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EXPLANATION OF PROPOSED AMENDMENTSA) Explanation of New Interpretive Notice to NFA Compliance Rule 2-4 Regarding Broker-Dealer Registration Requirements for Security Futures Products
The Commodity Futures Modernization Act of 2000 ("CFMA") provides that security futures products are securities as well as futures and therefore are subject to regulation in both the futures and securities industries. As a result, NFA Members that solicit or accept orders or carry accounts for security futures products are also required to be registered as broker-dealers under the Securities Exchange Act of 1934 (Exchange Act). Any NFA Member that is not currently registered as a full broker-dealer under the Exchange Act may notice-register as a broker-dealer by filing form BD-N with NFA.
The proposed interpretive notice clarifies that it is a violation of NFA rules for an NFA Member to solicit or accept orders, carry accounts or otherwise act as a broker-dealer for security futures products unless the Member is properly registered as a broker-dealer under the Exchange Act.
B) Explanation of Proposed Amendment to NFA Compliance Rule 2-37 and Its Proposed New Interpretive Notice Relating to Fair Commissions
The CFMA authorized trading in single-stock and narrow-based index futures on a principal-to-principal basis on August 21, 2001 and on a retail, exchange-traded basis on December 21, 2001 if NFA meets certain conditions by those dates. One of these conditions is that NFA have rules comparable to the National Association of Securities Dealers' ("NASD") customer protection rules.
NFA Compliance Rule 2-37 was amended to add subsection (g) which is almost identical to the provisions of NASD Rule 2440 relating to agency transactions. Its proposed interpretive notice discusses these provisions in more detail and reassures NFA Members that most Members' current commission practices already comply with these requirements. For example, the interpretive notice explicitly notes that the following practices are acceptable under Compliance Rule 2-37(g): charging commissions based on costs plus a reasonable profit, taking the services provided by the Member into consideration when setting commissions, and negotiating commissions with institutional customers based on volume or similar measures. The interpretive notice is also consistent with NFA's traditional approach, which requires full disclosure of fees and commissions.
As with most of the other security futures rules, proposed Compliance Rule 2-37(g) and its interpretive notice will apply only to FCMs and IBs who notice-register as broker-dealers under Section 15(b)(11) of the Exchange Act. Dual registrants will presumably be subject to the NASD's requirements (i.e., Rule 2440 and IM-2440).
C) Explanation of New Interpretive Notice to NFA Compliance Rule 2-4 Regarding the Best Execution Obligation of NFA Members Registered as Broker-Dealers Under Section 15(b)(11) of the Securities Exchange Act of 1934
An August 21, 2001 SEC Order requires NFA to adopt a best execution rule (comparable to NASD Rule 2320) before retail, exchange trading can begin. Given the complexity of the issues relating to best execution, NFA staff formed a working group with representatives from the futures exchanges, FCMs, end users, a securities options exchange and an alternative trading system to help formulate a best execution interpretive notice. In formulating NFA's approach to best execution, the working group analyzed NASD Rule 2320's terms, how best execution works in the equity options markets, and the SEC's rules relating to order execution and routing. From the outset, the working group felt that NFA's approach to best execution should be an interpretation of NFA Compliance Rule 2-4, which imposes an obligation upon Members to put their customers' interests before their own when soliciting and executing futures transactions.
The proposed interpretive notice is designed to set forth a Member's best execution obligation yet provide Members with flexibility in meeting this obligation. The interpretive notice reiterates NFA Compliance Rule 2-4's obligation of all Members and Associates to put their customers' interests before their own when soliciting and executing futures transactions. In those cases where a customer's order may be executed on two or more markets trading security futures contracts that are not materially different, Members and Associates have an obligation to use reasonable diligence to ascertain the market in which the customer's security futures order will receive the most favorable terms and, in particular, the best price available under prevailing market conditions. The interpretive notice provides guidance on how to fulfill that obligation.
First, the interpretive notice makes clear that if a customer or customer's designee requests that a security futures order be directed to a particular market, then the Member or Associate is required to follow the customer's or designee's instructions. However, in the absence of customer instructions, a Member or Associate must consider the relevant facts and circumstances including, at a minimum, the following factors in discharging its obligation to use reasonable diligence in ascertaining where a customer's security futures order will receive the most favorable execution available:
- The character of the market including, but not limited to, price, volatility, liquidity, depth, speed of execution, and pressure on available communications;
- The size and type of transaction, including the type of order; and
- The location, reliability and accessibility to the customer's intermediary of primary markets and quotation sources.
Members and Associates must also consider differences in the fees and costs to customers ( e.g. transaction fees, clearing costs and expenses) associated with executing transactions in each market. Unless specifically instructed by a customer or customer's designee or necessary to obtain the execution of an order, a Member shall not channel an order through a third party unless the Member can show that by doing so the total cost or proceeds of the transaction were better than if the Member decided not to channel the order through the third party.
The interpretive notice also recognizes that it may be impracticable for Members and Associates to make order routing decisions for retail orders on an order-by-order basis. Members and Associates that do not make order routing decisions for retail orders on an order-by-order basis should, at a minimum, consider the above factors and the materiality of any differences among contracts traded on different markets when establishing their retail order-routing practices and perform a regular and rigorous review of those practices to ensure that their best execution obligation is fulfilled.
As with most of the other security futures rules, the proposed interpretive notice will apply only to FCMs and IBs who notice-register as broker-dealers under Section 15(b)(11) of the Exchange Act. Dual registrants will presumably be subject to the NASD's requirements (i.e., Rule 2320).