COMMODITY FUTURES TRADING COMMISSION
Table of contents
- NOTICE: Part II
- DOCID: fr20ja10-26
- DOCUMENT ACTION: Proposed rules.
- SUBJECT CATEGORY:
- DOCUMENT SUMMARY:
- SUPPLEMENTAL INFORMATION
- A. The Commodity Futures Trading Commission Act of 1974
- \9\ Id. at 1154.
- \11\ Id. at 42985.
- B. The Futures Trading Practices Act of 1992
- C. The Commodity Futures Modernization Act of 2000
- \32\ See, 7 U.S.C. 2(c)(2)(C)(iv).
- E. The Commission’s Proposed Rules
- A. Structure and Approach
- [[Page 3287]]
- 2. Part 4 of the Commission’s RegulationsCPOs and CTAs
- \57\ Regulation 4.7(a)(2)(i)(B).
- \58\ Regulation 4.12(b)(i)(C).
- C. New Part 5
- 1. Proposed Regulation 5.1Definitions
- 3. Proposed Regulation 5.3Registration
- \70\ See, 7 U.S.C. 2(c)(2)(B)(iv) and 2(c)(2)(C)(iii).
- \73\ See, 7 U.S.C. 2(c)(2)(B)(i)(II)(cc)(BB).
- \81\ See, proposed Regulation 5.5(e).
- 7. Proposed Regulation 5.8Aggregate Retail Forex Assets
- \84\ Defined in proposed Regulation 5.1(l).
- FOR FURTHER INFORMATION CONTACT
RIN ID: RIN 3038-AC61
NOTICE: Part II
DOCUMENT ACTION: Proposed rules.
Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries
DATES: Comments must be received on or before March 22, 2010.
The Commodity Futures Trading Commission (“Commission” or “CFTC”) is proposing to adopt a comprehensive regulatory scheme (“Proposal”) to implement the CFTC Reauthorization Act of 2008 (“CRA”) \1\ with respect to offexchange transactions in foreign currency with members of the retail public (i.e., “retail forex transactions”). The Commodity Exchange Act, as amended by the CRA, generally provides that the Commission’s jurisdiction extends to contracts of sale of a commodity for future delivery (or an option on such a contract) or an option (other than an option executed or traded on a national securities exchange), and to certain leveraged or margined contracts in foreign currency that are offered to or entered into with retail customers. The Commission is proposing a scheme that would put in place requirements for, among other things, registration, disclosure, recordkeeping, financial reporting, minimum capital, and other operational standards, based on both the CFTC’s existing regulations for commodity interest transactions and commodity interest intermediaries, as well as rules of the National Futures Association (“NFA”) that are already existing with respect to retail forex transactions offered by NFA’s members. Additionally, the Proposal would amend existing regulations as needed to clarify their application to, and inclusion in, the new regulatory scheme for retail forex. \1\ Food, Conservation, and Energy Act of 2008, Pub. L. 110246, 122 Stat. 1651, 21892204 (2008).
Commodity Futures Trading Commission
The CRA provides the Commission with broad authority to “make, promulgate and enforce such rules and regulations as, in the judgment of the Commission, are reasonably necessary to effectuate any of the provisions of [the Commodity Exchange] Act” in connection with offexchange foreign currency futures, options, and options on futures, as well as leveraged offexchange contracts offered to or entered into with retail customers.\2\ The Commission is given similarly broad authority to promulgate and enforce rules regarding registration of persons who solicit, exercise discretionary trading authority or operate or solicit funds in connection with any of these types of transactions.\3\
\2\ See, 7 U.S.C. 2(c)(2)(B)(v) and 7 U.S.C.
\3\ See, 7 U.S.C. 2(c)(2)(B)(iv)(III) and 7 U.S.C.
Pursuant to this authority, the Commission is proposing a scheme that would put in place requirements for, among other things, registration, disclosure, recordkeeping, financial reporting, minimum capital, and other operational standards, based on both the CFTC’s existing regulations for commodity interest transactions and commodity interest intermediaries, as well as rules of the National Futures Association (“NFA”) that are already existing with respect to retail forex transactions offered by NFA’s members.
Subject to certain exceptions (e.g., for certain regulated financial intermediaries not under the Commission’s jurisdiction as established in the CRA), the Proposal would require persons offering to be or acting as counterparties to retail forex transactions but not primarily or substantially engaged in the exchange traded futures business, to register as retail foreign exchange dealers (“RFEDs”) with the CFTC. Registered futures commission merchants (“FCMs”) that are “primarily or substantially” (as defined in the Proposal) engaged in the activities set forth in the Act’s definition of an FCM would be permitted to engage in retail forex transactions without also registering as RFEDs.
The Proposal would further require certain entities other than RFEDs and FCMs that intermediate retail forex transactions to register with the Commission as introducing brokers (“IBs”), commodity trading advisors (“CTAs”), commodity pool operators (“CPOs”), or associated persons (“APs”) of such entities, as appropriate, and to be subject to the Act and regulations applicable to that registrant category. In addition, the Proposal would require any IB that introduces retail forex transactions to an RFED or FCM to be guaranteed by that RFED or FCM.
The Proposal would also implement the $20 million minimum net capital standard established in the CRA for registering as an RFED or offering retail forex transactions as an FCM; propose an additional volumebased minimum capital threshold calculated on the amount an FCM or RFED owes as counterparty to retail forex transactions; and require RFEDs or FCMs engaging in retail forex transactions to collect security deposits in a minimum amount in order to prudentially limit the leverage available to their retail
customers on such transactions at 10 to 1.
A. The Commodity Futures Trading Commission Act of 1974
Congress created the Commission in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States by the enactment of the Commodity Futures Trading Commission Act of 1974.\4\ While the bill was being considered, the Department of the Treasury (“Treasury”) sent a letter to the Senate Committee with jurisdiction over the bill, expressing concerns that Treasury had regarding the effect that passage would have on the off exchange foreign currency (“forex”) market that existed at the time between large, institutional customers.\5\ The letter contained proposed language for the bill which would have maintained the status quo for institutional offexchange forex trading, leaving jurisdiction over onexchange trading in futures and options contracts on forex with the newlycreated Commission. The bill was subsequently amended to add the suggested language contained in Treasury’s letter, which was intended to give the Commission jurisdiction over retail forex transactions and to exclude from the Commission’s jurisdiction the off exchange, institutional “interbank” market in foreign currencies. This language, which has come to be known as the “Treasury Amendment,” provided that:
\4\ Public Law 93643, 88 Stat. 1389 (1974).
\5\ See, Letter from Donald L.E. Ritger, Acting General Counsel, Department of the Treasury, to the Hon. Herman E. Talmadge (July 30, 1974), reprinted at 1974 U.S.C.C.A.N. 5843, 588789.
Nothing in this Act shall be deemed to govern or in any way be applicable to transactions in foreign currency * * * unless such transactions involve the sale thereof for future delivery conducted on a board of trade.\6\
\6\ Id. at 51.
As is discussed below, over time, and on numerous occasions, the Commission and the courts have opined on the proper boundaries of this exclusion.
The Commission first addressed the possible scope of the Treasury Amendment with regard to offexchange transactions in securities issued by the Government National Mortgage Association (“GNMA”). In an interpretive letter issued by the Commission’s Office of General Counsel, Commission staff stated that the remarks by the Senate Committee were
an expression that regulation by the Commission is unnecessary where there exists an informal market among institutional
participants in transactions for future delivery in the specified financial instruments only so long as it is supervised by those agencies having regulatory responsibility over those participants. However, where that market is not supervised and where those transactions are conducted with participation by members of the general public, we do not understand the Committee to have intended that a regulatory gap should exist. In these circumstances, we believe the Commodity Exchange Act should be construed broadly to assure that the public interest will be protected by Commission regulation of those transactions.\7\
\7\ Dealers in GNMA Certificates as a Board of Trade, CFTC Staff Interpretive Letter No. 7712, [19771980 Transfer Binder] Comm. Fut. L. Rep. (CCH) ] 20,467 (Aug. 17, 1977).
The scope of the exclusion, again with regard to offexchange transactions in GNMA securities, was addressed by the U.S. Court of Appeals for the Seventh Circuit (“Seventh Circuit”) when it determined that the Treasury Amendment did not exclude options on government securities from the Commission’s authority.\8\ Specifically, the court determined that although trading in GNMA securities was excluded from the Commission’s jurisdiction, trading in options on such instruments was within the Commission’s authority. As the court stated: \8\ Board of Trade of Chicago v. SEC, 677 F. 2d 1137, 1154 (7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982).
From the legislative history, it is quite clear that the Treasury Amendment was adopted by Congress only to prevent dual regulation by the CFTC and bank regulatory agencies of the banks and other sophisticated institutions that ordinarily trade in financial instruments.\9\
\9\ Id. at 1154.
Following that discussion, in 1985, the Commission issued a Statutory Interpretation concerning the Treasury Amendment that specifically dealt with forex.\10\ Responding to reports that forex futures contracts were being offered to retail customers on an off exchange basis, under the assumption that such transactions were excluded from the Commission’s jurisdiction, the Commission reaffirmed and republished its views, as follows:
\10\ Trading in Foreign Currencies for Future Delivery, 50 FR 42983 (Oct. 23, 1985).
[T]he Commission wishes to make very clear that any marketing to the general public of futures transactions in foreign currencies conducted outside the facilities of a contract market is strictly outside the scope of the [Treasury] Amendment. As a result, such an offexchange offer or sale of futures contracts involving foreign currencies is unlawful under section 4(a) of the Act, 7 U.S.C. 6(a) (1982).\11\
\11\ Id. at 42985.
The boundaries of the Treasury Amendment were again tested in Salomon Forex v. Tauber,\12\ where a sophisticated investor sought to invalidate a multimillion dollar trading debt by claiming that the Treasury Amendment only excluded spot or forward forex transactions from the Commission’s jurisdiction, and that trading in offexchange futures and options were within the Commission’s regulatory authority. If such transactions were deemed to be within the Commission’s authority, then the transactions could only occur legally on an approved exchange. The Court determined that the Treasury Amendment excluded offexchange trading in futures and options as well as “spot” and “forward” transactions from the Commission’s authority, if it involved “sophisticated, largescale foreign currency traders.” \13\ Although this holding has sometimes been misinterpreted to imply that offexchange forex transactions with the general public were outside the Commission’s jurisdiction, this holding concerned only largescale traders and banks that made up the informal network of the foreign currency “interbank” market. Indeed, the Court itself noted that: “[t]his case does not involve mass marketing to small investors, which would appear to require trading through an exchange and our holding in no way implies that such marketing is exempt from the CEA.” \14\
\12\ 795 F. Supp. 768 (E.D. Va. 1992), aff’d, 8 F.3d 966 (4th Cir. 1993).
\13\ Id. at 978.
B. The Futures Trading Practices Act of 1992
The Futures Trading Practices Act of 1992 reorganized certain sections of the Commodity Exchange Act, 7 U.S.C. 1, et seq. (2000) (the “Act”) and gave the Commission significant exemptive authority over the activities of a wide variety of persons, including FCMs, CTAs, and CPOs.
It was pursuant to this exemptive authority that the Commission addressed some aspects of the overthecounter (“OTC”) markets by adopting Part 35 of its regulations, which provides an exemption from regulation for certain swap agreements.\15\ However, the Commission did not use its newly
granted exemptive authority in the context of retail forex.\16\ \15\ See, Exemption for Certain Swap Agreements, 58 FR 5587 (Jan. 22, 1993).
\16\ See, e.g., Sections 4(c) and 4(d) of the Act, 7 U.S.C. 6(c) and 6(d).
Rather, the Commission’s efforts were directed to combating forex fraud activities through increased enforcement and public awareness. In response to increased fraud activity in the forex markets, the CFTC issued a fraud advisory to the public on March 30, 1998.\17\ Notwithstanding the Commission’s guidance and the legislative history, the ambiguity of the Treasury Amendment continued to present opportunities for defendants to challenge the Commission’s jurisdiction in the courts, which consumed much of the Commission staff’s time and resources.\18\ Unfortunately, these challenges would persist until the adoption of the Commodity Futures Modernization Act of 2000 (“CFMA”).\19\
\17\ Fraud Advisory from the CFTC: Foreign Currency Trading (Forex) Fraud, available at: http://www.cftc.gov/customerprotection/ fraudawarenessandprevention/fraudadvisories/fraudadv_forex.html. The Commission also issued brochures to alert customers to the possible scams involving forex fraud. See CFTC Brochure on Forex Fraud, available at: http://www.cftc.gov/enf/enfforex.htm and http://www.cftc.gov/stellent/groups/public/ @cpfraudawarenessandprotection/documents/file/enfforexbrochure.pdf (last visited Oct. 15, 2009).
\18\ For instance, in Dunn & Delta Consultants, Inc. v. CFTC, 519 U.S. 465, 469 (1997), the U.S. Supreme Court held that foreign currency options were “transactions in foreign currency” within the meaning of the Treasury Amendment.
\19\ Consolidated Appropriations Act of 2001, Public Law 106 554, App. E, 114 Stat. 2763 (2000), available at Commodity Futures Modernization Act of 2000, [20002002 Transfer Binder] Comm. Fut. L. Rep. (CCH) ] 28,433 (Dec. 21, 2000).
Under the Treasury Amendment, retail forex transactions were excluded from the Commission’s jurisdiction unless they were conducted on a “board of trade.” This broad phrase caused further confusion when courts tried to interpret its meaning in order to delineate where the Commission’s jurisdiction ended. The U.S. Court of Appeals for the Ninth Circuit (“Ninth Circuit”) relied on the language in the Senate Committee report to interpret the clause and believed that a proper reading of the Treasury Amendment excluded all offexchange forex transactionseven with retail customersfrom the Commission’s jurisdiction and that the Commission only had jurisdiction over forex transactions traded on organized exchanges.\20\ Other courts interpreting the same clause came to the conclusion that retail off exchange forex transactions were within the Commission’s jurisdiction and that the legislative history indicates that only large institutional trades were intended to be excluded from the Commission’s oversight.\21\
\20\ CFTC v. Frankwell Bullion Ltd., 99 F. 3d 299 (9th Cir. 1996).
\21\ See, CFTC v. Baragosh, 278 F.3d 319 (4th Cir. 2002), which relied on the Conference Committee Report, not mentioned in Frankwell Bullion, to arrive at the opposite conclusion from the Ninth Circuit; See also, CFTC v. Standard Forex, No. CV930088 (CPS). 1993 WL 809966 (E.D.N.Y. Aug. 9, 1993).
C. The Commodity Futures Modernization Act of 2000
The CFMA amended the Act to clarify the jurisdiction of the Commission in the area of forex futures and options trading. For the first time, offexchange retail forex transactions were expressly permitted, provided the counterparty was one of certain enumerated, regulated entities listed in the Acte.g., a registered FCM.\22\ Transactions between certain institutional entities (eligible contract participants, or “ECPs” \23\) remained outside the Commission’s jurisdiction altogether, based on several provisions of the Act and the Commission’s regulations.\24\ Shortly after the adoption of the CFMA, however, the Commission and the National Futures Association (“NFA”) \25\ noted that firms were registering as FCMs but not engaging in any exchangetraded activities. Rather, they were limiting their activities solely to retail forex. Additionally, the Commission noted that firms were registering as FCMs but conducting retail forex transactions through unregistered affiliates. Nothing in the Act or CFMA’s amendments to the Act prohibited these “shell FCMs” from conducting business through their unregistered affiliates.
\22\ See, 7 U.S.C. 2(c)(2)(B). Broadly stated, these entities included: (1) A financial institution; (2) a registered broker/ dealer (“BD”) or FCM; (3) an insurance company; (4) a financial holding company; and (5) an investment bank holding company. \23\ Section 1(c)(12) of the Act defines the term “eligible contract participant.” Entities classified as ECPs include financial institutions, insurance companies, certain commodity pools and individuals who meet certain asset thresholds. NonECPs, generally speaking, are retail customers.
\24\ For example, Section 2(d) provides that most sections of the Act do not apply to derivative transactions between ECPs; Section 2(g) provides that most sections of the Act do not apply to swap transactions between ECPs; and the Part 35 safe harbor for swap agreements, which predates the CFMA, provides another basis for excluding jurisdiction.
\25\ NFA is a registered futures association, pursuant to Section 17(b) of the Act. It is an industrywide, selfregulatory organization for the U.S. futures industry.
Although the CFMA provided some additional clarity for offexchange retail forex transactions, it did not provide the Commission with rulemaking authority, and the Commission was thus required to provide guidance to allow participants to navigate the statute. For instance, Advisory 0601 made clear that the Commission had jurisdiction over retail forex and only certain financial institutions that are enumerated in the Act could act as counterparties for retail customers in that regard. Similarly, Commission staff issued an Advisory in 2002 which sets out parameters for unlicensed intermediaries, such as pool operators, account managers and introducers, in retail forex transactions.\26\ Most recently, in August 2007, Commission staff issued an Advisory that addressed the following areas: registration of associated persons (“APs”) of FCMs, CPOs and introducing brokers (“IBs”); permissible unregistered forex affiliates; segregated funds; guaranteed IBs; combined account statements for forex and exchange traded futures; and forex trading platforms.\27\
\26\ Division of Trading and Markets Advisory Concerning Foreign Currency Trading by Retail Customers, available at: http:// www.cftc.gov/stellent/groups/public/@cpfraudawarenessandprotection/ documents/file/forex_advisoryretailcustomers.pdf (last visited Oct. 13, 2009).
\27\ Division of Clearing and Intermediary Oversight Advisory Concerning Retail OffExchange Foreign Currency Trading, available at: http://www.cftc.gov/stellent/groups/public/ @cpfraudawarenessandprotection/documents/file/forex_
advretailcustomers2007.pdf (last updated August 30, 2007).
Following passage of the CFMA, legal challenges to the Commission’s jurisdiction persisted and certain courts began to analyze the elements of a futures contractthe basis of the Commission’s jurisdiction over offexchange retail forex transactionsusing new criteria. Some firms began offering to retail customers transactions that had the elements of futures contracts, but that were marketed as “spot” transactions. However, unlike true spot transactions where delivery is contemplated, these transactions were “rolled over” at expiration (generally within a few days) and carried forward indefinitely. These “rolling spot” or “lookalike” contracts were the basis of many forex fraud cases brought by the Commission. However, the Commission’s ability to pursue fraud in this area was put in doubt by the decision of the Seventh Circuit in CFTC v. Zelener.\28\ The Zelener case
introduced a different framework for analyzing what constitutes a “spot” transaction and created confusion about the applicability of the CFMA to certain retail forex transactions. This departed from a line of previous nonforex cases that distinguished between futures and spot or forward contracts based on a multifactor analysis of the economic elements in the contract.\29\
\28\ CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), reh’g and reh’g en banc denied, CFTC v. Zelener, 387 F.3d 624 (7th Cir. 2004). The U.S. Court of Appeals for the Sixth Circuit relied on Zelener when it issued its opinion in CFTC v. Erskine, 512 F.3d 309 (6th Cir. 2008), determining that the foreign currency contracts at issue were not futures contracts and upholding the district court’s summary judgment against the Commission for lack of jurisdiction. \29\ See, e.g. CFTC v. Co Petro Mktg. Group, Inc. 680 F.2d 573 (9th Cir. 1982).
The court in Zelener determined that the contracts at issue were not offexchange futures contracts, but rather contracts in the commodity itself, and thus excluded from the Commission’s jurisdiction. The Seventh Circuit declined to rehear the case en banc and a split of authority among the circuits was created. Some courts continued to follow the traditional multifactor test while others followed the Zelener approach and only considered the language within the four corners of the contract.\30\
\30\ See, e.g., CFTC v. UForex Consulting, LLC, 551 F.Supp.2d 513 (W.D.La. 2008); CFTC v. Erskine, 512 F. 3d 309 (6th Cir. 2008). D. The Commodity Futures Trading Commission Reauthorization Act of 2008
The CRA \31\ was intended, among other things, to further clarify the Commission’s jurisdiction in the area of retail forex, particularly in light of the proliferation of lookalike forex transactions such as those in the Zelener and Erskine cases, and to give the Commission additional authority to regulate retail forex transactions and to register persons involved in intermediating these products with members of the public. To remedy the large number of fraud cases where jurisdiction had been questioned, the CRA gave the Commission jurisdiction over certain leveraged retail foreign exchange contracts without regard to whether it could prove the contracts were off exchange futures contracts.\32\ The CRA thus grants the Commission antifraud authority in leveraged retail forex transactions even if the transactions at issue are not futures or options. This allows the Commission to protect the public from fraud and provides a workable solution to the split in the decisions in the Federal appellate courts regarding when a socalled “spot” contract is a futures contract. \31\ Food, Conservation, and Energy Act of 2008, Public Law 110 246, 122 Stat. 1651. 21892204 (2008).
\32\ See, 7 U.S.C. 2(c)(2)(C)(iv).
The CRA also created a new category of registrant, the retail foreign exchange dealer, or “RFED,” and gave the Commission rulemaking authority over, and required registration of, intermediaries engaging in retail forex.\33\ The CRA provided that RFEDs and these other intermediaries must be NFA members and must register with the Commission subject to such terms as the Commission may prescribe.\34\ Among other requirements, the CRA established a $20 million minimum capital requirement for RFEDs and FCMs that offer retail forex.\35\ \33\ Previously, firms serving as counterparties to retail forex typically registered as FCMs (if they were not included in any of the other permissible categories), even though they did not engage in exchangetraded futures business, and thus did not meet the statutory definition of an FCM.
\34\ See, 7 U.S.C. (2)(c)(2)(B)(i)(II)(gg). The Commission plans on delegating the registration function for RFEDs to NFA, as is the case with the registration of FCMs, IBs, CTAs, CPOs and APs. \35\ See, 7 U.S.C. (2)(c)(2)(B)(ii).
The grant of authority over lookalike forex contracts is very broad and is intended to encompass transactions that do not result in actual delivery, or for which no legitimate business purpose exists for the customer to enter into the transaction. It is not intended to interfere with the large, sophisticated interbank market or to place additional requirements on businesses with a need to engage in forex transactions in connection with their legitimate business activities.
The CRA further provides that lookalike forex contracts are subject to the CFTC’s authority if they are offered on a leveraged or margined basis, or financed by the offeror, counterparty, or someone acting with the offeror or counterparty.\36\ The Commission’s authority, however, does not extend to securities, or to contracts that result in actual delivery within two days or that create an enforceable obligation to deliver between buyer and seller that have the ability to deliver or accept delivery in connection with their line of business.\37\ Thus, the CRA charges the Commission with regulating speculative forms of retail forex trading, but excludes from the Commission’s purview true spot transactions that have a legitimate business purpose or that result in actual delivery.
\36\ See, 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).
\37\ See, 7 U.S.C. 2(c)(2)(C)(i)(II)(bb)(AA); H.R. Rep. No. 110 627, at 979 (2008) (Conf. Rep.).
The Commission is proposing these regulations pursuant to separate authority provisions of the CRA with respect to the participants in the forex market and with respect to the transactions themselves. Off exchange forex futures and options transactions are subject to numerous provisions of the Act including sections 4(b), 4b, 4c(b), 4o, 6(c) and 6(d),\38\ 6c, 6d, 8(a), 13(a), 13(b), if they are offered or entered into by an FCM, an RFED, or an affiliate of an FCM that is not one of the otherwise regulated entities specified in the Act.\39\ The same provisions apply to lookalike forex transactions.\40\
\38\ Although the Commission had jurisdiction with regard to market manipulation in prior versions of the Act, the CRA removed that authority with regard to sections 6(c) and 6(d). All other cited sections remain in full effect.
\39\ See, 7 U.S.C. (2)(c)(2)(B)(iii). In addition to the sections included in the CFMA for forex futures and options transactions, the CRA adds sections 4(b), 4o, 13(a), and 13(b). \40\ See, 7 U.S.C. (2)(c)(2)(C)(ii)(II).
Notwithstanding the grant of authority with regard to certain sections of the Act specified above, the Commission has full rulemaking authority over the agreements, contracts or transactions in retail forex where “reasonably necessary to effectuate any of the provisions or to accomplish any of the purposes of [the] Act.” \41\ The Commission has full rulemaking authority over the futures and options transactions where such transactions are offered or entered into by FCMs, their affiliates or RFEDs; \42\ and retains rulemaking authority with regard to lookalike transactions only where such transactions are offered or entered into by RFEDs.\43\
\41\ See, 7 U.S.C. 2(c)(2)(B)(iv)(III); 2(c)(2)(B)(v); (2)(c)(2)(C)(ii)(III); (2)(c)(2)(C)(iii)(III).
\42\ See, 7 U.S.C. (2)(c)(2)(B)(v).
\43\ See, 7 U.S.C. (2)(c)(2)(C)(ii)(III).
E. The Commission’s Proposed Rules
In proposing the following rules, the Commission has endeavored, wherever possible, to apply the principles that have guided it in the regulation of onexchange instruments. Thus, many of the concepts in the proposed rules will be familiar to industry participants and practitioners. There are, however, essential differences between the trading of futures contracts on designated contract markets (“DCMs”) that are cleared through Commission registered derivatives clearing organizations (“DCOs”) and offexchange transactions between forex firms and retail customers. Many of the statutory and regulatory safeguards that are a critical feature of the trading and clearance of transactions in futures and options on futures on DCMs and DCOs, respectively, simply are not present in offexchange retail forex transactions.
The Commission’s proposed regulations are designed to deal with those differences, including the principaltoprincipal nature of the transactions and the inherent conflicts of interest between the retail customer and the marketmaker/counterparty. In
the nine years since the passage of the CFMA, the Commission has observed a number of improper practices that have raised concern, among them solicitation fraud, a lack of transparency in the pricing and execution of transactions, unresponsiveness to customer complaints, and the targeting of unsophisticated, elderly, low net worth and other vulnerable individuals.\44\
\44\ Between December 2000 and September 2009, the Commission has filed 114 forexrelated enforcement actions on behalf of more than 26,000 customers. Those efforts have thus far resulted in the award of approximately $476 million in restitution and disgorgement, and $576 million in civil monetary penalties. An overwhelming majority of these cases have involved solicitation fraud.
In addition to the regulations explicitly mandated by the CRA including new registration requirements \45\ and enhanced financial requirementsthe proposed regulations will require forex registrants to maintain records of customer complaints; require forex
counterparties to guarantee the performance of all persons who introduce accounts to the counterparty; require counterparties to disclose, with the Risk Disclosure Statement, the percentage of profitable nondiscretionary forex customer accounts; and require forex counterparties to designate a chief compliance officer to be responsible for development and implementation of customer protection policies and procedures.
\45\ The Commission’s proposed regulations include registration requirements for all persons engaged in the solicitation or acceptance of orders for retail forex transactions involving non ECPs, the exercise of discretionary trading authority in such transactions, or the operation or solicitation of funds for pooled investment vehicles in connection with such transactions.
Accordingly, the proposed rules include requirements that such persons become registered as CTAs, CPOs or IBs, as appropriate. The Commission is aware that the statutory definitions of these entities do not anticipate persons engaged in offexchange activities. The Commission has determined, however, that pursuant to its plenary power to regulate such offexchange retail forex transactions in section 2(c) of the Act, it will entrust such transactions only to persons registered as CTAs, CPOs and IBs, inasmuch as these are categories of registrants with which the Commission and the public are already familiar. This will allow the Commission to regulate offexchange retail forex transactions efficiently and effectively. For example, the proposed regulations would make use of the established standards for registration and denial of registration contained in the Act as well as the Commission’s previous
interpretations of these standards. See 41 FR 44560 at 4456162 (Oct. 6, 1976).
As noted above, the Commission believes that these additional requirements are militated both by the essential differences between onexchange transactions and offexchange retail forex transactions, and the history of fraudulent practices in this sector of the forex market.
II. SectionbySection Analysis
A. Structure and Approach
The CRA requires the Commission to register and regulate specified persons who intermediate offexchange retail forex transactions. In order to comply with this mandate, the Commission must adopt regulations providing for the registration of RFEDs and other off exchange retail forex intermediaries not excluded from Commission jurisdiction, and must specify the financial, operational and other requirements applicable to persons so registered. To the extent practicable, the Commission has endeavored to assemble the new off exchange retail forex provisions in a single new part of the Commission’s regulations, proposed to be designated part 5.\46\ The goal is to provide a single convenient location for regulations applicable to offexchange retail forex transactions and
intermediaries. Unfortunately, developing a completely selfcontained part of the Commission’s regulations that would contain all of the off exchange retail forex regulations is not practicable because it has also been necessary to draft amendments to various provisions of existing regulations maintained in other parts of 17 CFR Chapter 1. Among the reasons for these proposed additional amendments are the following: (1) Some regulatory provisions of general application name the specific registration categories they affect, and do not presently refer to RFEDs; (2) persons registered under certain existing registration categories (e.g., FCMs) will be able to engage in off exchange retail forex transactions under those existing registrations, subject to additional requirements, and restating the requirements pertaining to those registration categories in part 5 would be unwieldy; \47\ and (3) certain existing regulatory provisions that should apply to offexchange retail forex transactions and to the persons engaging in them are worded in terms of onexchange futures and commodity options transactions, and not in a way that would encompass offexchange retail forex transactions.
\46\ Former part 5 (Designation of and Continuing Compliance by Contract Markets) was removed and reserved. 66 FR 42256 (Aug. 10, 2001).
\47\ For example, essentially replicating the text of part 4 (which concerns CPOs and CTAs) within the new part 5 in order to cover providers of forex trading advice and operators of pooled forex trading vehicles would have needlessly increased the volume of the Commission’s regulations, when a simple incorporation of the same requirements by reference accomplishes the same purpose. B. Proposed Amendments to Existing Regulations
Many of the proposed amendments to regulations outside of proposed part 5 amount to merely adding references to offexchange retail forex transactions, offexchange retail forex customers and/or RFEDs to existing regulations.\48\ Accordingly, those proposed amendments will not be separately discussed. Other proposed amendments, however, involve a substantive change to the existing regulation because the existing regulation must operate differently in the context of off exchange retail forex trading.\49\ These substantive changes are discussed below.
\48\ See, proposed amendments to Regulations 1.4, 1.35, 1.36, 1.37, 1.40, 1.52, 1.65, 3.1, 3.4, 3.10, 3.12, 3.21, 3.30, 3.31, 3.33, 3.44, 3.45, 3.50, 3.60, 4.23, 4.25, 4.30, 4.33, 10.1, 160.1, 160.3, 160.4, 160.30 and 166.2.
\49\ See, proposed amendments to Regulations 1.1, 1.3, 1.10, 1.46, 3.1, 4.7, 4.12, 4.13, 4.14, 4.24, 4.34 and 166.5. In several instances, staff took the opportunity of this review and proposed rulemaking to propose deletion of obsolete material that either refers to already deleted regulatory provisions or has become outdated due to the passage of time. See proposed amendments to Regulations 1.52, 3.12, 3.31 and 160.18.
1. Part 1 of the Commission’s RegulationsGeneral Regulations
a. Regulation 1.1Fraud in or in connection with transactions in foreign currency subject to the Commodity Exchange Act.
This existing provision is specific to offexchange retail forex transactions. Consistent with the concept of a selfcontained off exchange retail forex part of the regulations, existing Regulation 1.1 is proposed to be deleted and its content to be incorporated into Regulation 5.2 of proposed part 5.
b. Regulation 1.3Definitions.
The definition of “guarantee agreement” is proposed to be amended to take account of IBs who may be guaranteed by RFEDs.\50\ The definition of “commodity interest” is proposed to be amended to include offexchange retail forex transactions over which the Commission has jurisdiction by virtue of the CRA.\51\ Including off exchange retail forex transactions within the “commodity interest” definition permits a wide range of provisions, especially within part 4 of the Commission’s regulations, to apply to such transactions without the need to separately revise each provision to expressly address off exchange retail forex, as well as futures contracts and commodity options.\52\
\50\ Regulation 1.3(nn).
\51\ Regulation 1.3(yy).
\52\ See, e.g., Regulation 4.6 as well as various provisions of Regulations 4.22 (reporting to pool participants), 4.23 and 4.33 (recordkeeping), and 4.24 and 4.34 (required disclosures).
c. Regulation 1.10Financial reports of futures commission merchants and introducing brokers.
Proposed new provisions would require all IBs and all applicants for registration as IBs in connection with retail offexchange forex transactions to enter into a guarantee agreement with an RFED or an FCM.\53\ To date, those persons who have introduced offexchange retail forex customers to counterparties have not been required to register as IBs, and fraudulent solicitation and sales practices have been commonplace. See supra note 46. The Commission believes that by requiring guarantee agreements between all offexchange retail forex IBs and the FCM/RFED counterparties to which they introduce off exchange retail forex customers, the counterparties will be forced to more carefully vet the persons who solicit business on their behalf and the practices those persons employ.
\53\ Regulations 1.10(a)(4), 1.10(j)(3), 1.10(j)(9)(i)(A)(2) and 1.10(j)(9)(i)(B)(2). See also, Proposed Regulation 5.18(h).
The Commission will be preparing a new Part C guarantee agreement to the Form 1FRIB, modeled on the guarantee agreement existing in Part B of Form 1FRIB, that will provide that FCMs and RFEDs that guarantee performance by an introducing broker that introduces off exchange retail forex transactions will be jointly and severally liable for all obligations of the introducing broker under the Act and Commission regulations with respect to the solicitation of, and transactions involving, all retail forex customer accounts of the introducing broker entered into on or after the effective date of the guarantee agreement. The Commission believes that the guarantee requirement serves the public’s interest in a marketplace where improper practices by IBs are discouraged while still permitting FCMs and RFEDs to make use of outside salespeople. An IB that is guaranteed by an FCM or RFED will not be subject to the minimum capital requirements set forth in Regulation 1.17(a)(1)(iii).
d. Regulation 1.46Application and closing out of offsetting long and short positions.
Like FCMs engaging in onexchange futures and option transactions under the existing regulation, RFEDs and FCMs engaging in offexchange retail forex transactions would be required to close out offsetting long and short positions in an offexchange retail forex customer’s account. But unlike existing Regulation 1.46, the requirement on RFEDs and FCMs engaging in offexchange retail forex transactions to close out offsetting positions would apply regardless of whether the off exchange retail forex customer has instructed otherwise.\54\ Also, unlike the existing provision for transactions in onexchange futures and option contracts, no exception is proposed for omnibus accounts because they are not used in offexchange retail forex trading. An RFED or FCM could, if permitted by the rules of a selfregulatory organization (“SRO”) of which the RFED or FCM is a member, offset at the retail forex customer’s request offexchange retail forex transactions of the same size, if the retail forex customer holds other transactions of a different size, but the RFED or FCM would be required to offset a transaction against the oldest transaction of the same size.\55\
\54\ NFA’s experience supports the conclusion that keeping open long and short positions in a retail forex customer’s account removes the opportunity for the customer to profit on the
transactions, increases the fees paid by the customer and invites abuse.
\55\ Regulation 1.46(a)(2).
2. Part 4 of the Commission’s RegulationsCPOs and CTAs
a. Regulation 4.7Exemption from certain part 4 requirements for commodity pool operators with respect to offerings to qualified eligible persons and for commodity trading advisors with respect to advising qualified eligible persons.
As proposed, in determining whether a person is a “qualified eligible person” (“QEP”) the NFAspecified minimum security deposit for offexchange retail forex transactions would be included in the calculation of the portfolio requirement.\56\ Such amounts are roughly equivalent to exchangespecified initial margin and option premium. In addition, in order to treat RFEDs and FCMs comparably, RFEDs would be included among the persons that do not have to meet the portfolio requirement to be QEPs.\57\
\56\ Regulation 4.7(a)(1)(v)(B).
\57\ Regulation 4.7(a)(2)(i)(B).
b. Regulation 4.12Exemption from provisions of part 4.
As proposed, the NFAspecified minimum security deposit for off exchange retail forex transactions would be included among the amounts that cannot exceed 10 percent of the fair market value of a pool’s assets in order for the operator to claim exemption under Regulation 4.12(b). Again, such amounts are roughly equivalent to onexchange initial margin and option premiums.\58\
\58\ Regulation 4.12(b)(i)(C).
c. Regulation 4.13Exemption from registration as a commodity pool operator.
As proposed, the NFAspecified minimum security deposit for off exchange retail forex transactions would be included among the amounts that cannot exceed 5 percent of the liquidation value of the pool’s portfolio in order for the operator to claim exemption from registration under Regulation 4.13(a)(3). Again, such amounts are roughly equivalent to initial margin and option premiums.\59\ \59\ Regulation 4.13(a)(3)(ii).
d. Regulation 4.14Exemption from registration as a commodity trading advisor.
As proposed, an RFED that provided trading advice solely in connection with its business as an RFED would be exempt from registration as a CTA. This is consistent with treating FCMs and RFEDs comparably, where appropriate.\60\
\60\ Regulation 4.14(a)(7)(ii). As noted in the Conference Report that accompanied the CRA, “To the extent their risk profiles are similar, the managers intend for FCMs and RFEDs to be regulated substantially equivalently in terms of their offexchange retail foreign currency business.” H.R. Rep. No. 110627, at 980 (2008) (Conf. Rep.). The Conference Report is available via the Internet on the CFTC’s website.
e. Regulations 4.24 and 4.34General disclosures required for CPO and CTA Disclosure Documents.
As proposed, the prescribed risk disclosure language for the front of the Disclosure Document would be required to include language warning that offexchange retail forex transactions may not be given the same preferential treatment as commodity customer claims under the Bankruptcy Code.\61\ This warning is necessary because definitions for such terms as “commodity contract,” “customer” and “customer property” in Subchapter IV of Chapter 7 of the Bankruptcy Code do not include or refer to offexchange transactions, generally, or to off exchange retail forex transactions or customers engaged in such transaction, specifically.\62\
\61\ Regulations 4.24(b) and 4.34(b).
\62\ 11 U.S.C. 761 et seq.
3. Part 166 of the Commission’s RegulationsCustomer Protection Rules
a. Section 166.5Dispute settlement procedures.
As proposed, the section of the Commission’s customer protection regulations dealing with dispute settlement procedures would be amended to expressly apply where a claim or grievance arises out of a retail forex transaction and the defined term customer would be amended to include
a retail forex customer.\63\ The existing text could be read to exclude customer claims arising out of retail forex transactions from coverage under Regulation 166.5.
\63\ Regulations 166.5(a)(1) and (a)(2).
C. New Part 5
As noted earlier, the proposed new part 5 to the Commission’s regulations is intended to permit, as much as possible, reference to a single portion of the regulations for matters concerning offexchange retail forex. Although it has been necessary to make changes to provisions elsewhere in the regulations, the Commission believes that in most cases, initial reference to part 5 should be sufficient to resolve questions (or to direct the reader by crossreference to the appropriate provision elsewhere).
1. Proposed Regulation 5.1Definitions
Proposed part 5 begins with a set of definitions of terms specific to offexchange retail forex and to the regulatory requirements that apply to offexchange retail forex. “Retail forex transaction” is defined by reference to the description in sections 2(c)(2)(B) and 2(c)(2)(C) of the Act. The proposed definition expressly excludes futures and commodity option contracts traded on a designated contract market or derivatives transaction execution facility.\64\ “Retail foreign exchange dealer” is defined as anyone who offers to be or who is a counterparty to a retail forex transaction, except for those persons excluded from the definition by the CRA.\65\ In order to apply the IB, CPO, CTA and AP registration and other requirements to analogous retail forex market participants, notwithstanding that statutory and regulatory definitions of the identifying terms do not necessarily comprehend involvement in retail forex trading, the terms are separately defined for the purposes of part 5.\66\ “Affiliated person of a futures commission merchant” (a term not previously defined in the Commission’s regulations) and an AP of such a person are defined by reference to section 2(c)(2)(B)(i)(II)(cc)(BB) of the Act.\67\ “Primarily or substantially” is defined for use in determining whether a registered FCM is primarily or substantially engaged in FCM activities, such that it need not also register as an RFED in order to conduct retail forex business.\68\ Certain terms used in determining the financial and reporting requirements applicable to persons engaged in retail forex business are also defined in Regulation 5.1 to clarify their use elsewhere in part 5.\69\
\64\ See, proposed Regulation 5.1(m).
\65\ See, proposed Regulation 5.1(h).
\66\ See, proposed Regulations 5.1(d), (e) and (f).
\67\ See, proposed Regulations 5.1(a) and (c).
\68\ See, proposed Regulation 5.1(g)
\69\ See, proposed Regulations 5.1(b), (i), (j), (k) and (l). 2. Proposed Regulation 5.2Prohibited Transactions: Antifraud
As noted above, under the proposal, existing Regulation 1.1 prohibiting fraud in connection with foreign currency transactions would be removed and replaced with new Regulation 5.2, which, in addition to prohibiting fraudulent conduct in connection with retail forex transactions, now prohibits anyone from acting as the counterparty for a retail forex transaction in an account for which that person has discretionary trading authority.
3. Proposed Regulation 5.3Registration
The CRA amends the Act to require that certain intermediaries for forex futures and options and for lookalike contracts (i.e., those at issue in Zelener) register in such capacity as the Commission shall determine and become members of a registered futures association.\70\ The Commission has determined that the appropriate registration categories for those intermediaries are as follows. Persons who solicit or accept orders for an RFED, an FCM, or an affiliate of an FCM should be registered as IBs. Persons who exercise discretionary trading authority over accounts should be registered as CTAs. Persons who operate or solicit funds or property for a pooled investment vehicle should be registered as CPOs. Finally, associated persons of the foregoing should be registered as APs. The proposed regulations include provisions to implement this part of the CRA.
\70\ See, 7 U.S.C. 2(c)(2)(B)(iv) and 2(c)(2)(C)(iii).
Prior to the passage of the CRA, many entities registered as FCMs solely to engage in retail forex transactions. The CRA provides that registered FCMs who currently trade retail forex may continue to do so as FCMs, or may be required to register as RFEDs, depending on their circumstances. A traditional FCM that is primarily or substantially engaged in exchangetraded futures business may continue to engage in retail forex as an FCM, and need not register as an RFED.\71\ Currently registered FCMs who solely trade in retail forex, or FCMs who are not primarily or substantially dealing in exchangetraded futures, will be required to register as RFEDs. Because there will be two categories of registrants competing for these customers, the stated Congressional intent is that an entity should not be advantaged or disadvantaged as a result of registering as an RFED instead of an FCM.\72\ The Commission has therefore endeavored to draft regulations that provide equivalent treatment of FCMs and RFEDs wherever possible.
\71\ The Commission is directed to determine, through notice and comment rulemaking such as this, what “primarily or substantially” means in this context. H.R. Rep. No. 110627, at 980 (2008) (Conf. Rep.); see also, Proposed Regulation 5.1(g).
\72\ See, H.R. Rep. No. 110627, at 980 (2008) (Conf. Rep.).
The enactment of the CFMA permitted registered FCMs and certain of their unregistered affiliates to act as counterparties to retail forex transactions, but it did not specifically require that intermediaries such as introducing brokers, account managers or pool operators be registered in order to engage in forex transactions with retail participants. This created problems when unregistered entities began soliciting retail customers. The lack of vetting by a regulatory agency or an SRO created a situation where members of the general public were being solicited by entities and persons regarding whom they were unable to obtain any background information. In some cases, persons banned from registering in the futures industry as a result of past misconduct were operating as unregistered intermediaries in retail forex transactions because of the lack of minimum requirements to operate in the forex business. Pursuant to the CRA, certain affiliates of FCMs may continue to be proper forex counterparties if the affiliated FCM makes and keeps the risk assessment records required in Section 4f(c)(2)(B) of the Act and the affiliate has at least $20 million in adjusted net capital.\73\ However, under the proposed regulations, the affiliates will have to register in the appropriate capacity in order to serve as a counterparty.
\73\ See, 7 U.S.C. 2(c)(2)(B)(i)(II)(cc)(BB).
Proposed Regulation 5.3 imposes the registration requirements called for by the CRA upon specified categories of persons intermediating retail forex transactions. RFEDs are required to register as such.\74\ FCMs not “primarily or substantially” engaged in FCM business are required to register as RFEDs,\75\ and FCM affiliated persons that serve as retail forex counterparties are also required to register as RFEDs.\76\ Persons introducing forex accounts are required to register as IBs.\77\ Operators
of pooled investment vehicles that engage in retail forex transactions are required to register as CPOs, and persons providing forex trading advice are required to register as CTAs.\78\ Finally, associated persons of all of the foregoing are required to register as APs. \74\ See, proposed Regulation 5.3(a)(6).
\75\ See, proposed Regulation 5.3(a)(4).
\76\ See, proposed Regulation 5.3(a)(1).
\77\ See, proposed Regulation 5.3(a)(5).
\78\ See, proposed Regulations 5.3(a)(2) and 5.3(a)(3).
The CRA’s registration requirements do not apply to certain otherwise regulated entities (e.g., brokerdealers), their associated persons, or persons who would be exempt from registration if they were engaging in such transactions on or subject to the rules of a contract market with regard to forex futures or options \79\ or lookalike contracts.\80\ This is consistent with the original intent of the Treasury Amendment that entities engaging in forex transactions should not be subject to regulation by multiple regulators concerning the same activity. Proposed Regulation 5.3 excludes from the registration requirement the persons specified in the CRA.
\79\ See, 7 U.S.C. 2(c)(2)(B)(iv)(II).
\80\ See, 7 U.S.C. 2(c)(2)(C)(iii)(II).
4. Proposed Regulation 5.4Operative Requirements for CPOs and CTAs
Proposed Regulation 5.4 applies all of the disclosure, recordkeeping, reporting and other existing requirements currently applicable to CPOs and CTAs in the context of onexchange futures and commodity option contracts to persons defined as, and required to register as, CPOs and CTAs because those persons operate pooled investment vehicles that engage in retail forex transactions or because they provide retail forex trading advice.
5. Proposed Regulation 5.5Risk Disclosure by FCMs, RFEDs and IBs
Proposed Regulation 5.5 requires RFEDs, FCMs and IBs to provide retail forex customers with a risk disclosure statement similar to that currently required by Regulation 1.55, but tailored to address the risks, conflicts of interest and unique characteristics of retail forex trading. For example, the required risk disclosure statement would also be required to disclose the number of nondiscretionary retail forex accounts maintained by an RFED or FCM, the percentage of such accounts that were profitable for each of the four most recent quarters, and a statement that past performance is not necessarily indicative of future results.\81\
\81\ See, proposed Regulation 5.5(e).
Under Section 2(c) of the Act, the Commission’s jurisdiction with regard to offexchange forex transactions extends to transactions involving entities that are not eligible contract participants as defined in Section 1a of the Act (i.e., retail customers). These transactions serve no broad price discovery function, and the Commission believes both that the vast majority of retail customers who enter these transactions do so solely for speculative purposes, and that relatively few of these participants trade profitably. Whether or not this is actually the case, the Commission believes that disclosure of the percentage of profitable accounts maintained by RFEDs and FCMs engaging in offexchange retail forex will provide the retail customer with vital information when deciding whether or not to engage in such transactions.
6. Proposed Regulations 5.6 and 5.7Minimum Financial Requirements
Under proposed Regulation 5.7, RFEDs and FCMs engaging in retail forex trading are required to meet the minimum net capital requirements prescribed in the CRA.\82\ Proposed Regulation 5.6 sets forth the “early warning” notification requirements pursuant to which RFEDs and FCMs engaging in retail forex trading are required to notify SROs and the Commission if an RFED or an FCM engaging in retail forex trading has experienced declines in capital, has discovered a material inadequacy in internal controls or has become undercapitalized.\83\ Because there is no equivalent to the futures regime of strict segregation of customer funds in offexchange retail foreign currency dealing, the notice requirement for RFEDs with respect to
undersegregation is not included in the proposed regulation. However, a requirement has been proposed that an RFED or FCM engaging in off exchange retail forex transactions give notice if it is holding liquid assets less than the aggregate retail forex obligation (as defined). The aggregate retail forex obligation is proposed to be the net obligation to all offexchange retail foreign currency customers at all times (excluding deficit accounts).
\82\ Analogous to Regulation 1.17 for FCMs trading only futures and commodity options.
\83\ The proposed requirement is analogous to existing Regulation 1.12 for FCMs that trade only onexchange futures and commodity option contracts.
The minimum net capital regulation for RFEDs and FCMs offering off exchange retail forex is proposed based on the significantly higher minimum net capital level for RFEDs and FCMs offering retail forex established in the CRA. The Commission believes that the higher level of $20 million reflects Congressional intent to ensure that substantially undercapitalized “shell” FCM offexchange retail forex dealers and their affiliates, from whom it may be impossible to recover funds in the event of customer claims, do not engage in offexchange retail forex activity. The existing regulation for the calculation of FCM net capital has been proposed for the calculation of net capital for RFEDs and FCMs offering offexchange retail forex, with the intent that an FCM offering retail forex should only have one calculation of its adjusted net capital. However, the CRA’s higher dollar threshold of minimum capital required, $20 million, will apply, as well as an additional early warning requirement of 110%, resulting in a notice reporting net capital level of $22 million. The proposed early warning level of 110% is lower than the FCM early warning level of 150% due to the substantially higher minimum dollar threshold established in the CRA, which results in an adequate minimum early warning “buffer” of no less than $2 million.
An amount of minimum net capital in addition to the minimum $20 million is proposed to the extent that an FCM or RFED has a total retail forex obligation in excess of $10,000,000. After that threshold, as proposed the FCM or RFED must have net capital of no less than $20,000,000 plus five percent of the total retail forex obligation in excess of $10,000,000. This proposal is intended to address concerns that, although the capital level contained in the CRA is believed to be high at $20,000,000, at particularly high levels of retail customer obligations there should be commensurate increases in an entity’s minimum required net capital. The NFA has enacted a similar requirement applicable to all its forex dealer members except those that only provide “straight through processing.” The Commission’s proposal has no exceptions for FCMs engaging in offexchange retail forex or for RFEDs.
Under the existing net capital regulation for FCMs contained in Commission Regulation 1.17, an FCM that becomes undercapitalized must immediately cease business and transfer its customers’ positions to another FCM, unless the Commission believes that it will be able to quickly remedy the situation, in which case the Commission may provide up to an additional 10 business days to return to compliance before ceasing business. Because the retail forex contracts at issue are not exchangetraded, and therefore, positions are not fungible among retail forex FCMs and RFEDs, should an RFED become undercapitalized, the [[Page 3290]]
Commission proposes that it either liquidate or transfer all off exchange retail forex accounts (with a transfer envisioned as a full novation of the retail forex contracts for such accounts by assignment and assumption of the contracts by another RFED or FCM) under the direction and supervision of the Commission or the entity’s designated selfregulatory organization (“DSRO”). The same 10 business day period has been proposed for the Commission or DSRO to delay such liquidation or transfer if determined appropriate. The proposal requires the refund or transfer of all funds associated with off exchange retail forex accounts contemporaneous with the liquidation or transfer. The possibility of an entity needing to refund all customers’ accounts and liquidate all positions in such circumstances makes it necessary to include a proposal to require such entity to maintain liquid assets available equal to the amount owed to offexchange retail forex customers.
Although not permissible to be counted as a liquid asset for fulfilling the requirement of Regulation 5.8, under the proposed net capital regulation, the unsecured receivable resulting from an RFED or FCM offsetting currency exposure with one of several enumerated parties (regulated financial intermediaries or foreign equivalents approved by NFA) will be treated as a current asset. The Commission proposes this, with the counterparty limitation, to balance an RFED’s or FCM’s need to hedge its net position from offering offexchange retail forex with the concern that such receivables are collectible for net capital purposes. Without this proposed addition to the net capital calculation, RFEDs and FCMs would have to take a 100% capital charge for such unrealized gains. The Commission understands that NFA, under subparagraph (c) of its Section 11 Financial Requirements for Forex Dealer Members, has been permitting existing forex dealer members to not take such a charge to the extent the counterparty has been considered regulated and approved by NFA, and is not an affiliate of the Forex Dealer Member. Thus, the Commission proposes that a DSRO be afforded the continuing ability to assess the appropriateness of counterparties for this purpose going forward, while making explicit the ability of an entity to cover the net exposure without the burden of a 100% net capital charge being applied. Also, the existing net capital charge with respect to options has been applied to offexchange retail forex transactions that are options. This net capital charge, with respect to the existing net capital regulation for FCMs, is derived from the SEC’s net capital charges for options that are not options on futures. Because these retail forex transactions are, by nature, offexchange transactions, the resulting charge under the SEC rule would be the charge for “unlisted” options. This charge is based on the notional transactional size of the option which may result in a very significant capital implication for retail forex transactions which are options. However, this result is consistent with the existing requirements for all offexchange or unlisted foreign exchange options for existing FCMs and brokerdealers.
7. Proposed Regulation 5.8Aggregate Retail Forex Assets
Proposed Regulation 5.8 requires RFEDs and FCMs engaging in retail forex transactions to compute the net credit balance resulting from combining all money, securities and property deposited by retail forex customers into their accounts, adjusted for realized and unrealized net profit or loss, and not including any accounts that contain net liquidating balances (the “retail forex obligation” of the RFED or FCM).\84\ Under proposed Regulation 5.8(a) each RFED or FCM engaging in retail forex transactions is required to hold assets of the type permitted under Regulation 1.25 equal to the retail forex obligation. Such assets would have to be maintained at one or more qualifying institutions in the U.S., or in money center countries (as defined in Regulation 1.49) where such countries have agreements acceptable to NFA that authorize sharing account information with NFA.
\84\ Defined in proposed Regulation 5.1(l).
The requirement to hold assets equal to the retail forex obligation is separate from the adjusted net capital requirement. In computing their adjusted net capital, pursuant to proposed Regulation 5.8(d), RFEDs and FCMs could not include assets held for purposes of complying with proposed Regulation 5.8(a) as current assets, or otherwise recording any property received from retail forex customers as an asset without recording a corresponding liability to such customers.
The requirement to maintain assets equal to or in excess of the retail forex obligation is intended to provide some degree of protection for customers in the absence of the protections afforded by the segregation of customer funds that is required in the context of futures and commodity options trading.\85\ The Commission recognizes that the retail forex obligation is not an equivalent substitute for the segregated funds regime, which cannot be replicated in the context of offexchange retail forex trading. Unlike segregation of customer funds deposited for futures trading, such amounts would not be provided any preferential treatment to unsecured creditors in a bankruptcy, and would not be held in separately titled accounts under the CEA. Because of the lack of bankruptcy preference with respect to the funds of retail forex customers held at FCMs or RFEDs, the Commission does not intend to propose a separation of funds requirement which may be misconstrued as being similar to the protections that are afforded to customers engaged in exchangetraded futures and options. As previously discussed, Regul
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