Foreign Exchange Controls
- I. The Forex Industry
- II. CFTC Regulation of Foreign Exchange
- III. Regulation of Forex Dealers and Transactions by the NFA
- IV. The Foreign Exchange Committee
- V. The Foreign Exchange Dealers Coalition.
- Reference List
I. The Forex Industry
A. Fraud in Retail Forex Industry
In recent times, there has been rampant fraud within the retail foreign exchange trading industry. Specifically, there have been numerous issues with unregulated, off-exchange, Forex dealers and transactions. Many retail consumers have lost substantial amounts of money in Forex trading. In certain types of Forex trading, Forex dealers serve as the counterparty to the contracts sold to the retail customer. The underlying contract is not traded on an actual exchange such as the Chicago Board of Trade, but is rather entered into off-exchange. Thus, if the investor lost money, the dealer, as the seller of the financial instrument, makes money. This can lead to a conflict of interest where the dealer may have a significant bias towards the investor losing money. Off-exchange transactions have led to fraudulent behavior by unscrupulous Forex dealers. In addition, many dealers would deceptively advertise Forex trading as an easy way to make money, without any significant risk of loss. Many unsophisticated investors were taken in by promises of easy wealth.
B. CFTC Advisory on Retail Forex
To that extent, the Commodities and Futures Trading Commission (“CFTC”) has issued an advisory to consumers regarding the threat of foreign exchange fraud.i This advisory warns consumers about offers for Forex that sound too good to be true. The advisory notes that off-exchange Forex investments are highly risky at best, and outright fraudulent in many cases. The advisory further states that while foreign exchange markets have some of the highest dollar volume in the world, the main participants in these markets are large financial institutions, companies, and certain investors. Therefore, foreign exchange markets may not be appropriate for the individual retail investor due to the nature of the markets and their participants. The advisory lists various enforcement actions the CFTC has taken against foreign exchange dealers who engaged in fraudulent activities.
C. Forex Hedging by Commercial Entities
Large financial institutions and companies use foreign exchange hedging in order to minimize risk due to foreign currency fluctuations. For example, if a United States company doing business in Japan is compensated in yen, that company has risk associated with fluctuations in the value of the yen versus the U.S. dollar. That company may wish to lock in its exchange rate and therefore define its risk by using forward contracts, futures or options on futures. The foreign currency exchange offers commercial entities liquid markets with which to hedge their risk associated with conducting business on an international scale.
II. CFTC Regulation of Foreign Exchange
A. Commodity and Futures Modernization Act of 2000
Due in part to the fraud associated with retail Forex transactions, Congress and the President enacted the Commodity Futures Modernization Act of 2000 (“CFMA”). The CMFA amended the terms of the Commodity Exchange Act of 1974 (“CEA”) to clarify the jurisdiction of the Commodities and Futures Trading Commission (“CFTC”) for retail offerings of foreign exchange futures and options not traded on an official exchange. The CFTC was created by the CEA, and regulates the futures and options trading industry in the United States.
Pursuant to the CMFA, the CFTC has the jurisdiction and authority to take legal action against unregulated firms offering foreign currency futures and options to the retail public. The CFTC further has authority to investigate and prosecute foreign exchange fraud for firms registered with the CFTC.ii Pursuant to the CMFA, off-exchange contracts and options were illegal unless the counterparty is a registered entity according to the provisions of the Commodity Exchange Act. Appropriate counterparties include future commission merchants (“FCMs”) and certain affiliated persons of FCMs.
After the passage of the CMFA, it was unclear whether the CFTC has jurisdiction over spot Forex transactions under the jurisdiction granted by the CEA. Forward contracts, including those involving foreign currency, are exempt from regulation pursuant to federal regulations.iii This issue was litigated before the Seventh Circuit Court of Appeals in the case CFTC v. Zelener.iv In that case, the Forex dealer asserted that it was exempt from CFTC regulation since its foreign exchange contracts settled within 48 hours. However, the CFTC argued that the dealer essentially rolled the contract every two days, which resulted in the investor having an ongoing open position in the foreign currency which should be subject to the jurisdiction of the CFTC. This practice by the Forex dealer in this case exploited a loophole in the CFTC regulations.
The contracts that the Forex dealer sold the investors were not fungible, and could not be traded on any exchange. The Court examined the foreign exchange contracts sold by the Forex dealer and concluded that they were trading in a specific commodity, rather than entering into futures contracts that could be traded on an exchange. The Court stated, “This looks more like the business of a wholesaler in commodities such as metals or rare coins than like the system of trading in fungible contracts that characterizes futures exchanges.” The Court thus held that off-exchange foreign exchange contracts were not subject to the jurisdiction of the CFTC.
Due to the exemption of the OTC spot transactions from regulation of the CMFA and the Commodity Exchange Act, problems with off-exchange retail Forex trading continued. Numerous consumers were impacted by rampant fraud within the industry. Further, retail Forex consumers were subject to substantial financial risk associated with the high leverage made available for retail Forex transactions. Such leverage could reach as high as 100:1. With such high leverage ratios, retail consumers were subject to a substantial risk of loss even if the underlying currency made relatively minor price movements. Any increased volatility in the currency markets had the potential to wipe out unsophisticated retail Forex consumers. However, the CFTC issued regulations in 2010 which limited leverage for retail consumers to 1:50 for major currency pairs, and 1:20 for all other pairs.v
In order to close the significant loophole discussed in the Zelener case, the CFTC Reauthorization Act of 2008 (“CRA”) was passed. The CRA amended the CEA, and gave the CFTC the statutory authority to promulgate rules governing certain foreign exchange trading activities. The CRA extended the reach of the CFTC to include off-exchange retail Forex transactions, providing it with the power to write and enforce regulations regarding such transactions. The CRA specifically amended section 2(c)(2) of the CEA by extending CFTC regulatory authority to include off-exchange retail Forex transactions.
The CRA further required the registration of those who solicit orders, operate commodity pools, or exercise discretionary trading authority with regard to off-exchange retail foreign currency transactions. In connection with the increased rulemaking authority conferred by the CRA, the CFTC created a new category of permitted counterparty for foreign exchange contracts in 2010, called a Retail Foreign Exchange Dealer (“RFED”). An RFED is an individual or organization which serves as a counterparty to an off-exchange foreign currency transaction with a non-eligible participant. The type of transactions covered include futures contracts, options on a futures contract, or an offer for a contract entered into on a leveraged or margined basis, or financed by the offeror, counterparty or person acting in concert with the offeror or counterparty.vi
C. The Dodd-Frank Act.
President Obama signed the Dodd-Frank Act (“Dodd Frank”) into effect on July 21, 2010.vii The alleged purpose of Dodd-Frank was to reduce risk, increase transparency and promote market integrity within the financial system. Dodd-Frank directed regulators to prescribe requirements for: disclosure, recordkeeping, capital and margin, reporting, business conduct, documentation and other standards or requirements as necessary.
Title VII of Dodd-Frank further amended the CEA by establishing a new regulatory framework for swaps and security based swaps. Such swaps may have been responsible, in part, for the financial crisis of 2008. The definition of swaps under Dodd-Frank is quite broad, and includes specific references to both currency and foreign exchange swaps.viii However, in November of 2013, the U.S. Treasury issued a rule which stated that foreign exchange swaps and foreign exchange forwards were exempt from the definition of swaps under the CEA.ix Thus, these types of transactions are exempt from the clearing and trading requirements of Dodd-Frank.
III. Regulation of Forex Dealers and Transactions by the NFA
Pursuant to Dodd-Frank and the CRA, the CFTC has adopted final rules applicable to off-exchange retail Forex transactions. According to the CFTC, these rules are based upon existing regulations for commodity interest transactions, as well as the rules of the National Futures Association (“NFA”) for retail Forex transaction already in effect for the members of the NFA.x The NFA is an independent self-regulatory agency charged with the regulation of the commodities and futures industry in the United States.
The NFA, along with the CFTC, is responsible for the regulation of RFEDs. An RFED must register with the NFA, unless otherwise exempt pursuant to the provisions of Title VII of the CEA, in order to conduct business with the public. An RFED must further have a principal that is registered as a Forex Associated Person with the NFA. The NFA defines any of its members that serve as counterparties to Forex transactions as Forex Dealer Members.xi
A. RFED Compliance Requirements.
RFEDs are further required to follow numerous compliance rules for Forex transactions. In order to register as an RFED with the NFA, the RFED must have at least one principal that is an approved Forex Associated Person by the NFA. Rule 2-36, promulgated by the NFA, sets forth requirements for Forex transactions.xii These requirements include, but are not limited to, not defrauding any other person, not creating any false records in connection with a transaction, and not engaging in manipulative acts or practices with regard to Forex transactions. Rule 2-36 also requires that Forex dealers adequately supervise their employees. In addition, certain disclosures for new customers and prohibitions on types of reporting of hypothetical results are set forth, similar to other futures and commodities market participants registered with the NFA. The risk disclosures must include the essential features and risks of Forex trading, and must be provided to customers prior to opening an account. The disclosure must include the language required by CFTC Regulation 5.5(b).
The NFA requires extensive reporting requirements for RFEDs, including daily, monthly and quarterly Forex transaction reports to be provided to the NFA.xiii RFEDs must further provide monthly statements to its customers which identify all account activity and comply with CFTC Regulation 5.13. The statements must show all offsetting transactions, rollovers, deliveries, exercise of options, trades, and monetary adjustments. A statement is still required every three months even if a customer’s account has had no balance changes or open positions since the prior statement. The statement must clearly show: open Forex transactions with acquisition prices, net unrealized profits or losses in all open transactions as marked to market, any money or other security held as margin, a detailed accounting of all financial charges and credits including realized profits and losses.
B. Capital Requirements for Forex Dealers
The NFA has set forth capital requirements for registered Forex Dealers. Pursuant to Section 11 of the NFA’s rules, Forex Dealers must maintain an adjusted net capital of at least $20 million, or the $20 million plus 5% of all liabilities owed to customers exceeding $10 million.xiv A Future Commission Merchant (“FCM”) may be required to maintain capital as required by other provisions of NFA regulations applicable to FCMs.
IV. The Foreign Exchange Committee
The Foreign Exchange Committee (“FXC”) is an industry group comprised of representatives from prominent financial institutions engaged in foreign currency trading in the United States. The group is sponsored by the Federal Reserve Bank of New York (“FRBNY”). As set forth in the FXC’s charter, the organization’s purpose is to serve as an advisory group providing guidance to the FRBNY on conditions and issues within the foreign exchange markets.xv The FCX has a number of stated purposes, including enhancing knowledge and understanding of the foreign exchange markets, to foster improvements in the quality of risk management in the foreign exchange markets, and to develop recommendations on market issues and practices in order to improve the functioning of such markets. The FCX is governed by a Committee of no more than 35 members. The current Committee includes members from Goldman Sachs & Co., Citigroup and Blackrock, among others. The FCX has issued its own guidelines for foreign exchange trading activities.xvi
V. The Foreign Exchange Dealers Coalition.
The Foreign Exchange Dealers Coalition (“FXDC”) was a group organized by major retail Forex dealers in 2007 in response to the actions taken by the CFTC and Congress regarding the proposed regulation in the industry. The FXDC wished to provide input to the proposals for major regulatory changes at that time, including the required registration for RFEDs with the NFA.xvii It appears that the group is no longer in existence.
i U.S. Commodities Futures Trading Commission, (2013, December 8). Foreign Currency Exchange Fraud. U.S. Commodities Futures Trading Commission. Retrieved December 8, 2013, from https://www.cftc.gov.
ii U.S. Commodities Futures Trading Commission, (2002, March 19). Advisory Concerning Foreign Currency Trading by Retail Customers. U.S. Commodities Futures Trading Commission. Retrieved December 8, 2013, from https://www.cftc.gov.
iii 7 U.S.C. § 1a(49).
iv C.F.T.C. vs. Zelener, 373 F.3d 861 (7th Cir. 2004).
v U.S. Commodities Futures Trading Commission, (2013, December 8). Final Retail Foreign Exchange Rules. U.S. Commodities Futures Trading Commission. Retrieved December 8, 2013, from https://www.cftc.gov.
vi National Futures Association, (2013, December 8). Retail Foreign Exchange Dealer. National Futures Association. Retrieved December 8, 2013, from www.nfa.futures.org.
vii U.S. Commodities Futures Trading Commission, (2011, September 12). Federal Register, Volume 76, Issue 176. U.S. Commodities Futures Trading Commission. Retrieved December 8, 2013, from https://www.cftc.gov.
viii 7 U.S.C. § 1a(47).
ix Wilson, Sonsini. Goodrich & Rosati, (2013, February 13). Second Update: Dodd-Frank Rules Impact End-Users of Foreign Exchange Derivatives – Next Steps. Wilson, Sonsini. Goodrich & Rosati. Retrieved December 8, 2013, from https://www.wsgr.com.
x U.S. Commodities Futures Trading Commission, (2013, December 8). Final Retail Foreign Exchange Rules. U.S. Commodities Futures Trading Commission. Retrieved December 8, 2013, from https://www.cftc.gov.
xi National Futures Association, Bylaw 306, Forex Dealer Members (October 1, 2011).
xii National Futures Association, Rule 2-36, Requirements for Forex Transactions (October 1, 2011).
xiii National Futures Association, (2013, December 8). RFED Reporting Requirements. National Futures Association. Retrieved December 8, 2013, from www.nfa.futures.org.
xiv National Futures Association, Section 11, Forex Dealer Member Financial Requirements (February 1, 2011).
xv Foreign Exchange Committee, (2013, January 16). Charter. Foreign Exchange Committee. Retrieved December 8, 2013 from https://www.newyorkfed.org/.
xvi Foreign Exchange Committee, (2010, November 1). Guidelines for Foreign Exchange Trading Activites. Foreign Exchange Committee. Retrieved December 8, 2013 from https://www.newyorkfed.org/.
xvii Investopedia, (2013, December 8). Foreign Exchange Dealers Coalition. Investopedia. Retrieved December 8, 2013, from www.investopedia.com.