Back in 1974, when the US Congress established the Commodity Futures Trading Commission to regulate futures trading, there was no retail foreign exchange trading industry. Even as recently as 2000, when Congress enacted the Commodities Trading Modernization Act (CTMA), the question of who would oversee non-bank trading of FX, other than on the regulated exchanges, was not only unclear, it had probably not even been asked. A year later, Congress attempted to resolve the issue. In its Treasury Amendment, it stated that the CFTC had the mandate to protect retail customers trading in what it called off-exchange FX futures.
At the same time that the CFTC was created, Congress also authorized the formation of registered futures associations to give the futures industry the opportunity to regulate itself. This led to the formation of the National Futures Association, to which the CFTC effectively outsourced regulation.
As a result of the CTMA, all non-bank firms serving as FX market makers – retail platforms such as Oanda, Gain, FXCM and others – effectively came under the CFTC’s and NFA’s jurisdictions if they wanted to operate in the US.
According to Michael Stumm, founder and joint chief executive of Oanda, most of the NFA’s new forex dealer members welcomed the introduction of regulation. And until recently, he says, they have generally had good working relations with it. "At Oanda, we were very pleased with our relationship with the NFA and were eager to have them regulate the dealers and the industry."
But Stumm says the relationship has become more challenging. "About a year ago, a dramatic change in the NFA’s direction became apparent and some strange things started to happen," he claims.
It is widely documented that the US retail industry has faced problems as a result of the existence of poorly capitalized firms and, more perniciously, the activities of fraudsters who have taken advantage of lax regulation. The NFA has had to respond, and while reputable firms have welcomed some of the measures it has introduced, beneath the surface there are mutterings that the association is unduly swayed by the futures industry it was originally established to serve.
"We have started to see a marked change in the way the regulators have introduced new rules and interpreted old ones," says Stumm. "These have clearly targeted forex dealer members. While it is undeniable that because the FX industry was unregulated for so long it allowed the establishment of a number of ‘bad apples’, there are also many honest firms providing a much-needed service. Unfortunately, the changes already implemented, and additional ones being contemplated, will negatively affect even the most ethical firms."
As an example, Stumm says he cannot understand why Oanda cannot segregate client funds in the same ways futures commission merchants (FCMs) can, and indeed have to. "The segregation of client funds is standard for dealers of exchange-traded instruments," he says. "The US Bankruptcy Act explicitly states that client funds are protected and get the highest priority in the case of a bankruptcy for commodity trading. While legal interpretations vary on whether the Bankruptcy Act applies to OTC forex or not, we are disappointed that the NFA interprets this to apply only to exchange-traded instruments. The recent Refco case would have been an ideal time to test this in court. One would think that the NFA would want to protect client funds but their position on this benefits exchange trading to the detriment of forex dealer members. This is particularly confusing, given the fact that forex dealer members were required to be regulated by the CFTC, specifically because forex was considered a commodity."
Drew Niv, chief executive of FXCM, agrees that the NFA’s position is odd. "I believe there is a misunderstanding between industry wishes and the regulators," he says. "The FX industry only wishes to have FX customer funds treated like customer funds of exchange traded-instruments in case of bankruptcy, meaning customers get priority return of their money before banks and any other secured creditors. Regulators perceive it as a request for fund safety that they can’t really police and think the industry is asking for some kind of insurance scheme." The position of the US is at odds with other jurisdictions, such as the UK and Canada, which allow the segregation of client accounts for such firms as Oanda and FXCM.
A spokesman for the NFA rebuts the notion that the association is biased. "The US Bankruptcy Code provides special protections for customers trading on an exchange," he says. "However, these protections do not apply to off-exchange forex transactions. Holding customer forex funds in accounts separate from the firm’s operating funds does not guarantee that those funds will be available to meet customer claims in the event of the firm’s bankruptcy. As the code is currently written, the forex customers’ funds are not afforded any priority in the event of a firm’s insolvency, but, rather, these funds are pooled with all of the firm’s assets and the customers are treated as general creditors.
"This is not a matter of NFA allowing or not allowing the segregation of forex client funds. In fact, NFA rules do not prohibit forex firms from holding customer funds in accounts separate from their own. They simply do not allow them to use that as a selling point, since segregation falsely implies that the funds may be protected in a bankruptcy. Obviously, only the US Congress can pass legislation amending the code. We are aware that some forex dealer members have lobbied members of Congress to pass such legislation, so their assertions to you that NFA has control over this issue is somewhat baffling."
The NFA’s stance is that the code should only be amended if the FX industry is subject to the same level of regulation as exchange-traded markets. Stumm argues that there is a legal difference between segregating funds and separating funds. "We don’t want to just separate funds and advertise safety, but want to be able to segregate funds so that client funds are appropriately protected, and we welcome the same level of regulation [as the exchanges]," he says.