Speeches and Testimonies

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April 16, 2002


APRIL 16, 2002

[Note: This speech was given before a group of attorneys who work in the derivatives industry and understand something about the forex markets. For those of you who are not familiar with those markets, the term "forex" refers to transactions that are based on foreign currency exchange rates. Also, the Commodity Exchange Act does not cover transactions that result in the immediate delivery of a commodity (called "cash" transactions) or where the parties anticipate that the commodity will be delivered but have deferred delivery for business reasons (called "forward contracts"). Therefore, the statements made in this speech do not apply to actual purchases of foreign currencies for foreign travel or business use.]

Prior to 1974, the Commodity Exchange Act (CEA) only covered futures and options on domestic agricultural procucts listed in the CEA. When the CEA was amended in 1974 it was extended to include futures and options on "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." The CEA also required all futures contracts to be traded on an exchange and required intermediaries to register with the Commodity Futures Trading Commission (CFTC).

The United States Treasury Department was afraid that the CEA would affect the interbank market in foreign currencies and certain other financial products. In particular, the Treasury Department was concerned that the interbank market would have to cease functioning as an over-the-counter (OTC) market due to the exchange-trading requirement and that the CFTC would impose dual regulation on the banks that were active in the interbank market.

As a result of these concerns, Congress included an exemption in the 1974 amendments. This exemption, which is commonly referred to as the Treasury Amendment, simply said, "Nothing in this Act shall be deemed to govern or in any way be applicable to transactions in foreign currency [or several other listed products] unless such transactions involve the sale thereof for future delivery conducted on a board of trade."

At the time the Treasury Amendment was adopted, the players in the interbank market were banks, large financial entities, and other sophisticated customers. It was not a retail market, and these products were not normally offered and sold to retail customers.

Sometime after 1974, however, a number of boiler rooms opened up and started offering OTC foreign exchange futures and options to retail customers. These firms were breeding grounds for fraud, so the CFTC tried to shut them down. In response, the firms argued that their forex transactions were covered by exemption in the Treasury Amendment. The courts agreed, and the CFTC's hands were tied. This left a regulatory gap that needed to be plugged.

Commodity Futures Modernization Act of 2000
The 2000 amendments to the CEA included a compromise intended to plug the regulatory gap without interferring with the legitimate OTC forex market. The CFMA continued to fully exempt over-the-counter forex transactions between sophisticated persons. It did, however, impose some requirements on OTC forex transactions with retail customers.

The CFMA allows the sale of OTC forex futures and options to retail customers if, and only if, the counterparty (the person on the other side of the transaction) is a regulated entity. These regulated entities are listed in the CEA. They are:

  • financial institutions, such as banks and savings associations,

  • registered broker-dealers and certain of their affiliates,

  • registered futures commission merchants (FCMs) and certain of their affiliates,

  • insurance companies and certain of their affiliates,

  • financial holding companies, and

  • investment bank holding companies.

The CFTC does not have jurisdiction over the forex activities of these regulated entities, even when retail customers are involved. There is one exception, which I will discuss in a minute.

The CFMA gives the CFTC authority to shut down any unregulated entity that acts as a counterparty to forex futures or options transactions. As a result, a number of firms have registered, or are in the process of registering, as FCMs for the primary purpose of offering forex to retail customers.

The CFMA also gives the CFTC authority to go after registered FCMs and their affiliates for violating the anti-fraud and anti-manipulation provisions of the CEA in connection with OTC forex transactions involving retail customers. This is the exception I mentioned a moment ago. However, this exception only applies to FCMs who are not also included in one of the other regulated categories. It does not, for example, apply to an FCM who is also registered as a broker-dealer.

Although Congress had been looking at this issue for a while, the CFMA was finalized rather quickly in order to get it done in that session of Congress. As a result, Congress did not have much time to get industry input or think through all of the implications of the language it ended up adopting. Although the CFMA plugged part of the regulatory gap, it left a number of other regulatory gaps and uncertainties. Let me give you a few examples.

The CFMA appears to allow unregulated entities and unregistered individuals to solicit retail customers for forex transactions as long as they introduce those customers to a regulated entity that becomes the counterparty to the transaction. This is probably an unintended result that was overlooked as Congress scrambled to put the CFMA together.

The law is silent about trading advisors and fund managers. It probably allows them to manage accounts for and solicit fund participations from retail forex clients without being registered.

The CFMA does not require the banking, securities, or insurance regulators to actually regulate the retail forex activities of banks, broker-dealers, and insurance companies, nor did it amend the banking, securities, or insurance laws to make sure the regulators can take action against the firms they regulate if they engage in fraud in connection with these transactions. This may have been intentional, but it could have unintended consequences down the road.

For example, foreign currencies traded over-the-counter are not securities under the federal securities laws. Therefore, unless the firm pools the funds to invest in forex or there is some other specific arrangement that turns the transaction into a security, forex transactions are not securities and are not subject to SEC regulation.

We will just have to wait and see how these issues are resolved.

CFTC Initiatives
The CFTC has been very active in applying the CFMA to retail forex activities. According to a February 27, 2002 CFTC release, the CFTC has filed eleven enforcement actions against multiple firms and individuals since the CFMA became effective on December 21, 2000. In the aggregate, these firms had over 1,000 customers who lost in excess of $60 million in illegal retail forex transactions.

The CFTC has also issued several advisories regarding forex transactions. The latest advisory was issued in March and responds to a number of questions that have been raised as a result of the language in the CFMA.

The March advisory says that any person who merely introduces retail customers to a qualified counterparty is not required to register with the CFTC, except that employees of an FCM acting as a counterparty must register as associated persons. The advisory goes on to mention several situations where an unregulated person acts in a manner that suggests it is actually acting as a counterparty. In particular, a person may be acting as a counterparty if it:

  • uses promotional material that fails to identify the regulated counterparty or that fails to make it clear who the counterparty is,

  • receives funds in its own name,

  • acts as a conduit to return funds the regulated counterparty owes retail customers, or

  • does business with the regulated counterparty on less than a fully-disclosed basis.

As I see it, these four situations can be boiled down into two. A person is a counterparty, and has to fall within one of the regulated categories, if either 1) it leads the retail customer to believe that it is the counterparty, or 2) the transaction with the regulated person is actually a second transaction where the unregulated person passes on the risk it took by acting as counterparty to the transaction with the retail customer.

The advisory also talks about registration requirements for money managers. According to the advisory, a person exercising trading authority over retail forex accounts or soliciting investments in a collective investment vehicle that engages in OTC forex transactions is not required to register as a commodity trading advisor or a commodity pool operator. However, if the person is acting as a trading advisor, the retail customer's funds must be held by a regulated counterparty. In addition, if the customer is a retail customer and the counterparty is not a regulated entity, the person managing the funds may be liable for aiding and abetting a violation of the CEA.

Finally, the advisory says that firms may not operate trading platforms that allow retail customers to trade directly with each other. The forex transactions executed using these platforms are illegal because the counterparty is another retail customer rather than a regulated entity.

NFA Initiatives
As I mentioned, there are a number of firms that have become registered as FCMs for the primary purpose of offering forex contracts to retail customers. The CFTC has a regulation that requires all FCMs to be Members of NFA, so these forex firms are also joining NFA.

Obviously, NFA wants to protect retail customers from any fraudulent practices these Members might engage in. On the other hand, NFA does not want to impose any undue burdens on NFA members that are already highly regulated based on their other financial market activities. NFA has resolved the tension between these two objectives by creating a new membership category for FCMs whose retail OTC forex activities are a substantial portion of their business. As a result, NFA adopted two new rules, which are currently waiting for CFTC approval.

Proposed Bylaw 306 creates a separate membership category for Forex Dealer Members. A Forex Dealer Member is any NFA Member that generates at least 35% of its gross revenue by acting as a counterparty to OTC forex futures and options transactions with retail customers. In calculating the 35%, forex transactions that take place on an exchange or that involve sophisticated customers are included in the denominator but not the numerator. The denominator, however, is limited to financial market transactions where the Member acts as a counterparty or agent. In other words, revenue from selling research reports or trading programs does not count.

Proposed Compliance Rule 2-36 is a general anti-fraud rule that applies only to Forex Dealer Members. Compliance Rule 2-36 prohibits these Members from engaging in fraudulent activities in connection with forex futures and options transactions. It applies only to OTC futures and options transactions with retail customers.

NFA's proposed rules are broader than the CFTC's jurisdiction over retail OTC forex transactions. Some people have questioned how NFA can regulate transactions that the CFTC cannot regulate. The answer is simple. The CFTC's jurisdiction comes from the CEA, but NFA's jurisdiction comes from the contract between NFA and its Members.

Although NFA is a registered futures association under the CEA, it was not created by the CEA any more than any other registrant. And, as long as NFA does not engage in conduct prohibited by the CEA, it is just as free to make business decisions outside of the CEA.

What NFA can and cannot do is governed by NFA's Articles of Incorporation, which are part of the contract between NFA and its Members. Among other things, Article III authorizes NFA to "promote the improvement of business conditions and the common business interests of persons engaged in commodity futures or related activity" by regulating its Members. Article III then goes on to authorize NFA to adopt, administer, and enforce requirements as to registered FCMs regarding fair practice, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and in general, to protect the public interest. These provisions clearly allow NFA to regulate the forex futures and options activities of its FCM Members.

What will NFA do next? We are currently studying whether NFA should adopt other rules governing the conduct of Forex Dealer Members. We do not, however, anticipate extending our regulation to Members that do not qualify as Forex Dealer Members.

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