CFTC Commissioner Bowen Issues Statement on Retail Foreign Exchange Markets
Commentary by Bob Zwirb
CFTC Commissioner Sharon Bowen issued a statement in which she urged the CFTC to "seriously consider" enhancing the regulations of retail foreign exchange dealers. The statement concerned recent activity in the retail foreign exchange markets.
Commissioner Bowen expressed concerns about "recent unsettling events" involving financial difficulties at retail foreign exchange dealers after the Swiss National Bank's policy change regarding the Swiss franc. She explained that the retail foreign exchange industry is the "least regulated" part of the derivatives industry, and that "lower standards are putting this industry in a precarious position and placing retail foreign exchange investors unnecessarily at risk."
In her statement, Commissioner Bowen opines that "[i]t is ironic, that following the enactment of Dodd-Frank, the retail foreign exchange industry is the least regulated part of the derivatives industry." Commissioner Bowen urged the CFTC to consider enhancing current regulations regarding retail foreign exchange dealers by establishing regulations on the retail foreign exchange industry that are "at least as strong" as those on the rest of the derivatives industry.
See: Commissioner Bowen's Statement.
Commentary
One may take issue with Commissioner Bowen's view of the regulation of the retail foreign exchange. In fact, notwithstanding the recent problems following the shock to the Swiss franc market, there is a good argument to be made that retail foreign exchange is one of the most heavily regulated sectors of the derivatives industry – especially in light of the rules adopted by the CFTC to combat fraud.
Even prior to Dodd-Frank, the CFTC had already adopted a comprehensive set of rules to regulate the retail forex sector. The rules, which comprise Part 5 of the CFTC rules, establish requirements for registration, disclosure, recordkeeping, financial reporting, minimum capital and operational standards with respect to retail forex transactions. They also create a new registration category, Retail Foreign Exchange Dealers ("RFEDs"), for persons and entities intermediating such transactions.
These rules and the accompanying preamble, which comprise more than 40 pages in the Federal Register, also impose new requirements on entities other than RFEDs that intermediate retail forex transactions or even those that enter into such transactions, such as commodity pool operators. Moreover, the SEC and the prudential banking regulators all have rules modeled on those of the CFTC to regulate retail forex dealers under their jurisdiction. Finally, the NFA has its own comprehensive set of financial and regulatory requirements for such firms. These rules are quite substantial. In fact, they are so substantial that one might reasonably argue they are not the solution to the problem so much as the cause of it. That is, the burden of these rules has led to the exit of larger firms with the kind of financial resources that regulators regularly desire for firms that act as brokers in retail foreign exchange.
With respect to margin, it is not as if the regulators were unaware of the margin levels that prevail in this industry. Indeed, in 2010, the NFA wrote to the CFTC in favor of the current levels, stating that they satisfied two public policy objectives: the financial integrity of retail forex dealers and the protection of retail customers. In particular, the NFA pointed out that the security deposit percentages set for retail forex transactions were "approximately in line with . . . existing margin requirements for exchange-traded foreign currency futures at the Chicago Mercantile Exchange," and that it regularly reviewed its requirements "in light of the prevailing practices in the forex market."
Since margin levels for comparable futures are computed in accordance with the Standard Portfolio Analysis of Risk algorithm, which takes into account, inter alia, historical and implied price volatilities as well as current and anticipated market conditions, including "reasonable worst case" scenarios, the real issue here is whether the extraordinary action by the Swiss National Bank, which precipitated this course of events, was something that could be "reasonably" anticipated by regulators without the benefit of hindsight even in the "worst case."
In summary, when there is a great shock to the financial markets – perhaps, ironically, a shock induced by (Swiss) governmental action – financial firms may have problems, just as energy firms may when energy prices collapse. That a financial firm should have problems does not demonstrate that it was previously unregulated. In fact, in the instant case, one can make a good argument that the failure is caused by regulation: isn't it to be expected that, as the financial regulators force credit-related businesses out of banks and into smaller specialized firms, these smaller firms have less resources to withstand price shocks, particularly large shocks initiated by government actions? If that thesis is correct, then it follows that the regulators should be very worried that they are forcing large credit exposures related to derivatives out of a fairly diversified group of major banks into a smaller pool of futures commission merchants. Does it really make sense to concentrate credit exposure in the manner that the law is now driving?