Forex regulation in spotlight: regulatory ambiguity resulting from the Zelener decision is one...

When the Commodity Futures Trading Commission (CFTC) goes through its periodic Congressional reauthorization this year, retail forex, in particular the Zelener decision, will be at the fore-front of review.

The Zelener decision produced confusion in determining when a contract is a

futures contract. In CFTC vs. Zelener, the U.S. Court of Appeals for the Seventh Circuit ruled that the forex contracts offered by the defendant were spot, rather than futures contracts. Because the CFTC's jurisdiction is limited to futures contracts, the court held that the CFTC lacked jurisdiction to bring an enforcement action against the forex dealer or its alleged agents for fraud.

In the Commodity Futures Modernization Act of 2000, Congress provided a clear distinction between retail participants in foreign currency transactions, who would be subject to regulation and those participants who would not. Although the CFTC's jurisdiction on off-exchange forex contracts was clarified by the CFMA, that jurisdiction depends on a determination that a forex contract is a futures contract.

"The NFA has taken a very visible role there; we firmly believe Congress should do something that essentially overturns or corrects the problems that were caused by the Zelener decision," says Dan Driscoll, COO at the National Futures Association (NFA).

It's also important to remember that while the Zelener decision is related to a foreign exchange case, that did not limit its applicability to foreign exchange, so the NFA believes the fix has to go beyond forex to all commodities."

ZELENER "FIX"

Registered forex firms are keeping an eye on the Zelener issue as something the CFTC's reauthorization of 2005 needs to resolve.

"Firms would be interested in a Zelener fix that clarifies [that the contracts in the Zelener case] are indeed under CFTC jurisdiction, then it would require firms not currently registered to become registered. And if solicitors [of these contracts] are brought under CFTC jurisdiction those firms would have to make a choice, 'Am I going to stay in this business and go through the registration process and be subject to CFTC and probably NFA jurisdiction, or am I going to get out of that business.' Those are the major factors.

"It's bad public policy to allow people to set up boiler rooms and bucket shops that offer these things that look like, smell like and act like futures contracts. And then cleverly being able to work their contracts by saying 'you can't come after us because it's not a futures contract.' That is in our view what it comes down to," Driscoll says.

Dan O'Neil, principal at Xpresstrade, says, "We wouldn't be surprised to see Congress attempt to define more clearly the differences between futures, spot and forward contracts. This was, after all, the crux of the issue in the Zelener matter. Ultimately, the CFTC's enforcement case was dismissed because it was found that forex contracts were outside the [CFTC's] jurisdiction, which is limited to futures contracts."

Mark Galant, CEO at Gain Capital Group, says, "After the Zelener decision, there is no question that the reauthorization will include specific language about the CFTC's jurisdiction over retail forex."

THIRD PARTY LOOPHOLE

Besides the Zelener decision, there's a lingering loophole that allows unregulated third party soliciting agents who do business through registered members to avoid CFTC registration.

While exchanges, which are already regulated, won't be affected by regulation, they welcome a resolution to the Zelener loophole.

"The loophole in the CFMA enables unscrupulous individuals to create so-called 'bucket shops' that advertise on late night TV and target the unsuspecting customer with false promises about foreign exchange trading," says Terry Duffy, chairman of the Chicago Mercantile Exchange (CME). "Unfortunately, some people might think these transactions occur on an exchange, but they do not, and so they have none of the investor protection provided by a regulated exchange. The issue is a growing concern to CME and that is why we strongly urge Congress to close the loophole by reversing the Zelener case in order to protect individuals from potential fraud."

Galant says his firm advocates mandatory registration of introducing brokers and other third parties.

Others agree. "Everyone doing business with a retail client should be registered," says Muhammad Rasoul, COO of Global Forex Trading "What we're looking for is definition and consistency, we just want to make sure everyone has to play by the same rules and that it's clear who's going to be regulating us."

Third party solicitors can be any individual or firm already in the business of trying to encourage the retail public to trade forex. This includes NFA members, introducing brokers, commodity pool operators or commodity trading advisors.

The NFA works closely with the CFTC and has been working to expand its authority in the forex market, but it would like to see the CFTC gain more authority over third parties.

"There is a myriad of ways that this can be accomplished," Driscoll says. "The NFA position is that we just want to see the general principal fulfilled, we're not particular in the specific way it gets done as long as the overall big picture solution gets accomplished."

Driscoll says one of the perceived loopholes in the CFMA is that the jurisdictional language focuses on who the counterparty is but is silent on individuals or firms that might be out soliciting the public.

"The whole idea that soliciting agents are brought into CFTC jurisdiction is something that is on the table for CFTC reauthorization," Driscoll says. "There tends to be more across the board support for doing something ... some sort of changes that anyone who's involved in soliciting the public on retail forex would be brought under the gambit of the CFTC."

The NFA adopted some forex rules in December 2003. "First we adopted the rule that said our forex dealer members, who are all registered futures commission merchants (FCM) that do retail forex, would be themselves jointly and separately liable for any bad things that any of their soliciting agents did who weren't registered NFA members," Driscoll says.

The NFA also adopted a rule that states that any NFA member introducing business to a forex FCM would be responsible for violations of the NFA's forex rules.

"Right now we have about 25 NFA-member FCMs that are forex dealer FCMs," Driscoll says. "We currently have a rule in place that says that if they employ third-party account managers or solicitors who become NFA members then the forex dealer FCM is not liable for all of their actions. But if they employ firms that are not registered NFA members then they are responsible for all of their actions. It still doesn't bring this in to the CFTC jurisdiction. It still doesn't require a registration for those people. But at least we were able to adapt our rules to make them responsible to us if they're going to be our members.

"Our rules can only apply to NFA members and you can't become an NFA member unless you're registered with the CFTC," says Driscoll, noting that the only way to crack down on these firms would be to have Congress require they register with the CFTC, which in turn would force them to become members of the NFA, and subject to its rules. "We were able to do certain things ourselves within our own authority to make sure that the rules applied to our members. Congress really is the only one that can make sure they come under the jurisdiction of the CFTC, and as a result of that the NFA, and that's why were talking with Congress." Driscoll says.

A LONG PROCESS

The Agricultural, Nutrition and Forestry Committee has met to consider a bill to reauthorize the CFTC. The proposed bill is a starting point for discussion on the final CFTC legislation planned for late September consideration by the Senate. A bill has to go through both houses of Congress and there are particular committees and subcommittees at the House and Senate that are responsible for this. They propose bills that go through both houses and then the president. Reauthorization can take longer than a year.

While the NFA and the CFTC continue to seek a clear regulatory mandate for forex and expand their authority, forex firms still say there's not too much regulation in their industry.

"Greater forex regulation is a complicated issue for many forex dealers," O'Neil says. "On the one hand, those firms which are duly registered with the CFTC and NFA as FCMs and therefore subject to continuous monitoring and strict regulatory requirements would welcome greater oversight because it will bring some of the unscrupulous operators into compliance, or force them out of the business. Stronger [regulation] may lend greater legitimacy and credibility to the forex arena, which will give investors and traders more confidence to participate in the market," he says.

"On the other hand, more regulation is always burdensome and costly," O'Neil says. "The futures industry is among the most tightly regulated businesses on the planet, so additional scrutiny, rules and requirements are never especially welcomed.... U.S. firms are competing against some very motivated, innovative and talented foreign rivals. We have to be careful that we don't ask U.S. firms to compete in this global marketplace with one hand tied behind their backs."

O'Neil adds, "Greater regulatory oversight will lend credibility to the industry and give investors the confidence they need to participate."

Rasoul says, "Initially it was a concern that there would be too much regulation, but so far I haven't seen anything that's overreaching."

He also says the proposed bill does a good job of putting to rest the Zelener issue and the definition of what the CFTC has authorization to regulate. The proposed bill can be found at www.agriculture.senate.gov/Hearings/hearings.cfm?hearingId=1585.

"The proposed bill looks to clarify the authority of the CFTC in regards to foreign exchange transactions," Rasoul says. "The definition is robust enough to cover the Zelener issue, but it looks like they just weren't thinking about the Zelener case, but fraud in general in the retail market place. So they're trying to use language that covers enough foreign exchange transactions so that anything else that may come up in the future, that they have regulatory authority over it."

He also says the Zelener problem will be a non-issue going forward.

RELATED ARTICLE: REGISTERED FOREX FCMS

Futures has tracked down the main players in the retail e-forex business to provide you with an idea of their experience, flexibility and customer support. This table includes two lists: forex-only firms and futures and forex firms. Forex-only firms are ranked here by adjusted net capital. Firms offering trading in both cash or e-forex and futures are not included in the forex-only ranking because their futures-related capital does not necessarily reflect just forex market activity. Firms offering both futures and forex are listed separately in alphabetical order.

                              Adjusted net
                              capital as of   Years in
                              6/30/05         business (1  Offices

FOREX ONLY
Oanda Corp.                    18,248,048      5            3
Gain Capital Group (4          17,700,952 (5   6            3
Forex Capital Markets (FXCM)   16,017,836      6            6
Global Forex Trading (6        13,853,413      8            5
Hotspot FX                      6,579,737      6            1
CMC Markets                     6,291,438     16            7
FX Solutions                    4,115,718      5            2
MG Financial Group              3,753,520     13            1
Capital Market Services         1,690,293      6            1
COES FX Clearing Inc.             490,370      3            1

FUTURES AND FOREX
Alaron FX                       3,872,509      5            6
Fimat FX                      348,365,972     11           17
GFS Securities & Futures        1,035,042      3            1
Peregrine Financial Group       5,757,103     11           10
Refco FX (7                   337,758,112      3            2
TradeStation Securities Inc.   28,442,658      2            1
Xpresstrade                     4,771,115      4            1

                              Regulated    Minimum     Minimum
                              in other     account     lot size
                              domains? (2  ($)         ($)

FOREX ONLY
Oanda Corp.                   N                 1            1*
Gain Capital Group (4         N               250       10,000
Forex Capital Markets (FXCM)  FSA; SFC        300       10,000
Global Forex Trading (6       ASIC            250       10,000
Hotspot FX                    N             7,500      100,000
CMC Markets                   ASIC; FSA     2,000       10,000
FX Solutions                  N               250        1,000
MG Financial Group            N               200       10,000
Capital Market Services       N               200       10,000
COES FX Clearing Inc.         N             5,000      100,000

FUTURES AND FOREX
Alaron FX                     N               300       10,000
Fimat FX                      FSA          none***     none***
GFS Securities & Futures      N            20,000      100,000
Peregrine Financial Group     N            Negotiable   10,000
Refco FX (7                   N               300       10,000
TradeStation Securities Inc.  N             5,000       10,000
Xpresstrade                   N               300       10,000

                              Are          Number of
                              commissions  currency pairs  Exotic
                              charged?     offered         currencies?

FOREX ONLY
Oanda Corp.                   N            30              Y
Gain Capital Group (4         N            17              N
Forex Capital Markets (FXCM)  N            20              Y
Global Forex Trading (6       N            62              Y
Hotspot FX                    Y            16              Y
CMC Markets                   N            60+             Y
FX Solutions                  N            10              N
MG Financial Group            N            10              N
Capital Market Services       N            18              N
COES FX Clearing Inc.         N**          19              Y

FUTURES AND FOREX
Alaron FX                     N            14              Y
Fimat FX                      Y            60              Y
GFS Securities & Futures      N            15              N
Peregrine Financial Group     Y****        12              N
Refco FX (7                   N            20              Y
TradeStation Securities Inc.  N            15              Y
Xpresstrade                   N            20              N

                              Pip spread
                              (most popular  Wireless
                              pairs)         trading? (3

FOREX ONLY
Oanda Corp.                   1.2 to 3       N
Gain Capital Group (4         3 to 5         Y
Forex Capital Markets (FXCM)  3              N
Global Forex Trading (6       3              Y
Hotspot FX                    1 to 3         N
CMC Markets                   3 to 4         N
FX Solutions                  3              N
MG Financial Group            3 to 5         Y
Capital Market Services       3 to 5         N
COES FX Clearing Inc.         1              N

FUTURES AND FOREX
Alaron FX                     3 to 5         Y
Fimat FX                      1 to 2         N
GFS Securities & Futures      3 to 5         Y
Peregrine Financial Group     1 to 5         N
Refco FX (7                   3              N
TradeStation Securities Inc.  3 to 5         N
Xpresstrade                   3 to 4         N

Key
1) For "Futures and Forex Firms," this number refers to number of years
forex trading has been available.
2) ASIC (Australia); FSA (U.K.); SFC (ASIA).
3) Mobile order entry typically using PDAs.
4) Operates Gain Capital, Inc. and Forex.com.
5) Numbers reflect Gain Capital's figures. Does not reflect additional
net capital held at Gain Capital Group.
6) Division of Global Futures and Forex Ltd.
7) Division of Refco.
* Oanda does not use concept of lots; trades can occur in any size.
** $10 transaction fee per lot.
*** No retail accounts.
**** Commissions are charged with best bid and offer and vary.
Note: Only registered clearing firms are listed. Some introducing
brokers offer third party e-forex services, and those firms and their
services are not included here.

Source: CFTC, the firms