Retail forex regulation: Still a work in progress

For an industry that’s often viewed as under-regulated, retail foreign exchange traders in the futures and options market face significant new regulation and there is more on the horizon though it is not clear what form it will take.

“The retail FX market may indeed seem like the Wild West,” said Sang Lee, managing partner at the Aite Group, a Boston-based consultancy focusing on technology and regulation in financial services. “But most of the large retail players are Commodity Futures Trading Commission (CFTC)-registered FCMs [Futures Commission Merchants] and members of the National Futures Association (NFA). Having some sort of regulatory stamp of approval will enhance the overall growth of the market as it provides certain levels of regulation, leading to more legitimacy in this rapidly growing market.”

The latest development will rein in some of the massive leverage involved in forex that many believe contributes to the churning of accounts. In September, the NFA announced that the CFTC approved changes to eliminate the existing security deposit exemption for Forex Dealer Members (FDMs) that maintain 150% of their required net capital. Beginning Nov. 30, FDMs will be required to collect security deposits of at least 1% for major currencies and 4% for all other currencies.

NFA president and CEO Daniel Roth stated in his Sept. 3 testimony at the CFTC/SEC joint meetings on regulatory harmonization, “There has been confusion over regulatory jurisdiction regarding retail forex since the CFTC was created in 1974.” At the Futures Industry Association conference in New York last month, Elizabeth King, the SEC’s associate director, division of trading and markets said, “Harmonization may be disruptive and require new legislation because the CFTC and SEC statutes are so different.”

The Commodity Futures Modernization Act of 2000 attempted to make clear the CFTC’s jurisdiction over retail foreign exchange trading but legal challenge weakened the Commission’s jurisdiction. The 2008 re-authorization of the CFTC marked the latest attempt to close the regulatory gap. In June, the CFTC’s Division of Enforcement created a task force charged with investigating and litigating fraud in the off-exchange retail foreign currency market.

While the Obama Administration’s Aug. 11 blueprint for regulatory reform seeks to cover nearly all over-the-counter derivatives cleared, it does not include forex. CFTC chairman Gary Gensler and the House Agriculture Committee have pushed to include forex.

“The way forex is traded is very different from on-exchange futures,” says Larry Dykeman, NFA communications director. “The structure of the trading platform is not as transparent and you’re not clearing to a central clearing organization. We know of people who violated rules and were barred from the futures industry that have migrated to the forex market because they don’t have to register with the CFTC.”

The NFA has moved forward with forex oversight. Two key events are the increase in the Adjusted Net Capital requirement for U.S. registered firms, which has jumped in May to $20 million from $250,000, and rule 2-43(b), the “hedging” rule that forces brokers to close trades on a first in, first out basis, otherwise known as FIFO.

Dykeman says the $20 million requirement is on forex counterparties that “are retail foreign exchange dealers (RFEDs) or are FCM-only firms primarily or substantially engaged in on-exchange futures activities.”

Sreekrishna Sankar, Bangalore-based analyst with the Celent Group, advises traders to be vigilant about the capitalization of their brokers. “This is a good one for the traders,” he says, noting they will be protected from the failure of low capitalized brokers. Critics, however, note that it offers little protection and simply eliminates smaller firms to the benefit of dealing banks.

“This is a noticeable departure from the risk-based capital requirement used not only in the U.K., Japan and Hong Kong, but also used to assess futures dealers in the U.S.,” says Samantha Roady, New York-based executive vice president at e-forex platform Gain Capital. “These requirements are set at levels that are commensurate with a firm’s business and trading activity and it has impacted a healthy percentage of the firms who registered to do business in the U.S.”

Rule 2-43(b), the so-called hedging rule, went into to effect Aug. 1 after an initial delay and Dykeman says that all FDM trading platforms are currently compliant.

“Most traders won’t miss hedging,” Roady says. “But we do believe there is a legitimate need for this type of functionality. Automated trading is proliferating as some traders are building portfolios using several different strategies and running them simultaneously. This approach sometimes means being long and short on a specific currency pair at the same time, in order to accommodate different trading strategies with different time horizons.”

The capital requirements have segmented the industry into those who can meet the net cap and those who can’t offer a technology platform or a matching engine, forcing existing customers to look elsewhere for brokerage services.

Roady says, “As of July 2009, we counted 15 registered forex dealer members (FDMs) in the U.S., down from less than 30 less than a year ago. Some have exited the U.S. market altogether and have moved offshore, some have consolidated with larger players. The ultimate result is less competition. That hampers innovation and puts customers at a disadvantage from a pricing and service standpoint.”

After the NFA enacted rules affecting the way trades must be accounted for, such as the hedging and FIFO rule, many forex FCMs allowed their customers to shift to affiliates in London so they could continue to hedge.

Those who move to foreign jurisdictions to escape U.S. regulations may be doing so at their own peril. “Any U.S. customer who chooses to trade with a forex firm under a foreign jurisdiction should educate themselves on what the regulations are in that country,” says Dykeman. “Also, if they encounter any problems with their forex firm they will have to file complaints with the foreign regulator.”

Dykeman adds, “U.S. traders can trade forex in foreign jurisdictions only if the transactions are not off-exchange futures contracts or options,” and are considered spot OTC transactions.

While retail forex brokers make up less than 1% of NFA membership, they make up a disproportionate number of its complaints and about half of enforcement actions, so they can expect greater regulator scrutiny in particular as we enter the post credit crisis era.

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