The impact on introducing brokers and retail traders
By Karen K. Wuertz
Faced with the daunting task of reading and analyzing the 2,315 pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), an individual may not notice some of the less-publicized aspects of the legislation, especially pertaining to introducing brokers (IBs) and retail over-the-counter (OTC) forex traders. However, that doesn’t diminish the impact certain provisions of the Dodd-Frank Act will have on these groups.
For example, Section 732 of the Dodd-Frank Act requires futures commission merchants (FCMs) and IBs to implement conflicts-of-interest systems and procedures to ensure that any person within the firm relating to “research or analyses of the price or market” are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in trading or clearing activities might potentially bias the judgment or supervision of the persons.
The CFTC has not yet written any rules with respect to Section 732, and, because of the broad nature of the Act’s language, the challenge to the CFTC will be to develop a rule that satisfies the Act’s requirements while not imposing unworkable standards. These new systems and procedures could be particularly burdensome to smaller IBs with limited resources.
The Dodd-Frank Act also contains several provisions that become effective in mid-2011, which close certain regulatory gaps in the retail forex area. First, with regard to Zelener contract forex products or “rolling spot,” the May 2008 Farm Bill ensured that the CFTC has antifraud authority over these Zelener forex transactions, but the dealers that offer these contracts are not required to be one of the enumerated counterparties outlined in the Act and, therefore, retail customers of these firms do not get all of the regulatory protections they need (see Zelener).
The Dodd-Frank Act closes this gap by requiring a person acting as a counterparty to forex Zelener contracts to be registered as an FCM. Presumably, the CFTC also could allow this person to register as a retail foreign exchange dealer. The Act also amends the definition of commodity pool operator (CPO), commodity trading advisor (CTA) and IB to include a registration requirement for other intermediaries that may engage in activity relating to forex Zelener contracts. The legislation goes even further in regard to non-forex Zelener contracts. The Act prohibits retail trading in Zelener-type futures look-alike products other than forex unless the transactions are done on-exchange. Therefore, with certain exceptions, firms will be prohibited from offering these types of contracts to the retail public unless the contracts are traded on-exchange.
A second regulatory gap closed by the Dodd-Frank Act relates to the list of the types of otherwise regulated entities that can act as counterparties to retail customers in off-exchange forex futures. The list currently includes banks, insurance companies, investment bank holding companies, FCMs, broker-dealers and “financial institutions.” Financial institutions are defined to include a range of highly regulated types of businesses, including, for example, federal or state credit unions and depository institutions covered by the Federal Deposit Insurance Corporation (FDIC). The definition of “financial institution” also includes “foreign banks” as defined in the International Banking Act of 1973, which covers any institution in any foreign country that engages in activities usually associated with banking in that particular jurisdiction.
The “foreign bank” exemption has become an increasingly popular means for forex counterparties to circumvent U.S. regulatory requirements designed to protect retail customers. The Dodd-Frank Act addresses this circumvention by providing that a financial institution only qualifies as an enumerated counterparty if it is a United States financial institution. This could dramatically impact U.S. retail customers who currently trade forex with entities located outside the U.S. When this provision becomes effective in mid-2011, it may be illegal for non-U.S. financial institutions to offer retail forex trading to U.S. customers. The Act also eliminates insurance companies and investment bank holding companies from the list of enumerated counterparties.
Even U.S. customers trading OTC retail forex through a U.S. bank or broker-dealer could be affected by the Dodd-Frank Act. Section 742 of the Act provides that if the otherwise regulated “enumerated counterparty” to retail forex OTC transactions (i.e. FCMs, broker-dealers, U.S. financial institutions) has a federal regulatory agency, the agency must issue rules governing OTC retail forex transactions by mid-2011. If the Federal regulatory agency does not issue forex rules, then the counterparty may be prohibited from entering into those OTC retail forex futures transactions.To date, the CFTC is the only federal regulatory agency to issue rules for retail forex, which become effective October 18, 2010. Therefore, unless other federal regulatory agencies act, the impact of this language could be that only FCMs could engage in OTC retail forex futures transactions after mid-2011. At this time, non-FCM counterparties whose federal regulators do not meet Section 742’s requirements could still engage in this activity by registering an affiliate as an FCM subject to the CFTC’s rules.
Although it may be too early to determine accurately the ultimate impact of the Dodd-Frank Act on IBs and retail traders, it’s safe to say the regulatory landscape has definitely changed.
The Commodity Futures Modernization Act of 2000 sought to (among other things) clarify the CFTC’s authority over retail foreign exchange trading. However, a District court ruled in the CFTC v. Zelener -- and the Seventh Circuit Court confirmed in 2004 -- that the CFTC did not have authority over certain retail forex trading because the contracts in question were not futures but “rolling spot” contracts and the CFTC authority was only for futures. The CFTC Reauthorization Act of 2008 closed the Zelener loophole and Dodd-Frank requires any entity offering retail forex trading to belong to a Federal regulator, which must have written rules by a specific date.
Karen K. Wuertz is senior vice president, strategic planning and communications at the National Futures Association.