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NFA Financial Requirements Section 11 ("Section 11") sets forth the financial requirements for Forex Dealer Members ("FDMs"). In February 2006, NFA's Board increased the minimum net capital requirement for FDMs to $1 million. After continued experience with FDMs and their activities in the off-exchange foreign currency ("Forex") market, NFA is amending Section 11 to raise the minimum capital requirement to $5 million.
Over the last twenty years, FCM insolvencies-which may cause significant harm to customers and substantially damage the futures industry's reputation-have been extremely rare. Since 1990 there were only two insolvencies by traditional FCMs trading on U.S. exchanges. In recent years, however, one type of FCM-FDMs-has been the exception to this trend. Of the four bankruptcy or receivership proceedings for insolvency occurring in the last four years, three have involved FDMs.1
The discrepancy between FDMs and traditional FCMs involved in on-exchange transactions is even greater when looking at the number of financial MRAs issued in the last ten years. During that period, NFA issued fifteen MRAs to FCMs for failing to demonstrate compliance with NFA financial requirements. Three of these firms were traditional FCMs with on-exchange business, one was a forex dealer registered as an FCM prior to the advent of the FDM category, and the remaining eleven were FDMs. In addition to these MRAs, since March 2007, nine different FDMs have fallen under the early warning requirement of $1.5 million.
NFA's concern that one day an FDM might be unable to meet its financial obligations to its customers has heightened as the amount of retail customer funds held by FDMs has increased to over $1 billion. The FDMs' insolvencies have done nothing to abate this concern, particularly with two of the FDMs' insolvencies occurring just months after the $1 million capital requirement became effective. If the receiver had not sold the FDMs customer accounts, then it is likely that three times within less than four years customers of FDMs would have lost funds due to an FCM insolvency.
One of the reasons for the 2006 increase to the FDM capital requirements was that an FDM's dealer activities create greater financial risks than the agency transactions involved in traditional exchange-traded futures and options. A second reason was that the need for adequate capital is particularly acute for FDMs since customers trading off-exchange forex have not received a priority under the Bankruptcy Code in the event of a firm's insolvency. Both of these reasons still exist.
NFA is not alone in recognizing the increased financial risk of acting as a dealer. Congress has recognized that acting as a dealer increases financial risk and requires substantially higher capital on the part of the dealer. Pursuant to Section 4c(d)(2)(A) of the Commodity Exchange Act (the "Act"), the grantor of a dealer option must maintain at all times a net worth of $5 million. The Commission has likewise recognized the increased financial risk resulting from being a dealer, imposing an adjusted net capital requirement of $2,500,000 on leverage transaction merchants ("LTMs").
When the Commission adopted the financial requirements for LTMs in 1984, it noted that the leverage market is "essentially a principals' market" and that the "purchaser of a leverage contract is solely dependent on the LTM for performance on the contract."2 This is the exact same situation that customers are in when they purchase or sell currencies with an FDM. Further, as with an LTM, an FDM "takes the other side of every [contract] entered into by a [customer]" and the FDM "is the sole guarantor of performance on the [contract]." When trading with an FDM "there is no clearing organization to take the other side of every trade, no FCM guaranty of variation margin to the clearing organization and no clearing organization guaranty fund and assessment power."3 Due to these factors, the financial requirements for FDMs, like LTMs, must be substantially higher than those for FCMs engaging in agency transactions.
The Commission imposed the $2,500,000 capital requirement for LTMs in 1984. Based upon the Consumer Price Index, $2,500,000 in 1984 dollars would be worth approximately $5 million today. Accordingly, NFA is raising the minimum adjusted net capital for FDMs to $5 million.4 An increased capital requirement would result in an FDM having a larger buffer to meet its obligations to its customers and would ensure that FDMs have a larger financial stake in their forex business.
Currently, NFA's Financial Requirements impose a concentration charge on significant positions with unregulated counterparties, including customers. The charge is designed, in part, to ensure that an FDM has sufficient capital to pay any losses even if it cannot collect profits due to counterparty defaults. This charge has proven unwieldy for both FDMs and NFA staff and consumes a significant amount of NFA audit resources. NFA reviewed this concentration charge over the past several months and solicited comments from FDMs. At least one FDM suggested that it would make more sense to impose a higher capital requirement on FDMs than a concentration charge.
While revision of the concentration charge was not the impetus for raising the capital requirements, a higher capital requirement may obviate the necessity for applying the concentration charge. The concentration charge provides a buffer against counterparty credit risk. Since the increased capital requirement also increases the buffer of funds available to pay customer losses in the event that an FDM becomes undercapitalized and subsequently goes out of business, NFA is eliminating the concentration charge and replacing it with a strict limitation on the types of firms with which an FDM may maintain assets and cover its exposure for purposes of CFTC Regulation 1.17.
Under the new requirements, an FDM may not include assets held by an unregulated person or affiliate in its current assets for purposes of determining its adjusted net capital unless the unregulated person or affiliate qualifies for an exemption under current NFA Financial Requirements Section 11(b) and 11(c), respectively. Similarly, positions entered into to cover an FDM's exposure could not be counted for purposes of avoiding the haircuts imposed by CFTC Regulation 1.17 unless the counterparty is an entity that qualifies for an exemption under current NFA Financial Requirements Section 11(b). Under that provision, entities that qualify for an exemption include-U.S. banks; NASD-member broker-dealers; NFA-Member FCMs; state-regulated insurance companies; banks, broker-dealers, FCMs, and insurance companies regulated in certain foreign jurisdictions; and other entities approved by NFA.
Positions entered into with an affiliate to cover an FDM's exposure could not be counted for purposes of avoiding the CFTC haircut unless NFA has issued an exemption for the affiliate under the more limited circumstances that currently qualify for an affiliate exemption under NFA Financial Requirements Section 11(c). Customer positions on the FDM's platform could be netted against each other, but this netting could not include positions with affiliates.
NFA sought comments from FDMs on the proposed increase in the capital requirement and the elimination of the concentration charge. NFA received sixteen comments regarding the proposal. Eight commenters supported the increased capital requirement and eight opposed it.
The comment letters that opposed the proposal noted that it will likely eliminate a number of the smaller FDMs. These smaller FDMs will be, obviously, those with less capital. The comment letters in opposition also noted that more capital does not necessarily mean that an FDM is better able to support and properly operate its forex activities. While more capital does not necessarily correlate to "better" FDMs, more capital does mean that they will have, at a minimum, a greater financial stake in running their forex businesses.
One comment letter also noted that an FDM's risk-management and operational internal controls are more important than the amount of capital an FDM has. NFA agrees that an FDM's internal controls are important and, under separate cover, NFA is submitting for Commission approval a new rule to ensure that FDMs have proper internal controls.
A number of the FDMs in their comment letters argued that the comparison to LTMs is not appropriate because of differences between leverage and forex contracts (e.g., contract duration and liquidity). The comparison is appropriate, however, because in both cases the firm is acting as a dealer rather than an agent. One of these FDMs also expressed a belief that a higher capital requirement will encourage FDMs to internalize order flow. NFA believes, however, that this risk is counterbalanced by the limitation on the use of affiliates to cover customer positions and the continuing application of the haircuts imposed by CFTC regulations on uncovered positions.
Several FDMs pointed to the recent MRAs and receivership proceedings as evidence that the current regulations are working. Regulating solely by enforcement proceedings is not the best way to protect customers, however. One of these FDMs claims that staff was unfair in its characterization of the problem with FDMs and forex. Specifically, this FDM pointed out that the number of bankruptcies involving traditional FCMs and FDMs is the same, with two of each.5 What this FDM does not recognize, however, is that the two traditional FCM bankruptcies occurred over a seventeen-year history of regulation, while those for FDMs has occurred in only a little more than seven years. Moreover, the traditional FCM population has average around 250 while the FDM population has averaged around 40.
A handful of comment letters stated that issues regarding bankruptcy would be better addressed by requiring segregation. As NFA has explained numerous times to the FDM community, however, any protections provided by segregation would be illusory without Congressional changes to the U.S. Bankruptcy Code.
Of the eight comments favoring the increased capital requirements, five also inquired about the effect this requirement would have on the security deposit exemption under NFA Financial Requirements Section 12(b). Financial Requirement Section 12(a) provides that an FDM must collect and maintain a minimum security deposit for each forex transaction, which is either 1% or 4% depending on the foreign currency. Financial Requirement Section 12(b) provides an exemption from this requirement for FDMs that maintain at least twice the amount of required minimum capital. The Foreign Exchange Industry Association and an FDM suggested that in light of the higher capital requirement the exemption be available to those FDMs that maintain greater than 150% of the required minimum capital. This is the same amount at which an FCM must file written notice with the CFTC pursuant to CFTC Rule 1.12(b), commonly referred to as the early warning requirement.
NFA's Board, however, believes that the security deposit is an important risk-management tool and that the current levels-which allow 1:100 leverage for major currencies and 1:25 leverage for all other currencies-are not burdensome. Therefore, the Board voted to retain the current requirement that an FCM maintain twice its required capital in order to receive the security deposit exemption.
1 The fourth FCM filed for bankruptcy not because customer funds were at risk but, rather, to facilitate the sale of its assets and the transfer of its accounts in connection with its parent company's insolvency.
2 49 Fed. Reg. 5498, 5512 (Feb. 13, 1984).
4 As of May 31, 2007, financial filings, twenty-five of the forty active FDMs have less than $5 million in adjusted net capital. Some of these firms may, of course, be able to infuse the additional funds.
5 This comment was received prior to the third Forex insolvency involving an FDM.