Dodd-Frank Precious Metal Trading Prohibition Could Make Hedge Fund FX Trading Illegal
Below we present some additional analysis on the implementation of Dodd-Frank's precious metal and FX OTC spot trading prohibition from law firm Morgan Lewis, as well as another potentially far more disturbing implication for non-US Hedge Funds which trade FX (and since virtually all hedge funds are located offshore due to tax implications, and since most hedge funds have now shifted to FX trading in an attempt to pursue volatility, we imagine this means absolutely everyone in the space). Basically it appears that hedge funds that have "one single US investor [who] has less than $10 million in investable assets, that fund will be classified as a retail FX fund. If an FX fund has investors that fail to meet the $10 million threshold,
that fund would therefore not be considered an eligible contract
participant. Gary Alan DeWaal, senior managing director and group general counsel at prime brokerage firm Newedge, said most non-US FX hedge funds seemed unaware of these obscure, burdensome requirements. “Most hedge funds would not think that they are retail funds. However, all it takes is one US client, who fits into this bracket to make them a retail FX fund. I think a lot of hedge funds could be forced to either throw out these clients from their funds or change their counterparties,” added DeWaal." Forget the liquidity freeze courtesy of Greece. Our own congressional and senatorial idiots are about to do it on their own without any country having to go into default.
And from COO Connect:
Hedge funds trading FX could be caught out by Dodd Frank
Non-US hedge funds trading in FX could be forced to find new US
counterparties if they want to avoid being inadvertently fined for
non-compliance by US regulators under some of the more obscure
provisions in the Dodd Frank Act.
Under Dodd Frank, hedge funds
trading FX with a US investor base constituting more than 10% of the
overall investors, would fall under US jurisdiction. However, if one
single US investor has less than $10 million in investable assets, that
fund will be classified as a retail FX fund. This is because Dodd Frank
states all investors must be eligible contract participants – not just
If an FX fund has investors that fail to meet the $10
million threshold, that fund would therefore not be considered an
eligible contract participant. This extra-territorial legislation could
force some non-US funds to change their counterparties and use certain
US Futures Commission Merchants (FCMs) or other US registrants.
Alan DeWaal, senior managing director and group general counsel at
prime brokerage firm Newedge, said most non-US FX hedge funds seemed
unaware of these obscure, burdensome requirements. “Most hedge funds
would not think that they are retail funds. However, all it takes is one
US client, who fits into this bracket to make them a retail FX fund. I
think a lot of hedge funds could be forced to either throw out these
clients from their funds or change their counterparties,” added DeWaal.
things stand, numerous Dodd-Frank provisions look set to be implemented
within 60 days unless Congress, the Securities and Exchange Commission
or the Commodity Futures Trading Commission raises any major objections
And going back to the topic at hand, some further advisory insight from Morgan Lewis on the upcoming OTC precious metal trading halt:
As things currently stand, on July 16, when the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act)
becomes effective, Securities and Exchange Commission (SEC)-registered
broker-dealers (BDs) will no longer be able to enter into many types of
foreign currency transactions for their retail customers.
Although the law is not entirely clear, there is even a question as to
whether BDs may purchase foreign currency for retail customers in
connection with foreign securities trades if the settlement date for the
currency transaction extends beyond two days.
The reason for these changes is that the Dodd-Frank Act included a
requirement that the applicable functional regulator pass rules
governing conduct of a regulated entity regarding retail forex in order
for an entity to be able conduct such business. The Commodity Futures
Trading Commission (CFTC) has passed rules and the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have proposed rules, but the SEC has done neither.
The bad news for BDs does not end there. A provision in the
Dodd-Frank Act disallows a BD from using its CFTC-registered futures
commission merchant (FCM) to conduct such foreign currency transactions
(even though a stand-alone FCM may legally carry out the trades), and
the CFTC has provided in its rules that a BD may not solve its problem
by registering as a retail foreign exchange dealer (Forex Dealer). Going
forward, unless the SEC acts, the only types of entities that may
solicit and effect foreign exchange transactions with customers that are
not "eligible contract participants" (ECPs) are banks and stand-alone
FCMs and Forex Dealers. Investment advisers that assist retail customers
will also have to separately register as commodity trading advisers
(CTAs) in order to advise on foreign exchange trades carried out at FCMs
and Forex Dealers.
The potential impact of these changes on existing transactions
between retail customers and BDs leaves room for doubt regarding their
ongoing validity. As a result, BDs and investment advisers that work
with retail customers should evaluate their current foreign exchange
business and evaluate how best to address the changes from a structural
perspective, including possibly moving existing transactions to a bank
affiliate or a stand-alone FCM or Forex Dealer.
Retail Forex Transactions
The Commodity Exchange Act (CEA) provides that only enumerated
regulated entities are permitted to "solicit" or transact in
off-exchange foreign currency transactions (forex transactions) for
These regulated entities include U.S.-regulated banks, SEC-registered
BDs, FCMs, and Forex Dealers. Covered forex transactions include
forwards and options conducted in the over-the-counter market as well as
off-exchange futures and leveraged transactions that do not result in
actual delivery of currency. An ECP is defined in Section 1a(18) of the
CEA, as amended by the Dodd-Frank Act, and includes, for purposes of
transacting in foreign exchange, (i) a corporation, partnership,
organization, trust, or other entity (other than a commodity pool) that
has total assets exceeding $10 million; (ii) an individual that has in
excess of $10 million "invested on a discretionary basis";
and (iii) a commodity pool that is formed and operated by a person
regulated under the CEA (but only if all of the participants in the pool
Spot transactions are excluded from the scope of the regulation, as
are physically settled transactions that are not "offered, or entered
into, on a leveraged or margined basis, or financed by the offeror."
Spot transactions are narrowly defined to include only physically
settled transactions settling in two business days and transactions that
create an enforceable obligation to deliver among persons that have the
ability to do so in connection with a line of business.
Neither the SEC nor the CFTC has provided interpretive guidance on what
it means for a transaction to be entered into on a leveraged or
margined basis or to be financed by the offeror. Although it would be
appear contrary to the common meaning of the term "financing," a
currency conversion carried out by a BD in connection with a securities
purchase for a retail customer could be interpreted to be a "financing"
due to the settlement risk. As a result, to the extent that the statute
was to be interpreted in this way, BDs would not be eligible to carry
out those conversions for retail customers after July 16, absent SEC
relief. While a BD could avoid this result by settling the foreign
currency conversion T+2 (ahead of the T+3 settlement for the security),
that approach would impose additional market risk on either the customer
or BD, depending upon how the one-day pricing risk was allocated.
Broker-Dealers Offering Retail Forex
Although the CEA provides that enumerated regulated entities may act
or offer to act as counterparty in retail forex transactions, the
Dodd-Frank Act added Section 2(c)(2)(E)
to the CEA, which provides that an otherwise regulated entity, such as a
bank or BD, for which there is a federal regulator, may not offer or
enter into retail forex transactions unless offered pursuant to rules of
the applicable federal regulator.
The applicable regulator for BDs is the SEC. However, to date, the SEC
has not published rules and the staff has informally suggested that the
SEC is not likely to do so. As a result, as of July 16, 2011, BDs will
no longer be able to effect transactions to purchase or sell currency
for their retail customers, unless the currency transaction will be
physically settled in two business days or otherwise falls outside the
coverage of the CEA (e.g., because the transaction is not leveraged,
margined, or financed). The CEA does not include exemptions for hedging
or de minimis transactions.
The prohibition on soliciting and transacting in retail forex applies
to every type of BD. As a result, clearing firms will not be able to
facilitate retail forex trades for customers of their U.S. and foreign
correspondents. A correspondent BD would not be allowed to handle
execution of retail foreign exchange itself (e.g., through its
institutional foreign exchange desk) unless the customers are ECPs. BDs
that direct retail forex to another entity that is appropriately
registered for the business (e.g., an FCM) would not be affected.
The CFTC's ability to fix this problem is limited. The CFTC is not
allowed to regulate or have its rules apply to a BD. The CEA expressly
provides that a BD may not qualify to carry out this activity by routing
the business through an FCM that is part of the BD. In its forex rules,
the CFTC has similarly provided that a BD may not address the problem
by dually registering as a Forex Dealer. As a result, unless the SEC acts, retail forex may only be conducted by a regulated entity that is outside of a BD.
BDs who currently conduct retail forex transactions for their
customers should work with their customers to open separate accounts for
the business at an FCM, bank, or Forex Dealer. In terms of legacy
transactions, it is not clear whether or not they would continue to be
enforceable and legal if carried by the BD. As a result, absent SEC
relief, BDs may want to consider novating them to a properly regulated
FCM, bank, or Forex Dealer.
Investment advisers are also impacted by these rules. Under the CEA
and CFTC rules, a person who exercises discretionary authority over a
retail forex account carried at an FCM or Forex Dealer must itself
register as a CTA. The CEA excludes from this requirement other
regulated entities that are permitted to act as counterparty to retail
transactions, but does not exclude registered investment advisers. Since
BDs will no longer be a type of authorized entity for such activity,
financial advisers and other types of registered investment advisers
(RIAs) will no longer be able to advise retail customers on foreign
exchange transactions conducted through an FCM or Forex Dealer unless
they are licensed as a CTA with the CFTC. To the extent that the retail
foreign exchange transactions on which an adviser provides advice are
executed through a bank, a discretionary adviser will not be required to
register as a CTA.
Section 4(a) of the CEA provides that contracts executed in violation
of the CEA are illegal. As a result-notwithstanding that many of the
retail forex transactions carried out today may in fact be outside of
the class of transactions regulated by the CEA, as may be much of the
advice on forex that is provided to retail customers by investment
advisers-given the lack of clarity and the fact that transactions
conducted in violation of the CEA pose risks regarding the
enforceability of trades, BDs and investment advisers should examine
their retail foreign exchange activities and consider moving their
affected business to an FCM, Forex Dealer, or a bank.
If you have any questions or would like more information on the
issues discussed in this LawFlash, please contact any of the following
Morgan Lewis attorneys:
. Pub. L. No. 111-203 (2010).
As an example, if a customer places an order to purchase ordinary
shares of British Petroleum, payment must be made in British pounds
sterling. If the customer only has U.S. dollars in his or her account,
the BD executing the transaction must purchase the pounds by settlement
date to deliver in payment for the ordinary shares. Settlement of the
stock purchase is typically T+3, or longer than the two business days
referenced in the Commodity Exchange Act for "spot" currency
transactions that are excluded from the requirement that a regulated
entity act as counterparty. Whether the conversion may be legally
carried out by a BD depends on whether the BD would be deemed to be
"financing" the conversion or not.
. See 76 Fed. Reg. 28358 (May 17, 2011).
. See 76 Fed. Reg. 22633 (Apr. 22, 2011).
. Section 2(c)(2)(B)(i)(II of the CEA
This provision is stricter than the current definition that counts as
an ECP a natural person having more than $10 million in assets.
. Section 2(c)(2)(B)(i)(II) of the CEA.
. Section 742(c) of the Dodd-Frank Act.
Section 2(c)(2)(E)(ii)(I) of the CEA prohibits an otherwise regulated
entity, such as a registered BD, from entering into a forex transaction
described in 2(c)(2)(B)(i)(I) of the CEA, unless done pursuant to rules
of a federal regulatory agency. The transaction described in section
2(c)(2)(B)(i)(I) of the CEA is a transaction in foreign currency that
"is a contract of sale of a commodity for future delivery (or an option
on such a contract) or an option" not executed or traded on an exchange.
The scope of what constitutes a transaction that would be covered by
the provision is not clear and has been the source of prior litigation. See CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), reh'g denied, 378 F.3d 624 (7th Cir.).
. 17 C.F.R. § 5.1(h)(1).
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