In passing the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Congress has attempted to close loopholes in connection with the regulation of retail foreign exchange (forex) transactions. In light of the Dodd-Frank legislation, as well as forex-related rules adopted by self-regulatory-organizations, broker-dealers must be cognizant of activities that may involve retail forex transactions in various ways. For example, as further discussed below, customer trading in “foreign ordinaries,” i.e., equity securities exclusively traded overseas, may lead broker-dealers to engage in retail forex trading, potentially subjecting them to forex-related regulation (either now or in the near future) by the SEC, CFTC, NFA, or FINRA.
Background on Forex Regulation
Prior to 2000, foreign currency trading by retail customers was largely unregulated. Congress attempted to address this situation in Commodity Futures Modernization Act of 2000. This law gave the CFTC the authority to regulate over-the-counter futures transactions involving a retail customer on one side of the trade. The CFTC was not, however, given jurisdiction to regulate OTC spot transactions, which normally settle in two days. Acting on this authority, the CFTC brought an enforcement case against a foreign exchange dealer that was offering retail customers the opportunity to buy and sell foreign currency contracts that nominally settled in two days (the normal settlement cycle for foreign currency trades), but in reality were virtually always rolled over into a new contract without settlement actually taking place until the transaction was offset.
The case was ultimately appealed to the Seventh Circuit Court of Appeals, which ruled in CFTC v. Zelener that rolling spot transactions were, in fact, spot transactions and, therefore, the CFTC had no jurisdiction to pursue its enforcement case.
Congress tried again in 2008 to address retail forex trading by amending the Commodities Exchange Act to regulate any OTC forex transaction involving a retail customer that did not, in fact, settle in two days by actual delivery of foreign currency. However, the law contained various exceptions for entities that were regulated by other regulators, such as insurance regulators or the SEC. The law went so far as to exclude “investment banking holding companies” which include all affiliates for a broker-dealer holding company. Thus, once again, an enterprising entrepreneur could avoid regulation, in this case by affiliating with an excluded entity.
Congress has tried a third time to get it right by including expanded regulatory authority over retail forex transactions in Dodd-Frank. This time, Congress has given regulatory jurisdiction to a number of federal regulators, hoping to close the loopholes created in 2008. Unfortunately, there have been unforeseen consequences.
Customer Trading of Foreign Ordinaries
For years, many broker-dealers have offered their customers the opportunity to buy and sell foreign ordinaries. In order to settle these transactions, brokers must necessarily convert customer dollars into foreign currency and back again. In the typical transaction, a broker would forward a customer order to a correspondent overseas, who would execute the transaction in the foreign market in the local currency. On settlement date, the executing firm would settle the transaction in the local currency, thereby necessitating either that it convert U.S. dollars into the local currency or that the introducing firm do the conversion. Ultimately, the U.S. customer would settle the trade in U.S. dollars without having to get involved in the actual currency conversion, in much that same way that credit card companies settle foreign credit card purchases with their customers in U.S. dollars.
Of course, this begs the question, now raised by Dodd-Frank, whether the purchase and sale of foreign ordinaries involves a retail forex transaction.
Mechanics of Forex Transactions
Spot forex transactions normally settle on the second day after trade date (T+2) and are expressly excluded from Dodd-Frank. Securities transactions, including trades in foreign ordinaries, however, settle on the third day after trade date (T+3); consequently, if a customer were to purchase and sell forex to coincide with foreign ordinary trading, settlement would be on T+3 and therefore subject to regulation. Although it is possible to settle purchases of forex on T+2, one day ahead of foreign ordinary settlement, it is not possible to settle sales of forex in conjunction with foreign ordinary sales on T+2, because proceeds from the sale of foreign ordinaries would not be available until T+3. As a result, forex trading that is incurred in connection with trading of foreign ordinaries may involve broker-dealers in regulated retail forex transactions.
In recognition of this issue, on July 13, 2011, the SEC issued temporary final rules that in essence extended the effective date of forex regulation on broker-dealers for one year. Notwithstanding this deferral, firms must recognize that self-regulators have not deferred the applicability of their regulations with respect to retail forex transactions by broker-dealers.
Regulators and Who They Regulate
CFTC. The CFTC is authorized to adopt registration rules and other requirements for retail forex dealers subject to its exclusive jurisdiction or unregulated by another federal agency. This would include FCMs that are registered with the CFTC but not subject to SEC or banking regulation, as well as dealers that are not regulated by any federal regulator (RFEDs).
The CFTC also is permitted to regulate any person soliciting retail forex transactions, including introducing brokers, as long as the person is not regulated by the SEC or a banking regulator.
SEC and Other Regulators. Under Dodd-Frank the SEC now has express authority to adopt rules regulating forex dealers that are broker-dealers. The statutory provisions would prohibit a broker-dealer from acting as a forex dealer absent enabling SEC regulations. On July 13, 2011, the SEC adopted rules that impose no new requirements for broker-dealers acting as forex dealers for one year in order for the SEC to study the impact of regulations in trading in foreign ordinaries among other issues.
Applicable statutory provisions do not prohibit self-regulatory organizations from regulating the activities of their members even though the federal regulator itself is prohibited from regulating those subject to its jurisdiction. As a result, both the NFA and FINRA have adopted rules governing retail forex activities of their members.
NFA. The NFA has amended its rules to establish a new category of membership, a Forex Dealer Member. As of October 1, 2011, this category will include any NFA member that acts as counterparty or offers to act as counterparty to a retail customer in a forex trade. Thus, any broker-dealer that is an NFA member and is acting as principal in retail forex trades would have to register as an NFA Forex Dealer Member and would be subject to a variety of NFA regulations.
In addition, various NFA rules of general application to its members may apply with respect to a broker-dealer’s retail forex activities, such as NFA Compliance Rule 2-29 on Communications with the Public and Promotional materials and related NFA notices.
Broker-dealers that are NFA members but do not intend on acting as principal in forex trades, but introduce their customers to another forex dealer, are not required to register as Forex Dealer Members, but are still subject to a variety of NFA regulations.
FINRA. In 2008, FINRA issued a notice to members (No. 08-66) advising them that certain FINRA rules will apply to members with respect to their retail forex transactions. Most importantly, FINRA states that engaging in retail forex activity entails a material change in business activity and, therefore, a firm proposing to engage in this activity must file a Rule 1017 application for a change in its membership agreement. FINRA also stated that its “catch-all” Rule 2110, requiring members to act in a just and equitable way, applies to retail forex transactions. However, FINRA states that it will look to NFA rules and interpretations as the applicable standards under Rule 2110. Finally, FINRA states that its advertising Rule 2210 will apply to retail forex activities.
Customer Funds Protection Considerations
If a broker-dealer carries customer accounts that include forex, it will be required to treat all forex positions as the equivalent of free credit balances for purposes of SEC Rule 15c3-3. This means that it may have to make Special Reserve Account deposits reflecting foreign currency positions maintained by it or its clearing firm if forex positions are held on an omnibus basis.
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