PROPOSED LEVERAGE of 100:1
The NFA has recently requested that the Commodity Futures Trading Commission (CFTC) approve another rule proposal that would place additional restrictions on the margin (leverage) levels that FDMs can offer to forex customers. If the CFTC approves this proposed rule, FDMs will be restricted from offering more than 100:1 leverage on major currency pairs and will be limited to 25:1 leverage on non-majors.
NFA has proposed this rule because it is “concerned that higher leverage amounts can deplete a customer’s account balance—and result in forced liquidation—much faster than retail customers realize.” CFTC has not yet approved this rule proposal, and there is not yet a specific date for when it would take effect.
Effectively, the proposed regulation would limit leverage to 100:1 on major currencies (GBP, CHF, CAD, JPY, EUR, AUD, NZD, SEK, DKK, NOK ) and 25:1 on all others.
EXPLANATION OF PROPOSED AMENDMENTS
NFA Financial Requirements Section 12 requires Forex Dealer Members (“FDMs”) to collect a security deposit of 1% of the notional value for specified currencies (called major currencies in the rest of this discussion) and 4% of the notional value for all other currencies.1 The rule also provides an exemption from collecting these amounts if an FDM maintains 150% of its capital requirement.
When NFA adopted Section 12 in 2003, it required a security deposit of 2% for major currencies and 4% for all other currencies. This was consistent with the margin requirements on the CME’s IMM at the time, which averaged 2% for major currencies and 3.9% for other currencies.
Before the rule became effective, NFA met with a number of FDMs that were concerned with the 2% requirement for the major currencies. These FDMs represented that the industry standard was 1% and that NFA’s requirement put them at a competitive disadvantage. NFA agreed to re-examine the security deposit requirement and issued an interim no-action position, allowing firms to charge 1% for the major currencies while NFA studied the matter. After evaluating its experience with the 1% level, NFA amended Section 12 to lower the requirement for the major currencies to 1%, and it adopted the exemption mentioned above, except that firms were required to maintain twice their capital requirement to qualify.
When NFA adopted the exemption, the minimum capital requirement for FDMs was $250,000. Given the substantial increase in the minimum capital requirement, in August 2008 NFA lowered the exemption threshold from 200% to 150% of an FDM’s capital requirement. (The FDM capital requirement was $5 million in August and will increase to $20 million by May 2009). The Board understood, however, that staff was continuing to study the security deposit requirement and ultimately would recommend a different approach.
Staff’s research focused on two areas. First, staff examined IMM margins to see how they compare with the security deposits required by Section 12. Second, staff also examined the actual leverage amounts offered by individual FDMs.
Current IMM margins are substantially higher than they were at the time Section 12 was adopted. As of December 24, 2008, margins for the major currencies averaged 5.6% and ranged from 3.5% to 8.2%. Margins for the other currencies traded on the IMM averaged 8.1% and ranged from 3.2% to 12.5%.
As with exchange margin, the primary purpose of the security deposit is to protect the FDM from absorbing the losses of defaulting customers which, if significant enough, could affect the FDM’s capital and put the funds of its other customers at risk.
Based on our experience with FDM practices, including that most FDMs use systems that liquidate customer positions before they reach a negative balance, NFA believes that the 1% and 4% security deposit requirement amounts remain sufficient at this time to protect against financial harm to FDMs and their customers even though they are significantly lower than margin requirements for on-exchange equivalents.
On the other hand, NFA is concerned that higher leverage amounts can deplete a customer’s account balance — and result in forced liquidation — much faster than retail customers realize. Of 21 FDMs, eight have the exemption from collecting minimum security deposits. Of these eight, one offers leverage of 700:1, four offer leverage of 400:1, two offer leverage of 200:1, and one offers leverage of 50:1. One of the firms without the exemption also offers leverage of 50:1. A proportionately greater number of the firms that offer higher leverage have also been the subjects of NFA complaints, while neither of the firms that offer 50:1 leverage has ever been the subject of an NFA or CFTC enforcement action. Of the 20 FDMs, eight have been named in ten complaints issued by the Business Conduct Committee in connection with their forex business. Seven of those complaints were against five FDMs that offer more than 100:1 leverage (including two firms with two complaints each).
These statistics indicate that FDMs can compete while offering leverage of 100:1 or less and that higher amounts can lead to abuses. The amendments leave the minimum security deposit amount at 1% and 4% and eliminate the exemption. Under the amendments, no FDM would be allowed to offer more than 100:1 leverage on the major currencies or more than 25:1 leverage on other currencies. This would bring the operation of the forex requirement more in line with on-exchange margins, which are not affected by the firm’s capitalization, while the required amounts would still allow FDMs to offer significantly higher leverage than is currently available for IMM contracts. NFA’s FCM Advisory Committee supported these amendments. NFA also sent the amendments to the FDMs for their comments and received eight responses.
One FDM with a large customer base fully supported this proposal, noting that it uses 50:1 leverage for the major currencies and has resisted customer requests for higher leverage because these levels force liquidation too quickly and frequently to be in a customers’ best interests. Another FDM supported eliminating the exemption but suggested that the requirement be changed to allow FDMs to offer 200:1 leverage in order to compete internationally. Five other letters also claimed that restricting them to 100:1 leverage would put them at a competitive disadvantage internationally. While these letters opposed the proposal, several of them stated that the international average
is 200:1 and this level would be an acceptable compromise. The other FDM opposed the proposal because it limits an FDM’s ability to use increased leverage as an incentive to place close-in stop orders. (This firm offers as much as 700:1 leverage.)
Commenters proposed several other alternatives besides increasing the allowable leverage to 200:1. One suggested providing exemptions for FDMs with effective risk management systems. Another commenter — whose preferred result is to increase the leverage to 200:1 — proposed, alternatively, that the rule only apply to U.S. customers. The ability to make these distinctions, however, may be problematic
since one commenter stated that even the disparity between the allowable leverage for major and minor currencies creates programming inefficiencies.
Finally, three letters took issue with comparing OTC security deposits with exchange margins. These letters suggested three factors that give FDMs more control over the risk in customer transactions than FCMs have over on-exchange transactions: FDM systems generally automatically liquidate positions before the account goes into deficit; the OTC forex markets operate continuously, with no gap between closing prices and the next day’s opening prices; and market-making gives firms more control over After reviewing the comments, NFA believes that the amendments are the best way to address NFA’s customer protection concerns with certain FDMs’ use of leverage. As noted above, the amendments already take the difference between on-exchange and off-exchange markets into account and allow higher leverage for OTC trades than is currently available for exchange transactions. Regarding the competition issue, two FDMs voluntarily use 50:1 leverage and those without exemptions manage with 100:1 leverage, indicating that firms can engage in the retail forex business and attract customers at these levels. Furthermore, the FDM that uses higher leverage to encourage close-in stop orders actually exemplifies one of the problems NFA is trying to address — that higher leverage can deplete the account balance and result in forced liquidation much faster than customers may realize.
NFA respectfully requests that the Commission review and approve the amendments to NFA Financial Requirements Section 12 and the Interpretive Notice regarding Forex Transactions.
Thomas W. Sexton
Vice President and General Counsel
Another NFA proposal is touching the topic of Forex Price Adjustments and Trade Practices