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NFA Bylaw 1301(e) imposes annual dues on Forex Dealer Members ("FDMs") based on their gross annual revenue from their forex business. Currently, FDMs for which NFA is the DSRO pay annual dues ranging from $20,000 (for those firms with revenue of $500,000 or less) to $100,000 (for those firms with revenue in excess of $5 million). FDM exchange members for which NFA is not the DSRO pay $4,125 less than non-exchange members with the same amount of revenue.1
In adopting this revenue structure, NFA intended to recover its regulatory costs so that fees from on-exchange transactions would not subsidize regulation of off-exchange transactions. The increased annual dues were a substitute for assessment fees, which would have been difficult to set given that, among other things, the contract sizes vary from firm to firm and the contracts are often rolled indefinitely. Additionally, the dues approach was much simpler to apply. As a result, NFA's Board believed it made more sense to increase an FDM's dues based on its annual revenue from its retail forex business.
The Board set the initial FDM dues using the cost information available to NFA in May 2003.2 That information came from NFA's limited experience regulating these firms-limited both by the small number of active firms (many of whom had just entered the business) and by the handful of rules that applied to Members engaging in retail off-exchange forex.
The information provided to the Board in May 2003 showed that NFA had fifteen active FDMs with approximately $130 million in liabilities to customers. By the beginning of September 2005, NFA was the designated self-regulatory organization for 31 active FDMs with liabilities to customers of approximately $795 million. During that period, the number of active FDMs doubled and the aggregate liabilities to customers increased by 500%. Today, NFA has 40 active FDMs with liabilities to customers of over $1 billion. Over the last several years, NFA has also adopted more extensive regulatory requirements tailored to the retail, off-exchange forex business of these firms, requiring NFA to expend additional resources on them.
In November 2005, NFA's Board reviewed information showing that NFA was recovering approximately one-third its costs under the original dues structure. Based on that information, the Board raised the dues to the current levels.
Unfortunately, this increase was not sufficient to meet NFA's goal to recover its regulatory costs without having on-exchange transactions subsidize regulating off-exchange transactions. Although the number of active FDMs may have recently stabilized, the liability to customers continues to rise and much of this growth has occurred in the top tier firms whose dues are currently capped at $100,000.
NFA also anticipated that our costs would moderate or decrease as firms became more familiar with NFA's rules and developed more sophisticated systems. Unfortunately, many of the start-up firms-and even some of the more established ones-do not have either the expertise or the systems one would expect given the nature of their business. Therefore, the cost of regulating forex firms continues to grow, and the current dues fall short of recovering those costs. Recent data indicates that annual income from forex dues will be approximately $1.2 million, which is approximately one-third of NFA's overall costs of regulating forex firms. This cost, of course, has steadily increased this past year as the compliance resources devoted to this area have increased.
In determining how to make up this deficit, NFA considered several options, including increasing dues and imposing a transaction fee. In the end, NFA came up with a hybrid solution that is partly a dues increase, partly an assessment fee, and partly a charge for an FDM's unregulated solicitors.
NFA solicited comments on the forex revenue structure in 2003 (before adopting the original dues structure) and again in 2005 (before the Board considered the charges that are currently in effect). The same general comments were received both times, with Forex Dealer Members split on whether NFA should recover the cost of regulation through dues or an assessment fee. Comments were solicited on the current proposal and eight responses were received.
Dues Increase. First, the amendments raise the minimum dues to $50,000 and the maximum dues to $125,000 with increases in the middle two tiers, as well. This is a 150% increase in the lowest tier and a 25% increase in the upper tier, which appears on first glance to place a disproportionate burden on the smaller firms. The reality is quite different, however.
Start-up and smaller firms consume significant compliance resources. For example, NFA expends resources on these firms to ensure that they understand their regulatory responsibilities and performs a review of an FDM's trading platform and procedures (e.g., AML, disaster recovery) before the FDM is approved for registration. These smaller firms are less likely to have knowledgeable staff and, therefore, are more likely to run into problems that result in a Member Responsibility Action and/or a disciplinary complaint. Since these firms do not have a significant volume of customer business, imposing an assessment fee would barely dent the cost of regulating them. A significant dues increase is the most effective way for NFA to recover those costs.
When commenting on the dues increases, one FDM agreed with the proposal; two supported some increase but felt the proposed dues were too large; one opposed any change to the dues structure; and one did not address this aspect of the proposal. Another FDM opposed increasing dues for the smaller firms and recommended removing the dues cap at the top end. One agreed with the dues increases if the other proposed revenue changes are not adopted but not in combination with other changes. The remaining FDM agreed with the proposal in principle but believes the formula should also take liabilities to customers into account, so that a firm with lower liabilities to customers would pay less than a firm with the same revenue and higher liabilities to customers.
Assessment Fee. A dues increase alone is less effective in recovering NFA's costs associated with regulating the larger FDMs, especially with the current dues cap. An assessment fee will provide significant revenue from these firms, and that revenue will continue to grow as their business grows. While an assessment fee will apply to the smaller firms as well, it will have the greatest impact upon the larger, more established firms.
The proposal staff sent out for comment would have charged FDMs a monthly assessment of .0006% of the aggregate notional value of open forex positions at the end of each month. This was not a transaction fee but would have been based on a snapshot of open customer positions at a particular point in time. NFA was initially concerned about a transaction fee because contract sizes vary from firm to firm, with each FDM setting its own contract size (leaving it some room to adjust the number of transactions that would be subject to the fee) and because the contracts are often rolled indefinitely. Furthermore, transaction fees rely primarily on self-reporting with an occasional check during an audit. While self-reporting has worked for on-exchange futures, traditional FCMs have more experienced accounting staffs and keep better records than many FDMs. As a result, a transaction fee could have had the undesired effect of causing NFA staff to expend more resources during exams to ensure that FDMs were paying the correct amount of transaction fees.
The comments from FDMs caused staff to rethink how the assessment fee should be calculated. One FDM commented that dues are easier to calculate and less burdensome than a transaction fee; one disagreed with the proposal because it based the fee on aggregate positions (the commenter stated that a firm that covers its positions should pay less than a firm that does not); and one found the proposal acceptable if, and only if, it replaces dues and is the only fee FDMs pay NFA. Three FDMs recommended that NFA replace the proposed fee with a transaction fee that they can pass on to their customers, and one FDM-while generally opposed to a transaction fee-stated that if NFA imposes one it should be based on the transaction's notional value and not graduated based on transaction size.3
Based on these comments, staff developed-and the Board approved-a transaction fee that addresses our original concerns and, although not a mirror image, is more analogous to the NFA assessment fee for exchange-traded transactions. In particular, the amendments impose a fee of .0001% of the notional value of each transaction. This equates to $.01 on a $10,000 contract. This fee will be assessed against initiating trades for retail customers and will not apply to rollovers.4 The amendments also allow an FDM to aggregate transactions under $10,000 and pay $.01 on each $10,000 and require it to round up or down to the nearest cent on larger odd lots.5 We believe that this percentage will generate sufficient funds-when combined with the increased dues and the proposed fee for unregulated solicitors-to cover NFA's regulatory costs.
Basing this fee on the notional value of the transaction resolves NFA's concerns about firms' ability to set their own contract sizes. Furthermore, a new forex interpretive notice that becomes effective on July 1 requires FDMs to maintain transaction data, which includes identifying initiating (new) transactions vs. rollovers and makes a transaction fee easier to calculate and confirm.
Charge for Unregulated Solicitors. The final element in the revenue mix is a charge for unregulated entities that solicit or introduce retail business or manage retail accounts for the FDM. Under NFA Compliance Rule 2-36(d), FDMs are subject to discipline for the activities of most of their unregistered solicitors and account managers.6 NFA spends significant resources reviewing websites and otherwise monitoring these unregulated entities that do not even pay dues. Over the past few years, NFA has charged numerous FDMs because their third-party solicitors' promotional material included misleading claims relating to slippage-free execution, zero or commission-free trading, FDIC insurance for customer funds, and customer funds' segregation protections.
The FDMs that rely most heavily on outside solicitors typically have 25 or more. Therefore, to recover the resources expended on NFA's review of these third-party solicitors, NFA is imposing a sliding scale annual fee on any FDM that uses unregulated solicitors or account managers. This fee is based upon the number of each FDM's solicitors as follows-for 1 to 4 solicitors the fee is $5,000; for 5 to 19 solicitors the fee is $10,000; for 20 to 99 solicitors the fee is $25,000; and for 100 or more solicitors the fee is $50,000.
Three FDMs agreed with the proposal, and one agreed with the concept but said the fee should be passed along to the unregistered solicitors and suggested $750 per entity (to match IB dues). Another FDM objected to this approach, suggesting that NFA should instead strengthen its efforts to get FDMs to self-monitor their unregulated solicitors.7 The proposed mix of increased dues, a separate fee to cover the expense of monitoring unregulated solicitors and account managers, and a transaction fee provides the best balance between the resources NFA spends on individual firms and the size of an FDM's forex business. The total amount NFA recovers will depend on the number of FDMs, the volume of their business, and the number of solicitors they employ-the same factors that dictate the resources NFA spends on these firms. Although it is difficult to project forex revenue with precision, we are confident that this should recover NFA's regulatory costs.
1 This distinction is based on the fact that NFA does not have to do as comprehensive an audit for exchange-member FDMs. Although we review the firm's forex activities, the exchange does most of the financial testing.
2 Under the original dues schedule, FDMs with revenue of $100,000 or less paid normal FCM dues, those with revenue over $100,000 but not more than $1.5 million paid an additional $5,500, and those with revenue over $1.5 million paid regular FCM dues plus $12,500.
3 The other commenter did not address this part of the proposal.
4 The fee would not apply to transactions by eligible contract participants since NFA does not regulate those transactions.
5 Although aggregating transactions would make it harder to pass on the fee, this is designed to ensure that customers do not pay NFA fees that are a significant percentage of their transactions.
6 Compliance Rule 2-36(d) does not, however, cover Members or Associates of NFA, otherwise regulated entities (e.g., broker-dealers), or entities that would be exempt from registration for on-exchange activities (e.g., foreign entities that solicit only foreign customers). The proposed fee would exclude these same entities.
7 The other three commenters did not address this part of the proposal.