Alert July 19, 2011

SEC Adopts Interim Final Rule for Broker-Dealers Engaging in Retail Foreign Exchange Transactions

The SEC adopted an interim final temporary rule (the “Interim Retail Forex Rule”), effective July 15, 2011, which permits broker-dealers registered with the SEC to continue to engage in foreign exchange transactions with persons who are not “eligible contract participants.”  This rulemaking was made necessary by Section 742(c) of the Dodd-Frank Act, which amended the Commodity Exchange Act (“CEA”) effective July 16, 2011 to provide that a person for which there is a Federal regulatory agency, including a broker‑dealer registered under Section 15(b) (except pursuant to paragraph 11) or 15C of the Securities Exchange Act of 1934 (the “Exchange Act”), may not enter into, or offer to enter into, a foreign exchange transaction described in Section 2(c)(2)(B)(i)(I) of the CEA with a person who is not an eligible contract participant as defined in the CEA (an “ECP”) except pursuant to a rule or regulation of a Federal regulatory agency allowing the transaction under such terms and conditions as the agency shall prescribe (a “retail forex rule”).  Transactions described in CEA Section 2(c)(2)(B)(i)(I) include “an agreement, contract, or transaction in a foreign currency that … is a contract of sale of a commodity for future delivery (or an option on such contract) or an option (other than an option executed or traded on a national securities exchange) registered pursuant to section 6(a) of the [Exchange Act].”

Under Section 742, a retail forex rule must provide for similar treatment of all agreements, contracts and transactions in foreign currency that are functionally or economically similar to agreements, contracts or transactions described in CEA Section 2(c)(2)(B)(i)(I).  Section 742 also requires a retail forex rule to prescribe appropriate requirements with respect to disclosure, recordkeeping, capital and margin, reporting, business conduct, and documentation, and may include such other standards or requirements as the Federal regulatory agency determines to be necessary.

As a consequence of Section 742’s amendment to the CEA, effective July 16, 2011, broker‑dealers registered with the SEC may not engage in off-exchange forex futures and options transactions with a retail customer except pursuant to a qualifying retail forex rule adopted by the SEC.  This prohibition does not apply to forex transactions with a customer that qualifies as an ECP or transactions that are spot forex contracts or forward forex contracts even if the customer is not an ECP.  However, as discussed below, the SEC has determined to treat a so‑called “rolling spot” forex transaction as a retail forex transaction required to be covered by a retail forex rule.

Industry Request for Rulemaking.  In the release adopting the Interim Retail Forex Rule, the SEC states that it had not been aware of industry concerns with respect to the operation of Section 742 of the Dodd-Frank Act in the absence of SEC rulemaking, and that this concern was brought to its attention for the first time in June of 2011.  Without a retail forex rule, after July 16 there could have been adverse effects on the ability of SEC-registered broker-dealers to facilitate the settlement of foreign securities transactions for retail customers, e.g., when a broker‑dealer purchases a foreign currency or exchange a foreign currency for U.S. dollars on behalf of a retail customer in connection with the customer’s purchase or sale of a security listed on a foreign exchange and denominated in the foreign currency.  In particular, the SEC recognized that Section 742 could operate to preclude broker‑dealers from continuing to engage in some types of foreign exchange transactions that are inherent in certain of their customers’ securities transactions, and that serve to minimize their customers’ risk exposure to changes in foreign currency rates.

Because the SEC has not had time to consider and propose for comment rules designed to address investor protection concerns specific to retail forex transactions, the SEC has adopted the Interim Retail Forex Rule, which is designed to enable broker-dealers to engage in retail forex business under the existing regulatory regime for one year.

Operation of the Interim Retail Forex Rule.  The Interim Retail Forex Rule thus does not impose any new substantive requirements on broker-dealers engaging in retail forex transactions.  The heart of the Interim Retail Forex Rule is paragraph (b), which provides that a registered broker or dealer may engage in a retail forex business provided that the broker or dealer complies with the Exchange Act, the rules and regulations thereunder, and the rules of the self-regulatory organizations of which the broker or dealer is a member, including the disclosure, recordkeeping, capital and margin, reporting, business conduct and documentation requirements of those rules and regulations as they apply to retail forex transactions.  Paragraph (a) contains relevant definitions, and paragraph (c) provides that any broker or dealer complying with paragraph (b) will be deemed to be acting pursuant to a qualifying retail forex rule, as required by CEA Section 2(c)(2)(B)(i)(I).  Paragraph (d) provides that the Interim Retail Forex Rule will expire on July 16, 2012. 

Rolling Spot Forex Transactions.  The SEC has determined that rolling spot transactions should be treated as retail forex transactions rather than as spot transactions that are excepted from the definition of retail forex transactions.  A rolling spot transaction is one that initially requires delivery of currency within two days.  In practice, contracts with a retail customer for a rolling spot forex transaction may be renewed for additional two-day periods every other day indefinitely, so that no currency is actually delivered until one party affirmatively closes out the position.  Thus, in the definition of “retail forex transaction” in the Interim Retail Forex Rule, the exception for a spot transaction provides that it must be a contract of sale that (1) results in actual delivery within two days or (2) creates an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business (effectively excluding retail customers who are not engaged in a forex business and do not have the ability to deliver or accept delivery of foreign currency).

Request for Public Comment.  Although it became effective on July 15, 2011, the SEC has requested public comment on the Interim Retail Forex Rule.  The adopting release also requests comment on permanent rulemaking to address retail forex transactions and more generally, on the appropriate regulatory framework for retail forex transactions.  Comments are due 60 days after Interim Retail Forex Rule’s publication in the Federal Register.