NFA Requirements: Good Question Atomm
We have recieved this same question from a few different individuals, so let me answer it here for once and for all! I am going to post this message from our VP of Business Development, Justin LeBlang. He answers all you wanted to know about the NFA requirements. I hope this answers it ALL! :
Hi all-
Well, looks like someone started a situation in the last 24 hours and I want to talk everyone through exactly what is going on. Let’s start with the facts, then move to the reality, and then maybe a little opinion. As you know, I try not to spend time naming or talking about other brokers specifically. My job is to help you out with EFX and not try to answer questions about (or bad-mouth) another platform.
The story that started all of the boards talking this morning was a post that the NFA is about to move the minimum net capital requirement to $5 million, and that they are closing the doors on a bunch of companies over the last few weeks. Along with about 20 other platforms, we were listed by whomever wrote the post as being “at risk” because we currently show a net cap that is well above the minimum currently required, but we don’t show $5 million.
Now, the clever part of the post that was put out there (you’d have to look at the bigger firms that intentionally maintain a higher net cap to figure out who had the motivation to do this) is that it implies that because six brokers doors were “shuttered” (term used in the post), the other 20 or so are in danger and the NFA is out to kill. This is a fairly ridiculous link. The firms that were closed had problems with their net capital dropping under the CURRENT minimum. In some cases, they were basically out of money. Of course they were closed after the NFA did their due diligence per the guidelines and eventually determined that they were not going to get their net cap back up.
Folks, the NFA is a regulatory body. They want to protect the public, but they also exist because of forex platforms. If they shut them all down unnecessarily, they hurt themselves too. They come around, they charge fees, they do audits, etc. Let’s set some facts straight.
The way we understand it, the NFA is going to vote on July 1 whether to raise the minimum net capital requirement to $5 million, up from the current $1.5 million. If they do approve that (that’s the first IF, nothing changes in the world if they don’t), then member firms will have until January 1, 2008, to get their net capital to $5 million. Do we feel like this would be an issue for us, as we already hold much more than the current requirement and over half of what we need to the potential new requirement? No. So let’s just take the vote at face value, assume that it happens, and then address what it should mean for us in the easiest solution. Nothing. I should point out that it wasn’t long ago that the NFA raised the minimum net capital from a few hundred thousand to $1.5 million, and we met that without any issues even though we weren’t showing it before.
They aren’t going to walk into all of these firms on July 2 and shut them down. And, just so we’re clear, if the NFA moves the cap requirement up and a firm can’t get the money in to meet the requirement, that doesn’t mean that your money as a customer is affected. Some of the things that I’ve heard over the last 24 hours are so crazy. Here’s one: “If the NFA moves the net cap requirement up and a firm can’t comply, don’t we lose all of our money as the customers of the firm because they have to close?” Huh? No relation. The firm would first need to lose all of their assets and then yours for that to be the case.
Let me talk a little bit about other options for some of the smaller firms. There is nothing that says that any of these firms have to be NFA members. They can operate through the SEC or NASD.
Before I get to what this means in a practical sense, let me post two paragraphs from MB Trading Futures' (our FCM) compliance department dealing with the issue:
"First, the National Futures Association (NFA) has noticed its Forex Dealer Members (FDM) of a new proposal to increase the minimum net capital requirements of those members. The proposal is in the early stages of the approval process; it has not been approved by the NFA Board, which is the minimum requirement.
NFA is simply providing FDMs with an opportunity to respond to the proposal that recommends increasing the minimum net capital requirements of FDMs to $5 million from $1 million (or 5% of total customer liabilities, whichever is greater), which are due on July 6, 2007. NFA will draft a final version of the proposal based on comments received from FDMs. The final version of the proposal will be submitted to NFA’s Board for approval. NFA’s Board could approve the final version or a modified version of the final proposal. Once the proposal is finally approved by the NFA Board, it must be submitted to the CFTC for approval. CFTC could approve the finalized version of the proposal as submitted by the NFA Board or approve a modify version. It is anticipated that the final stage of the approval process will be December 2007 at the earliest."
Now, those are the facts. Let’s talk about what this means in the real world. Why do firms need a net capital in the first place? I find it disturbing the number of people that trade forex and don’t understand how it works. 99% of firms out there are deal desks, including several that are pretending not to be. It doesn’t have anything to do with the size of their spreads or their software. It means ONE thing. They make their income by trading against YOU. You buy, they sell to you. You sell, they buy from you. At the end of the day, it’s very simple. They make money when their customers collectively lose money. Now, stop and think about it for a second. You’re a firm. You have hundreds or even thousands of customers, and you have to provide them with a quote (which you have complete control to move around REGARDLESS of what the real banks are showing on the interbank system). What happens if all of your customers want to buy the EURUSD one day? You’re selling it to them.
Forex is a highly leveraged deal. What if the EURUSD keeps going up? The firm is short and selling more if the customers are buying. While obviously most deal desks make a ton of money, the RISK of being the platform is huge. If you get caught heavy in the wrong direction and the market goes hard against you, you can eat up everything that your firm is worth quickly. And, just so we are clear, if a firm has a $5,000,000 capitalization and then all of their customer money, if they lose $8,000,000 on an “event,” meaning a big loss against their customers, they have no capital, and the customer assets are seized next. That’s the same in any financial business, brokerages and banks included. Whatever capital is required, and then potentially some insurance level for the company or the customers, and then any event that creates a loss that exceeds that and the customer money is at risk. This isn’t just forex. There was a major national stock brokerage firm in the last couple of weeks that went from having millions and millions of dollars to negative $18 million or so due to a bad trade/investment in the bond market. Firm is gone, customers are scrambling. It can happen.
And of course, in reality, just because a firm/brokerage/bank has a huge net capital doesn’t mean that things are safer. They tend to take bigger risks with that money because they need a return on that money. They don’t just leave it sitting in cash. So a firm with a $50,000,000 net capital is probably showing a risk level that is more in line with having that sort of valuation, which means they can get hit just as hard and fast if they don’t know what they are doing as a smaller operation.
Now, what is the situation with us here at EFX? We are, as has been discussed forever on these boards, NOT a deal desk. At all. Remotely. I challenge anyone to suggest differently. We’ll get on a webinar and walk you through it. Your order sits on a server that no one sees and when that order becomes marketable, it hits a bank in the interbank system. We don’t take the other side of your trade. Ever. Therefore, we aren’t at the same level of risk that all of these deal desks are on a daily basis. We pass your order through and settle your exchange of currency at the end of the day between ourselves and the bank that took the trade at the price that your order executed against the bank. We charge you a fee for making that transaction possible. Obviously, it’s working. We have so many banks now in the system that our EURUSD quote spends much of the day under 1 pip. So does the GBPUSD. Ever heard the phrase “When banks compete, you win”? Maybe we should have had that motto first.
So where is our risk of having financial troubles? The biggest risk lies in overseeing our customer accounts. If someone has $1000 in their account and buys 5 GBPUSD and the GBPUSD goes down 180 pips, the account is down to $100. That’s where the customer is at risk, because a news spike could then drop it a quick 40 more pips, and now the customer account has gone negative. We wish that everyone traded with a stop in the system to prevent this situation from arising, but they don’t. So, we have extensive systems in place that includes human and computer monitoring to make sure that accounts that get near zero are watched appropriately. We don’t want to close out a position for a customer, but when people trade without stops and get themselves into that type of situation, of course we have to. We have to protect ourselves and all of our other customers. Beyond that, our risk is really just our operations, the cost of having a back office that does what we do. That is not significant compared to the risk that most deal desks have to show daily.
Now, here’s my opinion. What you are seeing is exactly what we have wanted to see from this industry. It is regulating itself better to protect the consumer (trader). Doing so requires raising the amount of money necessary to do business. This keeps the smaller, less-capitalized players out, which is good for the consumer. We believe that LOWER leverage levels are going to be mandated eventually. No one makes money trading at 400 to 1. They get crushed. 100 to 1 or 50 to 1 as a maximum would be sufficient. The professional traders who make money in this business don’t trade anywhere near that level anyway. The industry needs to enforce better “truth in advertising” laws, and we’re seeing that more and more. You can’t pretend that you aren’t a dealing desk just because people like to hear you say that, but then make your money in the spread. If you aren’t charging a fee for providing a customer with an execution, then by definition, you are a dealing desk. Period. I have no idea if the NFA is actually going to raise the net capital requirement, but we see all of this as a positive as we continue to develop and prepare to deploy Project Omega, and we look forward to further improvements in the industry that help protect the consumer. And of course, we will comply with the guidelines of a regulatory body, as we always have.
Hope this answers everyone’s questions. Maybe after the week of Fourth of July, we will do a special webinar event to talk openly and answer direct questions. I’ll try to set it up with one of our VPs. Trade well.
__________________
Justin LeBlang
EFX Group
Thanks.
Andy Geller
EFX Group
