 net worth requirement on FCMs granting dealer options on physical commodities. CFTC Regulation 31.9(a) - which was adopted in 1984 - imposes a minimum adjusted net capital requirement on Leverage Transaction Merchants equal to $2,500,000 plus 20% of the market value of all uncovered leverage transactions plus 2.5% of the market value of short covered leverage transactions. NFA's requirement is in line with the requirements for these currently inactive dealer products, which have not been adjusted for inflation since they were adopted.1

Based on the August 31, 2005 financial reports, only two of the seven Forex Dealer Members who actively offer forex options would meet a $5,000,000 requirements and three of the seven would meet a $1,000,000 requirement. NFA does not have information showing how many FCMs who are not Forex Dealer Members act as principals for retail forex options.

NFA requested comments from Forex Dealer Members and received comment letters from six of the approximately thirty active Forex Dealer Members. All of the commenters said the proposed minimum is too high. Four commenters said the proposal will benefit larger players by eliminating most competition, and two of these commenters said that the lack of competition hurts customers.

Three commenters said that the proposed capital requirement is disproportionate to the risk. Two of them stated that granting options is less risky and less volatile than outright positions because time works in the grantor's favor, options are easier to hedge than outright positions, and options can be hedged more flexibly.

Three commenters stated that options provide customers with a less risky alternative to outright positions, and two of them implied that the proposal would move customers into what the commenters characterized as riskier forex investments.2 One stated that "Congress intended to make it easier for retail customers to learn about and invest in the foreign exchange markets" by relaxing regulation.3 Another commenter declared that a $5,000,000 capital requirement for derivatives is unprecedented, while yet another stated that the proposed requirement would likely cause it to move its forex business to an affiliate.

One commenter, while apparently opposing any increase, suggested, as an alternative, that NFA raise the minimum in smaller increments and analyze the need for each additional increase before imposing it. Another commenter noted that forex options would be a very small part of its overall business, offered primarily to meet the desires of existing customers, and that to impose a large capital requirement on a firm that offers options on this basis would be unfair.

Finally, one commenter agreed with the Special Committee's analysis of the risk involved in offering forex options but proposed a different solution. This commenter suggested a $1,000,000 minimum capital requirement plus a capital charge for unhedged options equal to 10% of the net delta for the position (offsetting long calls against short calls and long puts against short puts but not offsetting calls with puts).

The Board considered all the comments, many of which misunderstood the regulatory scheme or the risks involved in writing over-the-counter options. The Board concluded that a $5,000,000 requirement is the most appropriate response to the special risks posed by these transactions.

NFA respectfully requests that the Commission review and approve the proposed amendments to the Financial Requirements Section 1 regarding capital requirements for options counterparties.

1 According to the Consumer Price Index, it would take $4,730,000 in today's dollars to equal $2,500,000 in 1984 dollars.

2 Options have different risk characteristics than futures, but even buying options is not necessarily less risky. While the amount of the potential loss is limited, the probability of loss is greater since the market has to move farther for the buyer to recoup the premium and break even.

3 As you know, the opposite is true. The 2000 amendments were designed to ensure that only regulated entities could participate in the unregulated retail market - limiting access and increasing potential regulation rather than opening up the market and eliminating regulation.

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