FX Compliance

What Every Investor Should Know Before Trading In The FOREX Market

What is the general credit risk concern that you have as a client?

Over-the-counter (OTC") foreign currency ("FOREX") transactions are private agreements made between you, the client, and the dealer. As a result, you, the client, are subject to the risk relating to the credit worthiness of the dealer. Unlike other markets, there is no exchange or central clearing house to support the transaction. If you have profitable trades, you want assurances that the dealing firm has the ability to remit funds to you for such trades. Therefore, in the same way that a bank making a loan wants to know that the client has sufficient net worth to repay the loan, you want to know that the dealer on your currency trades has the capital base to make payment on trades.

Aren't all FOREX dealers regulated in a manner that ensures each such dealer will be able to make payment on client trades?

No. In fact, some of the parties with whom you enter a foreign currency transaction may be a legal entity with no capital at all.

The Commodity Exchange Act, the law that governs FOREX trading, was amended in 2000 to allow only regulated entities, such as banks, insurance companies, broker-dealers or futures commission merchants, and affiliates of such regulated entities to enter into FOREX trades with clients. Allowing these fully regulated entities to create affiliates that conduct such trading has proved problematic for regulators and is an issue that they have been working to address while handicapped with limited regulatory authority. These affiliates do not have the net capital requirements and many of the other regulatory requirements associated with a fully-regulated entity. As a result, many FOREX dealers create an affiliate to conduct FOREX trading with minimal regulation. While advantageous for the FOREX dealer, it exposes, you, the client, to greater risk.

The implications of this legal loophole were recently exposed with the bankruptcy filing of Refco, Inc. Refco, Inc. operated unregistered affiliates that were part of the bankruptcy filing. One such entity was Refco FX Associates, LLC. Refco FX Associates, LLC was a counterparty to FOREX trades, had no net capital requirements, and its clients are now creditors in bankruptcy court. The CFTC regulated division of Refco subject to greater oversight was not part of the bankruptcy filing and remains operational. Even client funds deposited in an FDIC-insured bank account are not protected if a dealer goes bankrupt.

What is the government doing about this issue?

The NFA has recently added additional rules in an effort to solve this issue. However, their power, and the potential impact, is hindered without any further legislation from Congress. They cannot force a FOREX dealer to sufficiently capitalize an affiliate, and cannot impose rules directly on the affiliate.

Addressing the issue means having our U.S. government examine and amend a few lines of the Commodity Exchange Act. However, when you take into account a few lines of an Act with hundreds of pages, and all of the other legislation on Capitol Hill, and then recognize that both the Congress and Senate must pass a law to complete this action, you can see how this matter is bogged down in bureaucracy. Who knows if and when action will take place?

So what can clients do to protect themselves?

You should ask any currency dealer how it is regulated (e.g., if it is an affiliate of a futures commission merchant) and check with the dealer's regulator about the dealer's registration status and background. You should also ask the dealer if its' regulator has adopted rules to regulate its' retail FOREX activities.

The CFTC, on their web site, publishes a list of registered futures commission merchants ("FCMs"). If you are currently trading with a currency dealer that is not on this list, than there is a strong likelihood that your currency dealer is an unregistered affiliate of a futures commission merchant, and you should ask your currency dealer if they are an affiliate of an FCM. You may also check broker/firm information on NFA's Web site at www.nfa.futures.org/basicnet/ by typing in the name of the currency dealer. If doing so, do not let a currency dealer provide you with the name of its registered FCM and lead you to believe that you are doing business with the registered entity. Your credit and risk are tied to the entity to which you remit a check to open an account and fund trades. So, hypothetically and by way of example, if you remit a check to FOREXtrader.com and they tell you to check their status as FOREX, LLC, do not let them mislead you that, because FOREX, LLC is a registered FCM, FOREXtrader.com is registered. Check under the name to which you remit funds.

So, a registered currency dealer / FCM with the most capital is the most creditworthy FCM?

Not necessarily, although a currency dealer with a lot of capital would like you to believe this.

An open trade with a client is a liability for a currency dealer, and the currency dealer must have assets to cover the liability. So, while a currency dealer with more clients may have more capital, they also have more liabilities. In other words, a currency dealer with $3 million in capital and $1 million in client liabilities is in a better financial position than a currency dealer with $60 million in capital and $59 million in client liabilities.

A question also worth examining is who owns an FCM/currency dealer, what affiliates are owned by an FCM, and what is the potential impact of such ownership issues? In the current Refco matter, Refco, Inc. owned twenty-three affiliates that filed for bankruptcy along with its parent company. The remaining entities owned by Refco are assets of Refco that are being sold in the bankruptcy proceeding. In most situations, this will, for better or worse, likely result in material changes in management and the business operations at these entities. You may check the ownership information of a currency dealer on NFA's Web site at www.nfa.futures.org/basicnet/ by typing in the name of the currency dealer. Owners of 10% or more of a firm are listed as principals of the firm.