Request for Comments on Forex Proposals

NFA is seeking comments on proposals that affect Forex Dealer Members ("FDMs"). The proposals pertain to the minimum adjusted net capital requirement and the concentration charge and set certain requirements for FDMs'internal financial controls.

Minimum Adjusted Net Capital and Concentration Charges

In the past twenty years, there have been nine FCM insolvencies. Since 1990, there have been only two insolvencies by traditional FCMs trading on U.S. exchanges, and no funds in segregated customer accounts were lost in either of those two instances. This is from a population that averages around 250 (over the last 20 years). Even in the Refco matter, the FCM filed for bankruptcy not because customer funds were at risk but, rather, to facilitate the sale of its assets and the transfer of its accounts in connection with the parent company’s insolvency.

The FCM insolvency rate becomes more troubling when FDMs are added to the mix. Of the three bankruptcy or receivership proceedings for insolvency occurring in the last four years, two have involved FDMs (Refco was the third), and they are drawn from the smaller FDM population (averaging around 40). Specifically,in late 2003, an FDMmisappropriated almost $2 million of customer funds, which depleted the amount of assets necessary to meet the amounts owed to customers. The Commodity Futures Trading Commission("CFTC") is still working to try to get back some of the customers’ funds. More recently, NFA took a Member Responsibility Action ("MRA") against an FDMwhose liabilities exceeded its assets by over $1 million. The CFTC also brought an emergency action in U.S. District Court,and the Court immediately appointeda receiver who was subsequently able to sell the FDM’s customer accounts. Due to this sale, it appears that the customers were made whole.

This discrepancy between FDMs and FCMs involved in on-exchange transactions is even greater when looking at the number of financial MRAs NFA has issued in the last ten years. During that period, NFA issued twelve MRAs to FCMs for failing to demonstrate compliance with NFA’s financial requirements. Three of these firms were traditional FCMs with an on-exchange business, one was a forex dealer registered as an FCM prior to the advent of the FDM category, and the remaining eight were FDMs.

NFA's concern that one day an FDM might be unable to meet its financial obligations to its customers has heightened as the amount of retail customer funds held by FDMs has increased to over $1 billion. The above described FDM insolvencies have done nothing to abate this concern, particularly with the most recent occurring just months after the $1 million capital requirement became effective. If the receiver had not sold the FDM's accounts, then twice within less than four years customers of FDMs would have lost funds due to an FCM insolvency. Additionally, since March, eight different FDMs have fallen under the early warning requirement of $1.5 million.

One of the reasons for the 2006 increase to the FDM capital requirements was that an FDM’s dealer activities create greater financial risks than the agency transactions involved in traditional exchange-traded futures and options. A second reason is that the need for adequate capital is particularly acute for FDMs since customers trading off-exchange forex have not received a priority under the Bankruptcy Code in the event of a firm’s insolvency. Both of these reasons still exist.

NFA is not alone in recognizing the increased financial risk of acting as a dealer. Congress recognized that acting as a dealer increases financial risk and requires substantially higher capital on the part of the dealer. Pursuant to Section 4c(d)(2)(A) of the Commodity Exchange Act (the "Act") the grantor of a dealer option must maintain at all times a net worth of $5 million. The Commission has likewise recognized the increased financial risk resulting from being a dealer, imposing an adjusted net capital requirement of $2.5 millionon leverage transaction merchants ("LTMs").[1]

When the Commission adopted the financial requirements for LTMs in 1984, it noted that the leverage market is "essentially a principals' market" and that the "purchaser of a leverage contract is solely dependent on the LTM for performance on the contract."[2] This is the exact same situation that customers are in when they purchase or sell currencieswith an FDM. Further, as with an LTM, an FDM "takes the other side of every [contract] entered into by a [customer]" and the FDM "is the sole guarantor of performance on the [contract]." When trading with an FDM "there is no clearing organization to take the other side of every trade, no FCM guaranty of variation margin to the clearing organization and no clearing organization guaranty fund and assessment power."[3] Due to these factors, the financial requirements for FDMs, like LTMs,must be substantially higher than those for FCMs engaging in agency transactions.

As noted above, the Commission imposed the $2.5 million capital requirement for LTMs in 1984. Based upon the Consumer Price Index, $2.5 million in 1984 dollars would be worth approximately $5 million today. Accordingly, NFA is proposing to raise the minimum adjusted net capital for FDMs to $5 million. An increased capital requirement would result in an FDM having a larger buffer to meet its obligations to its customers. Additionally, an increase in capital requirements for FDMs would ensure that FDMs have a larger financial stake in their forex business.

Along with the increased capital requirement, NFA is proposing to eliminate the concentration charge on significant positions with unregulated counterparties, including customers. The charge is designed, in part, to ensure that an FDM has sufficient capital to pay any losses even if it cannot collect profits due to counterparty defaults. As you know, NFA has been reviewing this concentration charge over the past several months. As part of its comments, at least one FDM suggested imposing a higher capital requirement on FDMsand eliminating the concentration charge. For some firms, eliminating the charge will free up additional capital to meet the increased net capital requirement.

NFA agrees that a higher capital requirement may obviate the necessity for applying the concentration charge. The increased capital requirement provides a greater buffer against counterparty credit risk. NFA would, however, replace the concentration charge with a limitation on the types of firms with which an FDM may maintain assets and cover its exposure for purposes of CFTC Regulation 1.17.

Under this proposal, an FDM may not include assets held by an unregulated person or affiliate in its current assets for purposes of determining its adjusted net capital, unless the unregulated person or affiliate qualifies for an exemption under current NFA Financial Requirements Section 11(b) and 11(c), respectively.[4] Similarly, positions entered into to cover an FDM’s exposure could not be counted for purposes of avoiding the haircuts imposed by CFTC Regulation 1.17 unless the counterparty is an entity that qualifies for an exemption under current NFA Financial Requirements Section 11(b). Under that provision, entities that qualify for an exemption include U.S. banks; NASD-member broker-dealers; NFA-Member FCMs; state-regulated insurance companies; banks, broker-dealers, FCMs, and insurance companies regulated in certain foreign jurisdictions; and other entities approved by NFA. Positions entered into with an affiliate to cover an FDM's exposure could not be counted for purposes of avoiding the CFTC haircut unless NFA has issued an exemption for the affiliate under the more limited circumstances that currently qualify for an affiliate exemption under NFA Financial Requirements Section 11(c). Customer positions on the FDM’s platform could be netted against each other, but this netting could not include positions with affiliates.

Internal Financial Controls

NFA also has concerns over the lack of adequate internal controls some FDMs have over their financial books and records. In the past year alone, NFA took two MRAs against FDMs that were under their minimum capital requirements. In both cases, the firms had inadequate internal controls over their financial books and records. In NFA’s experience, over the past few years many firms have entered the retail forex business with limited business and financial expertise. Some of these firms also use unknowledgeable personnel to handle their day-to-day bookkeeping. Furthermore, the fact that these are dealer markets makes the financial recordkeeping more complex than it is for a firm that is strictly an intermediary. Our experience also shows that the financial problems at these firms are compounded by the fact that many of the new FDMs—and even some of the more established ones—use relatively unknown accounting firms that may not have experience auditing companies with more complex financial requirements. As a result, FDMs have a much higher incidence of financial problems than traditional FCMs.

This situation concerns staff, and we recommend adopting a new rule to ensure that FDMs have proper internal controls and a means to evaluate those controls. Proposed Financial Requirements Section 15 has three prongs.

  • It requires new FDMs to provide NFA with an internal control report prepared and certified by an independent public accountant qualified to certify financial statements for public companies (i.e., a firm registered and in good standing with the Public Company Accounting Oversight Board). The Member would be required to provide this report before commencing its retail forex business. The rule would also authorize NFA staff to require an FDM to provide subsequent internal control reports if circumstances warranted.
  • The rule would authorize NFA staff -- in appropriate circumstances -- to require an FDM's annual financial statements to be certified by an independent public accountant qualified to certify financial statements for public companies. This requirement will give FDMs the freedom to choose other auditors unless NFA has reason to be concerned about the firm's financial statements.
  • Each FDM would be required to have an AP/principal who is responsible for supervising the firm’s financial functions. This individual would be subject to discipline if the firm’s internal controls are inadequate in their design or because they are not followed. Staff also proposes to amend the forex interpretive notice to clarify that part of this supervisory responsibility includes hiring and retaining qualified accounting staff and, unless the firm is a public company with an independent audit committee, to research and recommend the firm's independent auditor.

Staff would appreciate your input on each of these proposals. Comments should be in writing and must be received by July 6, 2007. The comments should reference "Forex Capital and Internal Controls" and be sent to:

National Futures Association

200 W. Madison Street, Suite 1600

Chicago, Illinois 60606

E-mail:

Fax: (312) 658-4193

If you have questions about these proposals, contact Michael A. Piracci, Senior Attorney ( or 312-781-1419) or Sharon Pendleton, Director, Compliance ( or 312-658-6540).

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[1] 17 C.F.R. § 31.9.

[2] 49 Fed. Reg. 5498, 5512 (Feb. 13, 1984).

[3]Id.

[4] Obviously, where the CFTC's requirements are more stringent, its requirements would apply.