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Felix Shipkevich July 29, 2008

April 7th, 2008

Felix Shipkevich, general counsel, and Anna Vidiaev, staff attorney, at online foreign exchange trading company Capital Market Services in New York say a proposed rise in capital requirements for retail brokers will result in an anticompetitive market.

In his September 26 testimony before the US House of Representatives Committee on Agriculture, Dan Roth, president of the National Futures Association (NFA), proposed a set of new rules and regulatory measures for the NFA’s two dozen foreign exchange dealer members (FDMs).

The NFA regulates the retail over-the-counter forex industry under the jurisdiction of the Commodity Futures Trading Commission (CFTC), which is pending reauthorisation. The proposal outlines rule changes designed to better protect retail investors. However, it will have a drastic effect on the industry, because it undermines the ability of some FDMs to continue their business, and could make the industry dangerously less competitive.

One of the proposed changes seeks to significantly alter retail FX dealers’ financial requirements by increasing the requisite adjusted net capital (ANC). The minimum adjusted net capital for FDMs has undergone several changes in the past few years. It was raised from $250,000 to $1 million in 2006, and then again to $5 million in December 2007. Even before this last change came into effect, and without seeing the effects of the newly established thresholds, the NFA proposed a new $20 million ANC requirement. The regulatory changes attached to the CFTC Reauthorisation Act include this proposed rule. Additionally, FDMs that offer the option of leveraging higher than 1:100 would be required to maintain an amount double the ANC. This additional requirement would raise the threshold to as high as $40 million.

If the new rule comes into effect, it might cause a major overhaul of the FX industry. The new threshold could force some existing dealers to consolidate and would make it undeniably harder for new and prospective FDMs to form in this relatively new industry, only a decade or so in existence. The industry is already small, with only about two dozen firms operating at this time. Only a handful of the FDMs have the resources to independently withstand such a drastic increase in capital requirements. All but the larger FDMs are alarmed that the adoption of the proposed rules will put them in the position of considering two unappealing possibilities: merging or liquidating. The NFA’s proposal would potentially weed out the smaller firms, who are less capable of holding the necessary capital, and would eliminate jobs from the industry. At the same time it would reward the larger, more capable companies with a bigger market share.

The presumed intent of the proposed regulations is to curb the fraudulent activity that has plagued the FX industry. One of the provisions of the proposed regulations requires the formal registration of solicitors with the NFA. Historically, most of the actions brought against entities for illegal FX activities involved unregistered solicitors, which is why the NFA’s proposition to require registration has received great support from most players within the industry. With the biggest threat to the market-place addressed by this mandatory solicitor registration, it is unclear whether the $20 million ANC requirement would have a significant additional impact on preventing forex fraud.

Although retail FX is a relatively new industry, it has been growing rapidly around the globe. Foreign jurisdictions such as the UK, Japan and Hong Kong have established FX industries without the retail fraud problems faced by the US. The regulations in these countries focus more on proper registration and oversight than on financial requirements. Rather than impose a high capital threshold for all, the capital requirements in these jurisdictions allow for the assessment of the particular risks and needs of the firm member. For example, the largest base requirement in the UK is e730,000 with additional risk-assessment based formulas. Japan’s capital requirements are entirely formula-based, tailoring the capital requirements to each individual firm. The largest capital threshold seems to be in Hong Kong, at approximately $4 million.

It is understandable that the intent behind raising the adjusted net capital is to provide some form of a safety net for existing customers and potential investors. Also, the new solicitor registration requirements go a long way towards addressing the industry’s core issues. The effects, however, would go well beyond merely bumping up an already existing regulation and could wipe out many smaller members of the industry. This proposed $20 million adjusted net capital requirement might prove to be unduly burdensome and could create a dangerously anti-competitive foreign exchange industry.

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