Regulatory Roundup : January 2009

Raising the licensing barriers in Retail FX

The birth of retail foreign exchange regulations brings to mind Clint Eastwood in the movie The Good, the Bad and the Ugly. Fearless and determined, Eastwood calmly dispatches a group of bandits in the streets of a dusty Wild West town. That is how we imagine the Wild West in the 19^th century--full of outlaws trying to dominate the newly built American towns.

The early years of foreign exchange regulations can be compared to the Wild West. Fortunately, in recent years regulators have taken aggressive enforcement steps to drive out the outlaws while establishing a regulatory framework to allow for industry growth. Not all jurisdictions, however, have embraced regulating retail FX. Arguably, the vast majority of developing countries do not have the requisite framework necessary to regulate this industry. These days, developing nations are busy struggling with the recent economic crisis, and are devoting little time--if any--to regulating the new industry.

A few jurisdictions prohibit it entirely. For instance, in China, soliciting clients and accepting funds for leveraged foreign exchange trading is strictly forbidden, except in Hong Kong. This restriction is strictly enforced, and some foreign FX brokers have paid a dear price in recent years for ignoring the local mandate.

Regulation through enforcement

Fraud is commonly present where there is lack of enforcement and regulation. In order to police an industry, law enforcement and regulators must be able to use a regulatory framework. Most of the unscrupulous activity in retail FX in the late 1990s was due to introducing solicitors and money managers being largely unregulated. As a result, in the past 8 years, legislators in the U.S., Canada, UK, Japan, Hong Kong, and Singapore enacted laws to police against FX fraud.

The United States has been at the forefront of developing retail FX regulations through its enforcement efforts. The Commodity Futures Modernization Act of 2000 (“CFMA”) enabled the Commodity Futures Trading Commission (“CFTC”) to prosecute corrupt operators. The CFMA further set a precedent that CFTC will prosecute firms for failing to registering with the industry’s Designated Self Regulatory Organization, the National Futures Association (“NFA”). The enforcement actions against unscrupulous operators legitimized the raidly growing industry in the United States since then.

The enforcement efforts also gave rise to new legislation. Recently enacted into law, the CFTC Reauthorization Act of 2008 set forth registration requirement for introducing solicitors, money managers and pool operators. While the CFTC is currently drafting rules regarding the oversight of these entitles, the agency has been hard at work, successfully prosecuting bad operators. As a result of this effort, for instance, on 9 December 2008, the Florida federal court ordered 9 defendants to pay more than $12 million in penalties and customer restitution.

Regulation through enforcement is visible in other jurisdictions as well. In the past 2 years, the Japanese Financial Supervisory Agency (“FSA”) has successfully revoked the license from several registered forex brokers for failing to comply with its rules and regulations. The majority of these firms lost their retail FX license because of misleading solicitation practices, failing to have the necessary risk controls, and failing to follow the required accounting standards. Another Japanese regulator, The Kanto Local Finance Bureau (“KFB”), has recently amended the Japanese Income Tax Law in order to ensure that both the brokers and their clients properly report their income (or loss) to the agency. Today, forex brokers in Japan are required to submit monthly customer transaction reports to KFB. These reports allow the regulator to assess whether retail clients properly reported their income for taxation purposes.

As a result of the enforcement efforts throughout the different jurisdictions, regulators also set forth higher entry barriers for forex brokers. The intent of a high threshold was not to eliminate competition from smaller firms, but rather to provide the regulators an opportunity to conduct a detailed due diligence on those who propose to offer retail FX services. For instance, in Hong Kong, a retail leveraged foreign exchange broker must be governed by two Responsible Officers. At least one of these officers must reside in Hong Kong. Each Responsible Officer is required to prove to the Hong Kong Securities and Futures Commission that they he has both knowledge of and experience in the industry. In addition to passing a challenging licensing examination, he has to show at least 3 years of relevant managerial experience to be fully licensed as a Responsible Officer.

Other regulated jurisdictions have similar, though not so rigorous, licensing requirements. For instance, the U.S., UK, Canada, Japan, and Singapore require sales staff to be licensed prior to engaging in solicitation of retail clients. Likewise, dealers have to be licensed prior to processing customer trades. The licensing barrier, however, was raised by another notch in the U.S. recently. In addition to passing the National Commodity Futures Examination, also known as the Series 3, the NFA recently announced a new Series 34 Examination titled Retail Off-Exchange Forex Examination. Proposed amendments to NFA Bylaw 301 will require any individual seeking approval as a forex firm or forex individual to pass the Series 34 examination before engaging in off-exchange forex business with retail customers.

Additional licensing barriers were set forth in the form of financial capital requirements. For instance, in the UK, a forex broker must have a base capital requirement of €730,000 in addition to capital derived from a market and credit risk formula. Japan's capital requirements are entirely formula based, tailoring the capital requirements to each individual firm. Until 2008, the largest capital threshold was in Hong Kong, at approximately $4 million. Earlier this year, the CFTC Reauthorization Act raised the minimum adjusted capital requirement to $20 million. The threshold was subsequently raised higher by the NFA to $30 million for firms who offer leverage greater than 100:1.

Regulations that set forth financial barriers cannot be left unchecked. Regulators typically audit forex brokers on an annual basis. The length and depth of the audit will vary depending on the size and jurisdiction of the firm. In Japan, the on-site audits are typically short in comparison to the U.S. The Japanese FSA will spend on average from 1 to 4 weeks on-site. In the U.S., NFA on-site audits can range from 4 to 8 weeks for a similar firm.

Annual audits allow regulators to check whether the firm is operating in compliance of its rules and regulations. If a firm has a pattern of violations, regulators will take an enforcement measures against that firm. For instance, from the enactment of the CFMA to 2007, the CFTC filed 7 actions against registered forex dealers and approximately 60 actions against unregistered firms. In the same time span, the NFA filed 29 Business Conduct Committee (“BCC”) actions against Forex Dealer Members (“FDMs”). Since 2007, these numbers have increased slightly as mostly larger and more reputable firms remained in the industry. In Japan, after registration of forex dealers began in 2005, the Financial Supervisory Agency warned several dozen member firms for failing to comply with the FSA regulations.

Finally, enforcement actions have played a significant role in setting forth regulations regarding introducing solicitors and money managers. Previously, jurisdictions that did not require registration of these entities were more likely to be infiltrated by unscrupulous players. Retail clients with little or no knowledge about the risk associated with leveraged FX were vulnerable to the misleading promises made by the introducing solicitors. Fortunately, enforcement actions against these introducers have helped to shape oversight over their activities. In addition to requiring introducing broker (“IB”) and money manager registration, the CFTC Reauthorization Act ensures that the same regulatory requirements are applied to commodity and futures IBs. Introducing solicitor registration has already been required in Canada, Japan, UK, Hong Kong and Singapore for a number of years. Annually, enforcement actions are taken against solicitors who fail to follow the regulatory law of their country. Enforcement has been a stepping-stone for regulators to legitimize retail FX and shape the future of the industry’s regulatory framework.

Key to successful regulation: Transparency

In jurisdictions where retail forex is regulated, transparency has been a key to successful oversight. In order for retail clients to distinguish between good and bad brokers, regulators require disclosure. The type and depth of the disclosure will greatly vary with each regulated country. However, regulatory transparency helps to guide retail clients in making educated choices prior to opening an account.

The risks associated with leveraged forex transactions are often ignored by clients’ speculative instincts. In the first few years of retail FX, unscrupulous brokers took advantage these instincts by failing to disclose the risks. When retail clients sustained losses as a result of misleading promises, regulators took notice. While enforcement efforts since the 1990s helped to curtail most of the fraud, transparency of risks and rewards was the cornerstone of recent regulations. In the U.S. and UK, for instance, suitability of customer risk tolerance is necessary prior to opening an account. Because of the OTC nature of the market, in the past 2 years regulators in the U.S. and across the European Union have mandated further transparency in dealing practices.

Since 2007, the Markets in Financial Instruments Directive (“MiFID”) a harmonized regulatory regime for investment services across the 30 member states of the European Economic Area (the 27 Member States of the European Union plus Iceland, Norway and Liechtenstein) required retail forex firms to take reasonable steps to obtain the best possible result in the execution of an order for a client. The best possible result is not limited to execution price, and also includes cost, speed, likelihood of execution and likelihood of settlement, and any other factors deemed relevant.

Similar to the MiFID initiative, in 2008, the NFA made significant strides to tackle the execution and dealing practices of its member firms. FDMs are now required to maintain records of all price adjustments that are filed with the NFA on a weekly basis. A recent proposal pending before the CFTC intends to limit FDMs’ ability to retroactively adjust prices. Also, a pending rule relating to electronic trading systems seeks to require FDMs to have annually reviewes of the integrity of their trading platforms.

Transparency practices in the regulated jurisdictions lead to a better understanding by clients of the risks associated with retail FX trading. The next step in the transparency movement was taken by U.S., UK and Japanese regulators to better understand the electronic trading systems offered by firms. As a result, regulators in these countries have assured retail clients that doing business with their member firms is safe.

The last decade has been instrumental in developing retail foreign exchange regulations. Many regulatory accomplishments helped to eradicate the initial, Wild West type of market. Like a sheriff saving a town from bandits, regulators in the U.S., Canada, UK, Japan, Hong Kong and Singapore helped to drive out unscrupulous firms. . Firms who have withstood the wild early years have made significant contributions in shaping the regulatory framework. Without firms who do honest business in FX, it would have been hard to curtail the fraud that took place in the 1990s, and without an adequate regulatory framework, retail clients would leave our rapidly growing industry.