A New Era of Regulation for the OTC Retail Forex Market
After several unsuccessful attempts to regulate over-the-counter (OTC) or off-exchange retail forex, the Commodity Futures Trading Commission (CFTC) has finally adopted rules that will regulate this important market. The final rules, summarized below, have some important differences from the rules proposed in January of this year, but the basic framework, designed to guard against fraud and protect small investors, remains largely intact.
The CFTC came under tremendous pressure to adopt final rules after Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173 2010 (Dodd-Frank) on July 15, 2010. Arguably the most sweeping financial regulatory overhaul since the Great Depression, Dodd-Frank would have shut down a large portion of the OTC retail forex market if the CFTC had failed to adopt final rules ahead of October 19th.
This article provides an overview of the state of regulation of OTC retail forex leading to Dodd-Frank, discusses the final rules published by the CFTC on August 30th (including how these rules differ from the rules proposed in January), and makes some suggestions for forex traders in light of the new regulations.
OTC Forex Regulation Before Dodd-Frank
OTC forex trading has been the subject of some regulatory controversy since the CFTC’s creation in 1974. Worried that the CFTC’s involvement in OTC forex markets would dampen the important institutional market in currencies, the Treasury Department lobbied for a specific amendment, which was included in the final version of the Commodity Futures Trading Commission Act of 1974, intended to exclude from the CFTC’s jurisdiction OTC forex contracts in the interbank market, or as between large, institutional market participants. However, the language of this amendment was so broad that it, at least on its face, served to exclude all OTC forex contracts from the CFTC’s jurisdiction. This amendment was subsequently construed in a variety of ways by different courts, leaving the CFTC’s authority over OTC retail forex in question.
In 2000, Congress passed the Commodity Futures Modernization Act (CFMA) which amended the Commodity Exchange Act (CEA) and, for the first time, gave the CFTC jurisdiction over OTC retail forex contracts that were either options or futures (including options on futures). Specifically excluded from the CFTC’s jurisdiction, and thus allowed without reservation, were certain OTC forex transactions with retail investors where the counterparty was a financial institution, broker-dealer, insurance company, financial holding company, or investment bank holding company. Retail investors that entered into OTC forex contracts with these entities would do so under the protection of the rules, anti-fraud and otherwise, of such entitys primary regulator. Also specifically excluded from CFTC jurisdiction were transactions between institutional market participants, called Eligible Contract Participants (ECPs).
Indeed, the CFMA did help to describe the jurisdictional boundaries of the CFTC with regard to OTC forex transactions. However, because the CFMA did not give the CFTC any rulemaking authority with regard to these new provisions, it was up to Congress and the courts to respond to ambiguities related to the application of the CFMA to contracts that were deemed futures look alike contracts. These contracts were often called spot transactions by the counterparties offering the contracts but instead of actually settling through delivery, as true spot contracts do, the contracts were perpetually rolled-over with each retail clients account reflecting the profits and losses from the prior contracts. In fact, this is how much of the OTC retail forex market works and many market participants refer to the market for look alike contracts as the spot market.
Following a split of authority in the courts regarding whether the CFTC had jurisdiction over futures look alike contracts, the Commodity Futures Trading Commission Reauthorization Act of 2008 (CRA) clarified the issue by again amending the CEA and specifically granting the CFTC authority to regulate, and create rules relating to, futures look alike contracts that are offered or entered into with retail customers on a leveraged or margined basis. The CFTC proposed rules under the CRAs grant of authority in January 2010, and published final rules to regulate the OTC retail forex market on August 30th, 2010.
The CFTC’s Final Rules
The CFTC published its final rules to govern OTC forex on August 30th 2010, under authority granted by the CRA. The rules impose a variety of registration, recordkeeping, reporting, and operational requirements on parties that intermediate transactions in OTC retail forex. They define a new category of registrant (created by the CRA), called a Retail Foreign Exchange Dealer (RFED) and impose restrictions on RFEDs as well as Futures Commission Merchants (FCMs), Introducing Brokers (IBs), Commodity Pool Operators (CPOs), Commodity Trading Advisors (CTAs), and the Associated Persons (APs) thereof that participate in the OTC retail forex market.
The following highlights some of the most noteworthy provisions of the CFTC’s final retail forex rules. These rules will become effective today.
Regulation of CPOs and CTAs
Persons that operate funds that trade forex and those that provide forex trading advice to retail clients will become subject to a regulatory scheme that essentially seeks to treat these advisers on equal footing with CPOs and CTAs that trade traditional on-exchange commodity future and option contracts. Interestingly, the terms Commodity Pool Operator and Commodity Trading Advisor are defined separately in the regulations for the purposes of OTC forex trading, rather than being incorporated by reference. This means that OTC forex advisers will be subject to a separate regulatory regime than those that trade traditional commodity contracts, under the final rules, even if it appears to be very similar.
Final Regulation 5.1(d) defines a CPO, for the purposes of the new Section 5 (dealing with OTC retail forex), as any person who operates or solicits funds or property for a pooled investment vehicle that is not an Eligible Contract Participant and that engages in retail forex transactions. Those that meet this definition will be required to register as CPOs and will have to meet all the operative requirements, including the disclosure, recordkeeping, reporting, and other requirements, currently applicable to CPOs in the context of on-exchange futures and commodity option contracts.
Final Regulation 5.1(e) defines a CTA, for the purposes of the new Section 5 (dealing with OTC retail forex), as a person that exercises discretionary trading authority over or obtains written authorization to exercise discretionary trading authority for or on behalf of any person that is not an ECP, in connection with retail forex transactions. Those that meet this definition will be required to register as CTAs and will have to meet all the operative requirements, including the disclosure, recordkeeping, reporting, and other requirements, currently applicable to CTAs in the context of on-exchange futures and commodity option contracts.
CPOs and CTAs subject to the new rules will be required to maintain records of all client communications related to possible violations of the CEA or the CFTC rules concerning OTC retail forex. These records will have to be turned over to the CFTC within 30 days of the advisers receipt of the communication, or if possible fraud is concerned, within 3 days of such receipt. CPOs and CTAs subject to the new rules will also have to disclose pending legal proceedings to the CFTC if an appeal is taken, within 45 days of such appeal.
Regulation of FCMs and RFEDs
The CRA created a new category of registrant, called an RFED, which is designed to properly register so-called shell FCMs or those FCMs that do not conduct business in commodity futures or options but rather only intermediate OTC retail forex transactions. The newly adopted regulatory scheme contemplates registration requirements for RFEDs that are very similar to those for FCMs. However, under the rules many firms that are currently registered as FCMs, but that are not primarily or substantially dealing in exchange-traded futures, will have to deregister as FCMs and register as RFEDs.
Both FCMs and RFEDs will be required to meet new disclosure requirements in connection with their activities in OTC retail forex. Regulation 5.5 will require each FCM and RFED to disclose the number of retail forex accounts maintained by the FCM or RFED, 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.
FCMs and RFEDs will also both be subject to the new net capital requirements outlined in the CRA, including an early warning system that will require notice reporting by FCMs and RFEDs when capital becomes too thin. The net capital requirement in the CRA is $20 million, a level substantially higher than that for FCMs engaged only in exchange-traded futures. According to the CFTC, this higher threshold likely reflects Congressional concern over the risk to retail clients from undercapitalized shell FCMs. FCMs and RFEDs that fall below the net capital requirement will be forced to liquidate if they are unable to cure the deficiency within ten business days.
These new registration, risk disclosure, and net capital requirements are coupled with additional requirements relating to financial reporting and recordkeeping, trading standards, and disclosure of pending litigation, among others, to provide a framework geared toward fraud prevention and protection of retail investors as they engage in forex transactions.
Regulation of IBs
Under the final rules, persons who solicit or accept orders for an FCM or RFED with regard to OTC retail forex transactions should register as an Introducing Broker. The CFTC notes that in the absence of such registration requirements fraudulent and deceptive sales practices have been common. The rules require IBs that are soliciting clients for OTC retail forex transactions to either maintain the net capital requirements applicable to futures and commodity options IBs or to enter into guarantee agreements with those FCMs and RFEDs with whom they have relationships.
This choice between the net capital requirement and the guarantee agreement is a change from the proposed rules which would have required guarantee agreements for all IBs soliciting retail forex accounts. The rules further state that an IB cannot be a party to more than one guarantee agreement at any given time, effectively making IBs that cannot or choose not to maintain the minimum net capital requirements exclusive sales agents for the FCM or RFED which they represent.
Regulation of Futures Look Alike Contracts
The rules treat leveraged futures look alike contracts on forex essentially on par with OTC forex options and futures. Counterparties that offer look alike contracts on forex to retail clients will be required to meet the registration requirements detailed above in addition to the applicable operational, disclosure, recordkeeping, and reporting requirements. True spot transactions which the CRA defines as those transactions that settle through actual delivery within 2 days or create an enforceable obligation between a buyer and seller that have the ability to deliver and accept delivery in connection with their line of business continue to be outside of the CFTC’s jurisdiction. However, the CFTC now has broad anti-fraud authority over futures look alike contracts on forex and has crafted its final rules in recognition of this new authority.
The final rules limit leverage for retail clients (non-ECPs) through a mechanism whereby the CFTC has set parameters and will delegate authority to the NFA to set specific limits within those parameters. The initial rules release provides for a maximum of 50:1 leverage on major currencies and 20:1 on all other currencies. While these parameters are stricter than the 100:1 limitation that currently exists in the market, they are far looser than the 10:1 level proposed in January. The CFTC received a record number of comments against the 10:1 level and has relaxed that level in response to the overwhelmingly negative response.
It is important to note that the final leverage restrictions will only affect retail clients. This does not include commodity pools with greater than $5 million in total assets that are formed and operated by either a registered CPO or a firm properly relying upon an exemption from CPO registration or CTA firms whose clients are all ECPs, including individuals or entities with greater than $10 million in assets. It also does not affect individual traders with more than $10 million in assets. However, these asset thresholds will change effective July 16, 2011 because of a provision contained in Dodd-Frank Section 741.
It is unclear whether retail forex counterparties located overseas will be willing or able to offer U.S. retail clients leverage beyond the levels adopted by the final rules. The practical ability of the CFTC to enforce these leverage restrictions against overseas counterparties is questionable, but these counterparties may not wish to invite the attention of the U.S. government in this respect. If overseas counterparties are willing to offer additional leverage to U.S. retail clients, these clients will be trading at their own risk and without the new anti-fraud protections included in the final rules.
The Effect on Forex Traders
As a forex trader, you should take this time to make yourself aware of where you fit in the new regulatory scheme and determine exactly what contracts you actively trade within the context of the CEA, as amended by so much intervening legislation. You should also determine how the regulators classify the counterparties you use to trade OTC forex.
Think carefully about how much leverage you need to trade forex profitably. Consider what cost you are willing to accept and what risk you are willing to bear in order to trade with leverage beyond 50:1, or 20:1 as the case may be. Remember that in moving your account to an overseas broker you will forfeit all of the CFTC protections included in the CRA and the recently adopted rules. Additionally, note that ECPs will not be subject to any new leverage restrictions, so you might explore the possibility of turning a forex trading hobby into a professional endeavor, if you believe that you could be successful in doing so.
For traders that are already professionals, advising separate accounts in OTC forex, be sure to inventory your clients to see if these individuals and entities are ECPs. Your access to leverage will be restricted if your clients are not ECPs. For professional traders advising a pooled investment vehicle with regard to OTC forex, you will be subject to the leverage limitations if the pool has less than $5 million in total assets. Both forex advisers and forex pool operators should also be prepared to register as CTAs and CPOs, respectively.
The CFTC’s final rules bring much needed investor protections to the OTC retail forex market and will change the way in which market participants run their own operations and interact with one another. From this point forward the forex market will look a lot more like the more heavily regulated securities and commodities markets. The time is now to figure out exactly how these new rules affect your personal and professional trading activities.
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ECPs include, acting for its own account, a financial institution, an insurance company, an investment company, a commodity pool run by a registered CPO with greater than $5mm in total assets, an entity with greater than $10mm in total assets, a broker-dealer, an FCM, an individual with greater than $10mm in total assets, and, acting on behalf of another ECP, a CTA or investment adviser. Note well that the Dodd-Frank Wall Street Reform Act contains provisions that change the definition of ECP for commodity pools and individuals. Effective July 16, 2011 the asset threshold for individuals will be raised to $10 million invested on a discretionary basis. Effective the same day, commodity pools with non-ECP participants will not be considered ECPs. Read our article on this development here.
The term retail forex transaction is defined in Final Regulation 5.1(m) as any account, agreement, contract, or transaction described in CEA Sec. 2(c)(2)(B) or Sec. 2(c)(2)(C). CEA Sec. 2(c)(2)(B) addresses OTC forex options and futures (and options on futures) offered to or entered into with a retail investor. CEA Sec. 2(c)(2)(C) addresses leveraged or margined OTC forex futures look alike contracts offered to or entered into with a retail investor.