August 2011 | Legislative Intelligence Update

August 2011—Legislative Intelligence Update | Retail Foreign Exchange under Scrutiny and in Regulatory Flux

Welcome to this edition of IMCA's Legislative Intelligence update. This month's update discusses retail foreign exchange currency (forex) transations. In recent years, both advisors and their clients have become interested in foreign currency (forex) transactions. As this interest has increased, so has scrutiny by financial regulators, especially in the area of off-exchange forex transactions aimed at retail customers. While it is uncertain what form final regulatory requirements for retail forex transactions will take, over the next year retail forex certainly will come under even greater scrutiny.

The purpose of this update, prepared by Morgan Lewis, is to give members legislative and public affairs intelligence and analysis and is strictly informational and educational. IMCA, as an education and credentialing organization, does not lobby legislators or regulators nor advocate for any particular legislative or regulatory position either on its own or through its relationship with Morgan Lewis.

If, after reading this update, you have additional questions please contact IMCA using the "Questions? E-mail IMCA" button at the bottom of this e-mail. We will either respond personally to your inquiry or include a response in an upcoming issue.
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Retail Foreign Currency under Scrutiny and in Regulatory Flux

In recent years, more and more financial advisors and their clients have become interested in foreign currency (forex) transactions, including for hedging purposes and speculation. As this interest has increased, so has scrutiny by financial regulators, especially in the area of off-exchange forex transactions aimed at retail customers. Amidst this increased demand and regulatory scrutiny is a realignment of the regulation of forex transactions as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). This means that retail forex transactions will come under even greater scrutiny over the coming year.

By way of background, in November 2008, FINRA issued Regulatory Notice 08-66 providing guidance on the applicability of its rules to the retail forex activities of its members, and in doing so put members on notice that sales practices in this area are a significant concern for the regulator. FINRA described the forex market as volatile and risky and indicated its belief that the retail forex market has grown "in part due to aggressive, and sometimes misleading, advertising that minimizes risks and exaggerates potential returns." In Notice 08-66, FINRA declared that the obligations of members to observe high standards of commercial honor and just and equitable principles of trade apply to a member’s retail forex activities, and that a member’s forex-related communications must be fair and balanced and have a sound basis for evaluating the facts regarding both the forex market generally, as well as the customers’ specific transactions. This includes adequately disclosing forex trading risks and not referencing Securities Investor Protection Corporation (SIPC) membership or protection. Nine months later, in August 2009, FINRA expelled a firm engaged in retail forex activities for violations of net capital, customer protection, and anti-money laundering rules.

More recently, the SEC has made clear its concerns regarding retail forex activities. On July 20, 2011, the SEC Office of Investor Education and Advocacy issued an investor bulletin warning individual investors of the "very risky" nature of forex trading. A week before, the SEC announced that it had filed fraud charges against the chief executive officer of a forex firm.

The SEC investor bulletin and enforcement action followed the SEC’s adoption of an interim final temporary rule (Interim Rule) that permits broker–dealers to engage in retail forex transactions through July 16, 2012, when the Interim Rule automatically expires. The SEC has indicated it will use this time to determine the appropriate regulatory framework for broker–dealers conducting retail forex business, including the possibility that it might prohibit broker–dealers from conducting retail forex transactions.

The Interim Rule was necessary due to changes to the Commodity Exchange Act (CEA) made by Dodd-Frank. The CEA provides that only enumerated regulated entities are permitted to enter into or offer to enter into off-exchange forex transactions with retail customers. These regulated entities include U.S.-regulated banks, SEC registered broker–dealers, and Commodities Futures Trading Commission (CFTC) registered futures commission merchants and retail forex dealers. For purposes of forex transactions, retail customers are defined as persons that are not so-called “eligible contract participants” (ECPs). ECPs are persons and entities with significant resources and sophistication. For example, as amended by Dodd-Frank, an individual is an ECP if he or she has in excess of $10 million “invested on a discretionary basis,” and a commodity pool formed and operated by a person regulated under the CEA is an ECP for purposes of retail forex transactions only if all of the participants in the pool are ECPs.

Dodd-Frank requires that a federal regulatory agency adopt rules on retail forex transactions in order for an enumerated entity subject to its jurisdiction to be able to conduct a retail forex business. The CFTC, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency each adopted a set of final rules that establish a set of regulatory requirements pursuant to which those entities subject to their jurisdiction may conduct retail forex transactions. The SEC, in adopting the Interim Rule, has only begun the process of determining whether registered broker–dealers will be permitted to enter into forex transactions with their retail customers and, if permitted, the rules to which such business will be subject.

While it is uncertain what form the SEC's final regulatory requirements for retail forex transactions will take, over the next year retail forex certainly will come under even greater scrutiny. When issuing the Interim Rule, the SEC noted news stories about “potentially abusive practices” and “concerns with regard to retail forex practices.” Firms engaging in forex transactions for clients or advising clients on forex transactions must remain mindful of the increasing regulatory scrutiny that retail forex activities are under and be alert for further changes as the SEC takes a more active role in this area.
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Endnotes
1. FINRA Regulatory Notice 08-66, (Retail Foreign Currency Exchange) (November 2008).
http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p117362.pdf.

2. The investor bulletin is available on the SEC website at: http://sec.gov/investor/alerts/forextrading.pdf.

3. SEC Charges Forex Ponzi Operator Who Fled After Scheme Unraveled, SEC Press Release 2011-147 (July 15, 2011). "http://www.sec.gov/news/press/2011/2011-147.htm.

4. See 76 Fed. Reg. 41676 (July 15, 2011).