CFTC Approves NFA Rules Enhancing Protections for Retail Forex Customers
Commentary by Bob Zwirb
The CFTC approved rule amendments and an interpretive notice filed by the NFA concerning enhanced protections afforded to the retail customers of NFA forex dealer members ("FDMs").
The approved amendments include requirements that: (i) impose additional capital requirements on FDMs; (ii) FDMs collect security deposits for off-exchange foreign currency transactions from eligible contract participant counterparties and retail counterparties; (iii) FDMs adopt and implement rigorous risk management programs; and (iv) FDMs provide additional market disclosures and firm-specific information on Web sites to permit current and potential counterparties to assess risks (such as engaging in off-exchange foreign currency transactions and of conducting business with a particular FDM) more effectively.
See: Proposed Amendments to NFA Compliance Rule 2-36; CFTC Press Release.
See also: CFTC Chair Massad's Statement; CFTC Commissioner Bowen's Statement.
Related news: NFA Proposes to Amend Rules Regarding Risk Management Program for Forex Dealer Members (with Zwirb Comment) (May 28, 2015).
Commentary
The statements by Chair Massad and Commissioner Bowen concerning this rulemaking paint a picture of a sector that is regulated too lightly. They seem to question the OTC nature of most retail forex transactions in a fundamental way. Indeed, Commissioner Bowen appears to argue in favor of regulating such transactions in the same manner as futures are regulated, and complains that "[t]oo much retail foreign exchange trading currently occurs 'over-the-counter' where customers are betting against the house instead of on supervised, fully-regulated exchanges." She recommends going even further than futures-style regulation; it appears that she wants the CFTC to specify the margin levels for such transactions.
This sector is far from lightly regulated. To get a sense of this, one need only glance at the CFTC's Part 5 rules that, along with the preamble, take up more than 40 pages of the Federal Register, or the many rules and notices imposed on Retail Foreign Exchange Dealers ("RFEDs") by the NFA. This sector is subject to a comprehensive set of rules that are imposed not only by the CFTC and the NFA, but also by the SEC and the federal banking agencies, which dictate requirements for registration, disclosure, recordkeeping, financial reporting, and minimum capital and operational standards upon RFEDs. Indeed, the requirements are so substantial that a number of important dealers - with the kind of financial and compliance resources that regulators would usually find attractive - have exited the industry in recent years, leaving only a few dealers to serve those who wish to invest in this area.
This is not to say that enhancing protections and increasing capital requirements is inappropriate in light of recent events. Even so, whether a transaction involves swaps, metals or foreign currency, it is not obvious that layering even more requirements on those already in place would be better, nor would otherwise making everything that is OTC more futures-like (as at least one member of the CFTC appears to favor). Doing so will not protect dealers and their customers from the kind of financial shock that occurred earlier this year, when the Swiss National Bank allowed the Swiss franc to weaken abruptly. Nor is it clear that the CFTC should be setting margin levels here, as Commissioner Bowen appears to favor. Margin levels in this sector, as the NFA noted in 2010 in a letter to the CFTC, are "approximately in line with . . . existing margin requirements for exchange-traded foreign currency futures at the Chicago Mercantile Exchange," and are regularly reviewed "in light of the prevailing practices in the forex market."
Finally, these capital requirement enhancements might not work in the way that most would think. Because the requirements are based on a percentage of what forex dealers owe to their customers, when a customer's positions go up in value, the capital requirement is increased (because the dealer now "owes" more to the customer). Conversely, and counter-intuitively, when a customer's account goes down in value, the capital requirement on the dealer is lessened (because the dealer "owes" less to the customer). The problem during the Swiss franc crisis involved the latter.